Q1) Explain the Origin and Definition of Financial Institutions

Definition: A financial institution is an intermediary between consumers and the capital or

the debt markets providing banking and investment services.

Financial Institution Mean

A financial institution is responsible for the supply of money to the market through the
transfer of funds from investors to the companies in the form of loans, deposits, and
investments. Large financial institutions such as JP Morgan Chase, HSBC, Goldman Sachs or
Morgan Stanley can even control the flow of money in an economy.

The most common types of financial institutions include commercial banks, investment
banks, brokerage firms, insurance companies, and asset management funds. Other types
include credit unions and finance firms. Financial institutions are regulated to control the
supply of money in the market and protect consumers.

Finance is defined as the management of money and includes activities like investing,
borrowing, lending, budgeting, saving, and forecasting. There are three main types of
finance:
(1) Personal
(2) Corporate
(3) Public/government.

The term ―financial services‖ comprises many different things. There are a plethora of
opportunities in the financial sector for candidates to find the right fit. From banking to
investments and beyond, the options are vast and varied.

So if you are considering a career in financial services, you first need to get an idea of the
industry‘s scope in order to decide which path best suits you and your skills.

"Banking institutions" redirects here. For banks as financial institutions, see Bank.

The oldest financial institution in the world, Banca Monte dei Paschi di Siena, founded in
1472.
Financial institutions, otherwise known as banking institutions, are corporations that provide
services as intermediaries of financial markets. Broadly speaking, there are three major types
of financial institutions
Depository institutions – deposit-taking institutions that accept and manage deposits and
make loans, including banks, building societies, credit unions, trust companies, and mortgage
loan companies.

Contractual institutions – insurance companies and pension funds

Investment institutions – investment banks, underwriters, brokerage firms.
Financial institutions can be distinguished broadly into two categories according to
ownership structure:

Commercial
Cooperative

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Some experts see a trend toward homogenisation of financial institutions, meaning a
tendency to invest in similar areas and have similar business strategies. A consequence of this
might be fewer banks serving specific target groups, and small-scale producers may be under-
served.

Let‘s look at an example.

Example
Bank ABC is a shareholder-owned institution that offers banking and investment services to a
wide range of customers. The bank acts as an intermediary between retail and institutional
investors, who supply the funds through deposits and retail and institutional investors, who
are looking for financing. The bank pays a 2% interest on the deposits it accepts from
households and businesses from the interest earned from lending services. In addition, the
bank offers fund management and health and life insurance services through its subsidiaries.

Furthermore, Bank ABC operates in the wholesale market, seeking to lend large
conglomerates and corporations as well as government agencies. In this context, the bank has
a highly-equipped advisory team, which offers corporate finance, forex, capital markets and
investment management services.

The bank is regulated for the protection of consumers. Hence, its funds undergo strict
scrutiny by the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve
System. These two Federal agencies are responsible for guaranteeing that the bank will be
able to repay the borrowed funds.

As already observed financial intermediaries are institutions that serve as ―middleman‖ in the
transfer of funds from savers (millions of households) to those who invest in real assets such
as houses, equipment, factories, etc. These funds can be channeled from surplus units either
directly, e.g; through stocks, bonds or other debt instruments, or indirectly through financial
intermediaries who hold these primary claims as investments, obtain funds from them by
issuing secondary claims on themselves like safe deposits, insurance policies, mutual funds,-
etc., and sell them to the surplus units (savers).

Banks are the biggest financial intermediaries. Many non-¬banking institutions like UTI,
LIC, GIC also act as intermediaries, and when they do so they ate known as non-banking
financial intermediaries (NBFI). Some non-intermediaries, e.g., IDBI, IFC, NABARD have
been set up by the government, they are called non-banking statutory financial organizations
(NBSFO). The Indian financial system also comprises a large number of privately owned,
decentralized and relatively small-sized financial intermediaries which are either primarily
engaged on fund based activities, while the others primarily provide financial services. For
convenience the former are called non-banking financial companies (NBFSCs).

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Q2) Explain the Concept of Financial Institutions

The financial sector in the Indian economy has had a checkered history. The story of the post-
independent (i.e., post-1947) Indian financial sector can perhaps be portrayed in terms of
three distinct phases—the first phase spanning over the 1950s and 1960s exhibited some
elements of instability associated with laissez faire but underdeveloped banking; the second
phase covering the 1970s and 1980s began the process of financial development across the
country under government auspices but which was accompanied by a degree of financial
repression; and the third phase since the 1990s has been characterized by gradual and
calibrated financial deepening and liberalization. While the present paper is devoted primarily
to the period since the 1990s, we also provide a brief account of the earlier two phases.

Indian Financial Sector: 1950–1990

From Laissez Faire to Government Control
The Reserve Bank of India (RBI) was founded in 1935 under the Reserve Bank of India Act
―…to regulate the issue of Bank Notes and keeping the reserves with a view to securing
monetary stability in India and generally to operate the credit and currency system of the
country to its advantage.‖ Apart from being the central bank and monetary policy authority,
the RBI is the regulator of all banking activity, including non-banking financial companies,
manager of statutory reserves, debt manager of the government, and banker to the
government.
At the time of independence in 1947, India had 97 scheduled private banks, 557
―nonscheduled‖ (small) private banks organized as joint stock companies, and 395
cooperative banks. Thus, at the time of India‘s independence, the organized banking sector
comprised three major types of players, viz., the Imperial Bank of India, joint-stock banks
(which included both joint stock English and Indian banks) and the foreign owned exchange
banks. The decade of 1950s and 1960s was characterized by limited access to finance of the
productive sector and a large number of banking failures. Such dissatisfaction led the
government of left-leaning Prime Minister (and then Finance Minister) Mrs Indira Gandhi to
nationalize fourteen private sector banks on 20 July 1969; and later six more commercial
banks in 1980. Thus, by the early 1980's the Indian banking sector was substantially
nationalized, and exhibited classical symptoms of financial repression, viz., high pre-emption
of banks' investible resources (with associated effects of crowding out of credit to the private
sector), subject to an intricate cobweb of administered interest rates, and accompanied by
quantitative ceilings on sectoral credit, as governed by the Reserve Bank of India. Besides
the commercial banks, there were four other types of financial institutions in the Indian
financial sector: development finance institutions (DFIs), co-operative banks, regional rural
banks and post-offices.

Over the 1950s and 1960, in the absence of effective capital markets, a network of DFIs was
established over much of the developing world, usually encouraged by external aid agencies.
The sources of funds of these DFIs were diverse but raised primarily from the domestic bond
market, from multilateral institutions like the World Bank, refinance window of the RBI, and
government budgetary provisions. But by the 1990s, with stoppage of refinance from the RBI
and government budgetary provisions, and accumulation of nonperforming assets, it became
clear that the DFIs would not be viable in the long run. Consequently, the IDBI and ICICI
have been converted into commercial banks, and the IFCI is effectively non-functional.
NABARD, the NHB and SIDBI are continuing largely as refinance institutions with support
from the government.

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 As of 2015, there are 1,579 urban co-operative and 94,178 rural cooperative banks. A
majority of these banks tend to operate in a single state, and they are regulated and supervised
by state-specific Registrars of Cooperative Societies (RCS), along with overall oversight by
the Reserve Bank of India. Thus there has been dual control of regulation and supervision of
co-operative banks between the state-specific RCSs and the RBI, which has often been
problematical. They have also suffered from governance problems along with the incidence
of frequent local political interference which has hampered the effectiveness of these banks.
There have also been slow to modernize.

Regional Rural Banks (RRBs) were established in 1975 as local level banks in different states
of India. They are co-owned by the Central and State Governments, and by sponsoring public
sector banks. Unlike the cooperative banks, RRBs are structured as commercial banks and
were established with a view to developing the rural economy. They were envisaged to create
a supplementary channel to the 'Cooperative Credit Structure' for enlarging institutional credit
extended to the rural and agriculture sectors. While these were vehicles for financial
inclusion, their high cost-income ratios and non-performing assets have been causes of
concern. Thus, there have been substantial mergers within this sector and the number of
RRBs has come down from 196 in 1990 to 56 in 2015.

The Post Office Savings Bank (POSB) has a customer base of about 330 million account
holders as on March 2015 (Government of India, 2016) thereby contributing significantly to
financial inclusion on the deposit side. However, observers of financial inclusion in India
often count only bank accounts and neglect the coverage of post office accounts. The POSB
offers only deposit and remittance facilities but not any credit to account holders.

The Bombay Stock Exchange, the first stock exchange in India, was founded in 1875.
However, by modern standards, the Indian equity market was still quite underdeveloped till
about the late 1980s. It was governed by an archaic regulatory structure whereby the
Controller of Capital Issues (CCI) in the Finance Ministry was the effective equity market
regulator. Government bonds were available on tap at a fixed coupon and primarily catered to
deficit financing of the government. Draconian foreign exchange controls resulted in a
virtually non-existent market for foreign exchange.

In a similar track, insurance in India has had a long history. The life insurance business was
nationalized in 1956 giving birth to the Life Insurance Corporation of India (LIC), which then
had had a monopoly in the insurance business till the late 1990s when the Insurance sector
was opened to the private sector. The general insurance business was nationalized later in
1972 when 107 insurers were amalgamated and grouped into just four government owned
companies.

Thus, by the end of the 1980s, the financial sector in India was virtually owned by the
government with nationalized banks and insurance companies and a single public sector
mutual fund. Consequently, reforming the financial sector was a very important part of Indian
economic reforms initiated in the early 1990s. Thus, over the years, the Indian financial
sector has emerged as a substantial segment of the economy comprising diverse financial
institutions and various markets

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Q3) Structure of Financial Institutions

A financial institution is an establishment that conducts financial transactions such as

investments, loans and deposits. Almost everyone deals with financial institutions on a
regular basis. Everything from depositing money to taking out loans and exchanging
currencies must be done through financial institutions. Here is an overview of some of the
major categories of financial institutions and their roles in the financial system.

Commercial Banks
Commercial banks accept deposits and provide security and convenience to their customers.
Part of the original purpose of banks was to offer customers safe keeping for their money. By
keeping physical cash at home or in a wallet, there are risks of loss due to theft and accidents,
not to mention the loss of possible income from interest. With banks, consumers no longer
need to keep large amounts of currency on hand; transactions can be handled with checks,
debit cards or credit cards, instead.

Commercial banks also make loans that individuals and businesses use to buy goods or
expand business operations, which in turn leads to more deposited funds that make their way
to banks. If banks can lend money at a higher interest rate than they have to pay for funds and
operating costs, they make money.

Banks also serve often under-appreciated roles as payment agents within a country and
between nations. Not only do banks issue debit cards that allow account holders to pay for
goods with the swipe of a card, they can also arrange wire transfers with other institutions.
Banks essentially underwrite financial transactions by lending their reputation and credibility
to the transaction; a check is basically just a promissory note between two people, but without
a bank's name and information on that note, no merchant would accept it. As payment agents,
banks make commercial transactions much more convenient; it is not necessary to carry
around large amounts of physical currency when merchants will accept the checks, debit
cards or credit cards that banks provide.

Investment Banks
The stock market crash of 1929 and ensuing Great Depression caused the United States
government to increase financial market regulation. The Glass-Steagall Act of 1933 resulted
in the separation of investment banking from commercial banking.

While investment banks may be called "banks," their operations are far different than deposit-
gathering commercial banks. An investment bank is a financial intermediary that performs a
variety of services for businesses and some governments. These services include
underwriting debt and equity offerings, acting as an intermediary between an issuer of
securities and the investing public, making markets, facilitating mergers and other corporate
reorganizations, and acting as a broker for institutional clients. They may also provide
research and financial advisory services to companies. As a general rule, investment banks
focus on initial public offerings (IPOs) and large public and private share offerings.
Traditionally, investment banks do not deal with the general public. However, some of the
big names in investment banking, such as JP Morgan Chase, Bank of America and Citigroup,
also operate commercial banks. Other past and present investment banks you may have heard
of include Morgan Stanley, Goldman Sachs, Lehman Brothers and First Boston.

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Generally speaking, investment banks are subject to less regulation than commercial banks.
While investment banks operate under the supervision of regulatory bodies, like the
Securities and Exchange Commission, FINRA, and the U.S. Treasury, there are typically
fewer restrictions when it comes to maintaining capital ratios or introducing new products.

Insurance Companies
Insurance companies pool risk by collecting premiums from a large group of people who
want to protect themselves and/or their loved ones against a particular loss, such as a fire, car
accident, illness, lawsuit, disability or death. Insurance helps individuals and companies
manage risk and preserve wealth. By insuring a large number of people, insurance companies
can operate profitably and at the same time pay for claims that may arise. Insurance
companies use statistical analysis to project what their actual losses will be within a given
class. They know that not all insured individuals will suffer losses at the same time or at all.

Brokerages
A brokerage acts as an intermediary between buyers and sellers to facilitate securities
transactions. Brokerage companies are compensated via commission after the transaction has
been successfully completed. For example, when a trade order for a stock is carried out, an
individual often pays a transaction fee for the brokerage company's efforts to execute the
trade.

A brokerage can be either full service or discount. A full service brokerage provides
investment advice, portfolio management and trade execution. In exchange for this high level
of service, customers pay significant commissions on each trade. Discount brokers allow
investors to perform their own investment research and make their own decisions. The
brokerage still executes the investor's trades, but since it doesn't provide the other services of
a full-service brokerage, its trade commissions are much smaller.

Investment Companies
An investment company is a corporation or a trust through which individuals invest in
diversified, professionally managed portfolios of securities by pooling their funds with those
of other investors. Rather than purchasing combinations of individual stocks and bonds for a
portfolio, an investor can purchase securities indirectly through a package product like a
mutual fund.

There are three fundamental types of investment companies: unit investment trusts (UITs),
face amount certificate companies and managed investment companies. All three types have
the following things in common:

An undivided interest in the fund proportional to the number of shares held Diversification in
a large number of securities
Professional management
Specific investment objectives
Let's take a closer look at each type of investment company.

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Unit Investment Trusts (UITs)
A unit investment trust, or UIT, is a company established under an indenture or similar
agreement. It has the following characteristics:

The management of the trust is supervised by a trustee.

Unit investment trusts sell a fixed number of shares to unit holders, who receive a
proportionate share of net income from the underlying trust.
The UIT security is redeemable and represents an undivided interest in a specific portfolio of
securities.
The portfolio is merely supervised, not managed, as it remains fixed for the life of the trust.
In other words, there is no day-to-day management of the portfolio.
Face Amount Certificates
A face amount certificate company issues debt certificates at a predetermined rate of interest.
Additional characteristics include:

Certificate holders may redeem their certificates for a fixed amount on a specified date, or for
a specific surrender value, before maturity.
Certificates can be purchased either in periodic installments or all at once with a lump-sum
payment.

The most common type of investment company is the management investment company,
which actively manages a portfolio of securities to achieve its investment objective. There are
two types of management investment company: closed-end and open-end. The primary
differences between the two come down to where investors buy and sell their shares - in the
primary or secondary markets - and the type of securities the investment company sells.

Closed-End Investment Companies: A closed-end investment company issues shares in a

one-time public offering. It does not continually offer new shares, nor does it redeem its
shares like an open-end investment company. Once shares are issued, an investor may
purchase them on the open market and sell them in the same way. The market value of the
closed-end fund's shares will be based on supply and demand, much like other securities.
Instead of selling at net asset value, the shares can sell at a premium or at a discount to the net
asset value.

Open-End Investment Companies: Open-end investment companies, also known as mutual

funds, continuously issue new shares. These shares may only be purchased from the
investment company and sold back to the investment company.

Nonbank Financial Institutions

The following institutions are not technically banks but provide some of the same services as
banks.

Savings and Loans

Savings and loan associations, also known as S&Ls or thrifts, resemble banks in many
respects. Most consumers don't know the differences between commercial banks and S&Ls.
By law, savings and loan companies must have 65% or more of their lending in residential
mortgages, though other types of lending is allowed.

S&Ls emerged largely in response to the exclusivity of commercial banks. There was a time
when banks would only accept deposits from people of relatively high wealth, with

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references, and would not lend to ordinary workers. Savings and loans typically offered lower
borrowing rates than commercial banks and higher interest rates on deposits; the narrower
profit margin was a byproduct of the fact that such S&Ls were privately or mutually owned.

Credit Unions
Credit unions are another alternative to regular commercial banks. Credit unions are almost
always organized as not-for-profit cooperatives. Like banks and S&Ls, credit unions can be
chartered at the federal or state level. Like S&Ls, credit unions typically offer higher rates on
deposits and charge lower rates on loans in comparison to commercial banks.

In exchange for a little added freedom, there is one particular restriction on credit unions;
membership is not open to the public, but rather restricted to a particular membership group.
In the past, this has meant that employees of certain companies, members of certain churches,
and so on, were the only ones allowed to join a credit union. In recent years, though, these
restrictions have been eased considerably, very much over the objections of banks.

Shadow Banks
The housing bubble and subsequent credit crisis brought attention to what is commonly
called "the shadow banking system." This is a collection of investment banks, hedge funds,
insurers and other non-bank financial institutions that replicate some of the activities of
regulated banks, but do not operate in the same regulatory environment.

The shadow banking system funneled a great deal of money into the U.S. residential
mortgage market during the bubble. Insurance companies would buy mortgage bonds from
investment banks, which would then use the proceeds to buy more mortgages, so that they
could issue more mortgage bonds. The banks would use the money obtained from selling
mortgages to write still more mortgages.

Many estimates of the size of the shadow banking system suggest that it had grown to match
the size of the traditional U.S. banking system by 2008.

Apart from the absence of regulation and reporting requirements, the nature of the operations
within the shadow banking system created several problems. Specifically, many of these
institutions "borrowed short" to "lend long." In other words, they financed long-term
commitments with short-term debt. This left these institutions very vulnerable to increases in
short-term rates and when those rates rose, it forced many institutions to rush to liquidate
investments and make margin calls. Moreover, as these institutions were not part of the
formal banking system, they did not have access to the same emergency funding facilities.
(Learn more in The Rise And Fall Of The Shadow Banking System.)

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Q4) Role of Financial Institutions.

The objective of any development strategy, particularly in capital scarce developing

countries, is to raise considerable financial resources required to improve the standard of
living, employment generation and national output. The huge amount of finance required for
over all economic development could not be met by Government itself. It is in this context,
the concept of development banking came into the picture with the object of mobilising
resources from the internal (public) and external sources besides government. Imbalances in
the distribution of development and wealth also necessitated specialised institutions backed
by public funds to correct lopsided socio-economic development. In the early 1940s the need
to reduce the gap between the standards of living of the developing countries in Africa, Asia
and Latin America on one hand and those in Europe and North America on the other, brought
about the need for more conscious promotion of economic development by means of
development financing institutions.

With the attainment of independence by many developing countries after the Second World
War, the need to accelerate the process of economic development became more prominent
and pressing. Rapid growth of population, adoption of western style of living and consequent
increase in fashions, styles and wants added to the urgency of having variety in economic
production. Emphasis was placed on industrialisation as a means of achieving faster
economic growth. However, the necessary ingredients of development viz., capital,
information on investment opportunities and local entrepreneur were absent. These
inadequacies inhibited private initiative in new areas of economic activity that appeared
risky. Consequently, vicious cycle of inadequacies formed from which there appears to be no
escape for the Third World Countries. In the words of Franklin Root.

―Productivity is low because investment is low; investment is low because savings are
insufficient; savings are insufficient because incomes are low; incomes are low because
productivity is low.

There is an important angle to the role of financial institutions in economic development,

particularly of banks, which has been popularised by distinguished economists like
Schumpeter, Kalecki and Keynes. He wrote, ―the banker, therefore, is not so much primarily
a middleman in the commodity `purchasing power‘, as a producer of this commodity. Newly
created purchasing power by banks placed in the hands of the entrepreneur enables him to
secure command over physical resources and thus push through his investment projects. Once
the investment results in the increased production, the initial credit inflation disappears and
the equivalence between money and commodities streams is restored. Both Kalecki and
Keynes regarded the availability of finance as a key factor in ensuring independence of
investment from savings. Schumpeter had vehemently emphasised the crucial role of credit
institutions in the financing of innovations and thus facilitating economic development.

So that the advent of `Development Banking extended the horizon of the mobilisations of
scarce resource (capital) nationally and internationally and succeeded to a greater extent in
stimulating the economy and industrial output on one hand and correcting the lopsided
structure of the economy on the other. But along with industry other major sectors like
agriculture, infrastructure, transport, education and health also require a considerable increase
in capital investment, since industry itself cannot grow in isolation.

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By providing resources for investment in infrastructure, agriculture and industry,
development banks play a prominent role in diversification and distribution of income,
employment and output more effectively. Perhaps this may be evident from the recent past
that considerable progress has been made by numerous countries in this regard. It is but
natural as finance has the strength to command all resources and direct their flow in socially
desirable directions. Development banks are thus acting as a catalyst for the pace of industrial
growth and for promoting industries by development in otherwise industrially backward
regions.

Besides performing the financial functions, financial institutions also provide entrepreneurial
assistance to the individual entrepreneurs/projects, act as an agency for securing foreign
technical advice and raising funds from the capital markets of advanced countries. The
institutions also facilitate the expansion of markets through distributive techniques and
undertake other promotional jobs of an essential nature, such as, marketing and investment
research surveys, techno-economic feasibility and cost-benefit studies of different growth
sectors or a region, particularly the backward regions of the country so as to identify potential
for economic growth.

Prior, industrial finance by development banking is highly preferable as it rises productivity,

income and standard of living, capital formation and national output besides employment
generation. The development banks also can prevent the concentration of economic power
and be successful in promoting the indigenous growth of small entrepreneurs.

Thus, financial institutions not only help in mobilisation and collection of scattered savings
from different sections of population, but they also help to increase the overall level of
savings and investment and allocate more efficiently scarce savings among most desirable
and productive investments in accordance with the national priorities.

Therefore, it required a lot of imagination, effort, enterprise, determination and the supporting
institutional framework so that a sustained and well-diversified industrial growth could
blossom to meet the objectives of Indian planning, national priorities and national aspirations.

In the period that followed, there was a rich crop of new institutions in the background of the
Five Year Plans. These also included the financial institutions which marked a sharp break
with the past and the erstwhile stagnating tendencies in the Indian economy. The direct
government investment in agriculture, industry, education and infrastructure opened up a new
vista of investment opportunities on a broader front and on a much larger scale. ―This called
for efforts in other areas to convert the emerging opportunities and catalyses the growth
impulses into productive enterprises. For realising these objectives, there was a special role to
be played by the financial institutions insofar as the financial input of the right magnitude,
right types, and at accessible sources was the missing link around which the human and
material resources could be harnessed to generate increasing volumes of real outputs and
services‖.

As a result of the developmental programmes spread over a long chain of Five Year Plans
which cover up the entire country and touch almost the entire gamut of the socio-economic
aspect of the country it has now been possible to overcome the bottlenecks to growth to some
extent. It has set the stage for the financial institutions from where they can take a leap
forward to be face to face with the new challenges in the economy.

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The Indian banking system which has developed under the influence of British banking
practices had not been well disposed to extending term loans to industry on any significant
scale. It was for this reason that immediately after independence, the Government of India
decided to set-up the Industrial Financial Corporation of India in 1948. In view of the
immensity of the task of industrialisation and the vastness of the country, subsequently it was
necessary to establish a regional bank for each one of the States and the State Financial
Corporation Act was passed by the parliament in 1951. The National Small Industries
Corporation was set-up in 1955 to assist small scale units through promotional financing and
other activities. During the same year, the Industrial Credit and Investment Corporation of
India was set-up with a view to provide term loans in foreign currencies for industrial
projects. The Life Insurance Corporation of India which was established by amalgamating the
several private sector insurance corporations also continued to play a useful role in providing
finance to industry.

The purpose of setting up the Industrial Development Bank of India in 1964 could be best
described in the words of the then Finance Minister of India, Shri. T.T.Krishnamachari who
said, while introducing the bill on IDBI in the parliament that ―Where a long – term view is
necessary and a certain amount of risk has to be taken, the existing institutions tend, by
reason of their statutory obligations and traditions, to be conservative and cannot in any case
be very helpful. We are envisaging the new Industrial Development Bank as a central co-
ordinating agency, which ultimately will be concerned, directly or indirectly, with all the
problems or questions relating to long or medium-term financing of industry and will be in a
position, if necessary, to adopt and enforce a system of priorities, in promoting the future
industrial growth‖. Simultaneously, the Unit Trust of India was also established with a view
to providing an outlet to private risk capital which was shy in entering into equity
investments.

All these development banks which have come into existence are set-up primarily to provide
long-term finance though some of them, like the IDBI are not precluded from giving working
capital funds. Despite the flexibility of their objectives of incorporation, development banks
have continued to focus their attention primarily on providing long-term resources to
industries. It contributed to economic development.

A financial system comprises financial institutions, markets and instruments which together
provide the essential framework for mobilisation and allocation of savings. The primary role
of any financial system is to act as a conduit for the transfer of financial resources from net
savers to borrowers i.e., from those who spend less than they earn to those who earn less than
they spend. Thus, the role of an integrated financial infrastructure in stimulating and
sustaining economic growth is well recognised now. A network of financial institutions helps
an economy to augment its savings. At the same time it leads to a more efficient utilisation of
the available investible resources. Thus, a sound and efficient financial system can contribute
to economic growth and development in a number of ways.

The Indian financial system has undergone a remarkable transformation over the last six
decades and now comprises an impressive network of financial institutions – mainly in the
public and co-operative sectors – financial markets and a wide range of financial instruments.
The system has become more sophisticated in response to the varied needs of the economy.
Now India has been successful at developing a large financial sector, and one of the largest
capital markets in the developing world.

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Q5) Non-Bank Financial Companies – Introduction

We studied about banks, apart from banks the Indian Financial System has a large number of
privately owned, decentralised and small sized financial institutions known as Non-banking
financial companies. In recent times, the non-financial companies (NBFCs) have contributed
to the Indian economic growth by providing deposit facilities and specialized credit to certain
segments of the society such as unorganized sector and small borrowers. In the Indian
Financial System, the NBFCs play a very important role in converting services and provide
credit to the unorganized sector and small borrowers.

NBFCs provide financial services like hire-purchase, leasing, loans, investments, chit-fund
companies etc. NBFCs can be classified into deposit accepting companies and non-deposit
accepting companies. NBFCs are small in size and are owned privately. The NBFCs have
grown rapidly since 1990. They offer attractive rate of return. They are fund based as well as
service oriented companies. Their main companies are banks and financial institutions.
According to RBI Act 1934, it is compulsory to register the NBFCs with the Reserve Bank of
India.

The NBFCs in advanced countries have grown significantly and are now coming up in a very
large way in developing countries like Brazil, India, and Malaysia etc. The non-banking
companies when compared with commercial and co-operative banks are a heterogeneous
(varied) group of finance companies. NBFCs are heterogeneous group of finance companies
means all NBFCs provide different types of financial services.

Non-Banking Financial Companies constitute an important segment of the financial system.

NBFCs are the intermediaries engaged in the business of accepting deposits and delivering
credit. They play very crucial role in channelizing the scare financial resources to capital
formation.

NBFCs supplement the role of the banking sector in meeting the increasing financial need of
the corporate sector, delivering credit to the unorganized sector and to small local borrowers.
NBFCs have more flexible structure than banks. As compared to banks, they can take quick
decisions, assume greater risks and tailor-make their services and charge according to the
needs of the clients. Their flexible structure helps in broadening the market by providing the
saver and investor a bundle of services on a competitive basis.

Non Banking Finance Companies (NBFCs) are a constituent of the institutional structure of
the organized financial system in India. The Financial System of any country consists of
financial Markets, financial intermediation and financial instruments or financial products.
All these Items facilitate transfer of funds and are not always mutually exclusive. Inter-
relationships Between these are parts of the system e.g. Financial Institutions operate in
financial markets and are, therefore, a part of such markets.

NBFCs at present providing financial services partly fee based and partly fund based. Their
fee based services include portfolio management, issue management, loan syndication,
merger and acquisition, credit rating etc. their asset based activities include venture capital
financing, housing finance, equipment leasing, hire purchase financing factoring etc. In short
they are now providing variety of services. NBFCs differ widely in their ownership: Some
are subsidiaries of large Manufacturers (e.g., T.V. Motors T.V. Finances and Services Ltd).

12
Many others are owned by banks such as ICICI Banks, ICICI Securities Ltd, SBI Capital
Market Ltd, Muthoot Bankers Muthoot Financial Services Ltd a key player in Kerala
financial services. Other financial institutions are IFCIs IFCI Financial Services Ltd or IFCI
Custodial Services Ltd (Devdas, 2005).
Non-banking Financial Institutions carry out financing activities but their resources are not
directly obtained from the savers as debt. Instead, these Institutions mobilize the public
savings for rendering other financial services including investment. All such Institutions are
financial intermediaries and when they lend, they are known as Non-Banking Financial
Intermediaries (NBFIs) or Investment Institutions.
The term ―Finance‖ is often understood as being equivalent to ―money‖. However, final
exactly is not money; it is the source of providing funds for a particular activity. The word
system, in the term financial system, implies a set of complex and closely connected or inter-
linked Institutions, agents, practices, markets, transactions, claims, and liabilities in the
Economy. The financial system is concerned about money, credit and finance. The three
terms are intimately related yet are somewhat different from each other:

Money refers to the current medium of exchange or means of payment.

Credit or loans is a sum of money to be returned, normally with interest; it refers to a debt
Finance is monetary resources comprising debt and ownership funds of the state, company or
person.

Non-Banking Financial Companies (NBFCs) play a vital role in the context of Indian
Economy. They are indispensible part in the Indian financial system because they supplement
the activities of banks in terms of deposit mobilization and lending. They play a very
important role by providing finance to activities which are not served by the organized
banking sector. So, most the committees, appointed to investigate into the activities, have
recognized their role and have recognized the need for a well-established and healthy non-
banking financial sector.

Non-Banking Financial Company (NBFC) is a company registered under the Companies

Act, 1956 and is engaged in the business of loans and advances, acquisition of
shares/stock/bonds/debentures/securities issued by Government or local authority or other
securities of like marketable nature, leasing, hire-purchase, insurance business, chit business
but does not include any institution whose principal business is that of agriculture
activity, industrial activity, sale/purchase/construction of immovable property.
Non-banking institution which is a company and which has its principal business of receiving
deposits under any scheme of arrangement or any other manner, or lending in any
manner is also a non- banking financial company.

The Non-Banking Financial Companies (NBFCs) are the financial institutions that offer the
banking services, but does not comply with the legal definition of a bank, i.e. it does not hold
a bank license.

A Non Banking Financial Company (NBFC) is a company registered under the Companies
Act, 1956 of India, engaged in the business of loans and advances, acquisition of shares,
stock, bonds, hire-purchase insurance business or chit-fund business but does not include any
institution whose principal business includes agriculture, industrial activity or the sale,
purchase or construction of immovable property.

13
The working and operations of NBFCs are regulated by the Reserve Bank of India (RBI)
within the framework of the [[Reserve Bank of India Act, 1934]] (Chapter III-B) and the
directions issued by it. On November 9, 2017, Reserve Bank of India (RBI) issued a
notification outlining norms for outsourcing of functions/services by Non-Bank Financial
Institution (NBFCs) As per the new norms, NBFCs cannot outsource core management
functions like internal audit, management of investment portfolio, strategic and compliance
functions for know your customer (KYC) norms and sanction of loans. Staff of service
providers should have access to customer information only up to an extent which is required
to perform the outsourced function. Boards of NBFCs should approve a code of conduct for
direct sales and recovery agents. For debt collection, NBFCs and their outsourced agents
should not resort to intimidation or harassment of any kind. All NBFCs‘ have been directed
to set up a grievance redressal machinery, which will also deal with the issues relating to
services provided by the outsourced agency.

Q6) Non-Bank Financial Companies Concept and Definition

Non-Banking Financial Company has been defined as:

(i) A non-banking institution, which is a company and which has its principal business the
receiving of deposits under any scheme or lending in any manner.
(ii) Such other non-banking institutions, as the bank may with the previous approval of the
central government and by notification in the official gazette, specify.
NBFCS provide a range of services such as hire purchase finance, equipment lease finance,
loans, and investments. NBFCS have raised large amount of resources through deposits from
public, shareholders, directors, and other companies and borrowing by issue of non-
convertible debentures, and so on.
Non-banking financial companies represent a heterogeneous group of institutions engaged in
hire purchase, housing finance, lease finance, investors, etc. The number of such companies
runs into thousands but only a small proportion of them report to/file return with the RBI.
Four types of institutions categorized in terms of their primary business activity and under the
regulatory purview of the Reserve Bank are: equipment leasing companies, hire purchase
companies, loan companies and investment companies. The residuary non-banking
companies (RNBCs) have been classified as a separate category as their business does not
confirm to any of the other defined classes of NBFC business. Besides, there are other
NBFCs, viz., miscellaneous non-banking companies (chit funds), mutual benefit finance
companies (nidhis and potential nidhis) and housing finance companies which are either
partially regulated by the Reserve Bank or are outside the purview of the Reserve Bank.

There is a considerable overlap in the functioning of these institutions-both mobilize savings

and facilitate financing of different activities. However, the difference lies in fact that banks
accept deposits which are repayable on demand (i.e., they have cheque facility), their deposits
liabilities constitute a major part of money supply and banks also create credit.

NBFls play an important dual role in the financial system.

They complement the role of commercial banks by filling gaps in their range of services. At
the same time, they also compete with banks and force them to be more efficient and
responsive to the needs of customers. They have helped to bridge the credit gaps in several
sectors wherein the banks were unable to do so. Their role in delivering credit to the
unorganized sector including farms and small borrowers at the local level on a sustained basis

14
is widely recognized. They provide a diversified range of functions to individuals, corporate
and institutions clients. The NBFls are very effective as they have the ability to take quicker
decisions, assume greater risks and customize their services. This is because Fls have access
to private information such as loan application deposit history, incomes, assets, liabilities and
credit history. They are also able to monitor the borrower's activities better and so are better
equipped to make more rational loan decisions. They provide the lender information,
diversification and financial expertise. They benefit the borrower by reducing transaction
costs through broadening the rate of instrument, denomination and maturities that deficit
spenders can issue.
Non-banking Financial Institutions carry out financing activities but their resources are not
directly obtained from the savers as debt. Instead, these Institutions mobilize the public
savings for rendering other financial services including investment. All such Institutions are
financial intermediaries and when they lend, they are known as Non-Banking Financial
Intermediaries (NBFIs) or Investment Institutions:
UNIT TRUST OF INDIA.
LIFE INSURANCE CORPORATION (LIC).
GENERAL INSURANCE CORPORATION (GIC).

Q7) Meaning and scope of Non-Bank Financial Companies

Scope of Non- Banking Financial Companies:

(1) Receiving benefits:
The primary function of nbfcs is receive deposits from the public in various ways such as
issue of debentures, savings certificates, subscription, unit certification, etc. thus, the deposits
of nbfcs are made up of money received from public by way of deposit or loan or investment
or any other form.
(2) Lending money:
Another important function of nbfcs is lending money to public. Non- banking financial
companies provide financial assistance through.
(a) Hire purchase finance:
Hire purchase finance is given by nbfcs to help small important operators,
professionals, and middle income group people to buy the equipment on the basis on
Hire purchase. After the last installment of Hire purchase paid by the buyer, the
ownership of the equipment passes to the buyer.
(b) Leasing Finance:
In leasing finance, the borrower of the capital equipment is allowed to use it, as a hire,
against the payment of a monthly rent. The borrower need not purchase the capital
equipment but he buys the right to use it.
(c) Housing Finance:
NBFC‘s provide housing finance to the public, they finance for construction of
houses, development of plots, land, etc.

(d) Other types of finance provided by NBFCs include:

Consumption finance, finance for religious ceremonies, marriages, social activities,
paying off old debts, etc. NBFCs provide easy and timely finance and generally those
customers which are not able to get finance by banks approach these companies.
(e) Investment of surplus money:
NBFCs invest their surplus money in various profitable areas.

15
3) LIQUIDITY RISK MANAGEMENT

Measuring and managing liquidity needs are vital for effective operation of NBFCs. By
ensuring an NBFC's ability to meet its liabilities as they become due, liquidity management
can reduce the probability of an adverse situation developing. The importance of liquidity
transcends individual institution, as liquidity shortfall in one institution can have
repercussions on the entire system. NBFCs management should measure not only the
liquidity positions of NBFCs on an ongoing basis but also examine how liquidity
requirements are likely to involve under different assumptions.
Experience shows that assets commonly considered as liquid, like Government securities and
other money market instruments, could also become illiquid when the market and players are
unidirectional.

NBFCs holding public deposits are required to invest up to a prescribed percentage (15% as
on date) of their public deposits in approved securities in terms of liquid asset requirement of
section 45-IB of the RBI Act,1934. Residuary Non-Banking Companies (RNBCs) are
required to invest up to 80% of their deposits in a manner as prescribed in the Directions
issued under the said Act. There is no such requirements for NBFCs which are not holding
public deposits. Thus various NBFCs including RNBCs would be holding in their
investments portfolio securities which could be broadly classifiable as 'mandatory securities'
(under obligation of law) and other 'non-mandatory securities'.

4) Financial Companies Regulation Bill, 2000.

The Government of India framed the Financial Companies Regulation Bill, 2000 to
Consolidate the law relating to NBFCs and unincorporated bodies with a view to ensured
posit or protection. The salient features of this Bill are:
All NBFCS will be known as Financial Companies instead of NBFCs; NBFCs holding public
deposits would not be allowed to carry on any non-Financial business with out the prior
approval of RBI; RBI would have the powers to prescribe minimum net-worth norms;
unsecured depositors would have first charge on liquid assets and assets created out of
deployment of part of the reserve fund.
Financial Companies would require prior approval of RBI for any change in name,
management or registered office; Regulation of unincorporated bodies would be in the hands
of the respective State Governments; Penalties have been rationalized with the objective that
they should serve as a deterrent and investigative powers have been vested with District
Magistrates and Superintendents of Police; RBI would be empowered to appoint Special
Officer(s) on delinquent financial companies; Any sale of property in violation of RBI order
would be void; The Company Law Board will continue to be the authority to adjudicate the
claims of depositors. Financial companies would have no recourse to the CLB to seek
deferment of the depositors‘ dues. The Bill has been introduced in Parliament in 2000 and has
since been referred to the Standing Committee on Finance. 8.0 Anomalies in the NBFC
regulations.

16
Q8) Role of Non-Bank Financial Companies
ROLE OF NON- BANKING FINANCIAL COMPANIES.
(1) Promoters Utilization of Savings:
Non- Banking Financial Companies play an important role in promoting the utilization of
savings among public. NBFC‘s are able to reach certain deposit segments such as
unorganized sector and small borrowers were commercial bank cannot reach. These
companies encourage savings and promote careful spending of money without much wastage.
They offer attractive schemes to suit needs of various sections of the society. They also
attract idle money by offering attractive rates of interest. Idle money means the money which
public keep aside, but which is not used. It is surplus money.
(2) Provides easy, timely and unusual credit:
NBFC‘s provide easy and timely credit to those who need it. The formalities and procedures
in case of NBFC‘s are also very less. NBFC‘s also provides unusual credit means the credit
which is not usually provided by banks such as credit for marriage expenses, religious
functions, etc. The NBFC‘s are open to all. Every one whether rich or poor can use them
according to their needs.
(3) Financial Supermarket:
NBFC‘s play an important role of a financial supermarket. NBFC‘s create a financial
supermarket for customers by offering a variety of services. Now, NBFC‘s are providing a
variety of services such as mutual funds, counseling, merchant banking, etc. apart from their
traditional services. Most of the NBFC‘s reduce their risks by expanding their range of
products and activities.

(4) Investing funds in productive purposes:

NBFC‘s invest the small savings in productive purposes. Productive purposes mean they
invest the savings of people in businesses which have the ability to earn good amount of
returns. For example – In case of leasing companies lease equipment to industrialists, the
industrialists can carry on their production with less capital and the leasing company can also
earn good amount of profit.
(5) Provide Housing Finance:
NBFC‘s, mainly the Housing Finance companies provide housing finance on easy term and
conditions. They play an important role in fulfilling the basic human need of housing finance.
Housing Finance is generally needed by middle class and lower middle class people. Hence,
NBFC‘s are blessing for them.
(6) Provide Investment Advice:
NBFC‘s, mainly investment companies provide advice relating to wise investment of funds
as well as how to spread the risk by investing in different securities. They protect the small
investors by investing their funds in different securities. They provide valuable services to
investors by choosing the right kind of securities which will help them in gaining maximum
rate of returns. Hence, NBFC‘s plays an important role by providing sound and wise
investment advice.
(7) Increase the Standard of living:
NBFC‘s play an important role in increasing the standard of living in India. People with
lesser means are not able to take the benefit of various goods which were once considered as
luxury but now necessity, such as consumer durables like Television, Refrigerators, Air
Conditioners, Kitchen equipments, etc. NBFC‘s increase the Standard of living by providing
consumer goods on easy installment basis. NBFC‘s also facilitate the improvement in
transport facilities through hire- purchase finance, etc. Improved and increased transport
facilities help in movement of goods from one place to another and availability of goods
increase the standard of living of the society.

17
(8) Accept Deposits in Various Forms:
NBFC‘s accept deposits forms convenient to public. Generally, they receive deposits from
public by way of depositor a loaner in any form. In turn the NBFC‘s issue debentures, units‘
certificates, savings certificates, units, etc. to the public.
(9) Promote Economic Growth:
NBFC‘s play a very important role in the economic growth of the country. They increase the
rate of growth of the financial market and provide a wide variety of investors. They work on
the principle of providing a good rate of return on saving, while reducing the risk to the
maximum possible extent. Hence, they help in the survival of business in the economy by
keeping the capital market active and busy. They also encourage the growth of well-
organized business enterprises by investing their funds in efficient and financially sound
business enterprises only. One major benefit of NBFC‘s speculative business means investing
in risky activities. The investing companies are interested in price stability and hence
NBFC‘s, have a good influence on the stock- market. NBFC‘s play a very positive and active
role in the development of our country.

(10) Greater Employment Opportunities and Standard of Living

NBFCs help attain the objective of macroeconomic policies of creating more jobs in the
country by promoting SMEs and private industries through lending them loans. This increase
in new businesses consequently raises the demand for manpower and creates employment.
Furthermore, the Purchasing Power Parity (PPP) of people rises and so does their standard of
living.

(11) Strengthening of Financial Market

The financial market relies heavily on Non-banking financial institutions for raising capital.
The start-ups and small-sized businesses are dependent on funds offered by NBFCs and also
in order to maintain liquidity. For an effective functioning and balance in the financial
market, NBFCs play a significant role.

(12) Supplying long-term credits

Unlike the regular banks, NBFCs extend long-term credits to infrastructure, commerce and
trade companies. The traditional banks expect timely, schedules and short-term repayment of
loans that may not always suit the requirements of these industries. NBFCs, on the other
hand, fund large projects and so promotes economic growth. They also allow industries to
participate in equity.

(13) Mobilisation of Funds

Non-banking financial companies help in rotation of resources, asset distribution and
regulation of income to shape the economic development. They enable converting saving into
investments and thus helps in the mobilisation of funds/resources in the economy.

(14) Growth of National Income

As NBFCs aim to build capital for several industries – private and otherwise – they aid in
accumulating a capital stock for the country. This directly adds on to the national income and
results in the progression of Gross Domestic Product (GDP).

18
Q9) Structure of NBFCs

Equipment Leasing Company:

(a) Equipment leasing company means any company which is carrying on the activity of
leasing of equipment, as its main business, or the financing of such activity.
(b) The leasing business takes place of a contract between the lessor (lessor means the
leasing company) and the lessee (lessee means a borrower).
(c) Under leasing of equipment business a lessee is allowed to use particular capital
equipment, as a hire, against a payments of a monthly rent.

(d) Hence, the lessee does not purchase the capital equipment, but he buys the right to use
it.
(e) There are two types of leasing arrangements, they are:
(i) Operating leasing: In operating leasing the producer of capital equipment offers his
product directly to the lessee on a monthly rent basis. There is no middleman in operating
leasing.
(ii) Finance leasing: In finance leasing, the producer of the capital equipment sells the
equipment to the leasing company, then the leasing company leases it to the final user of the
equipment. Hence, there are three parties in finance leasing. The leasing company acts as a
middleman between the producer of equipment and the user of equipment.

Benefits/Advantages of Leasing:

(1) 100% finance:

They borrower in the equipment can get up to 100% finance for the use of capital through
leasing arrangement in the sense, that the leasing company provides the equipment
immediately and the borrower need not pay the full amount at once. Hence, the borrower can
use the amount for fulfilling other needs such as expansion development, etc.

(2) Payment is easier:

Leasing finance is costlier. However, the borrower finds it convenient (easy) as he has to pay
in installments out of the return from the investment in the equipment. Hence, the borrower
does not feel the burden of payment.

(3) Tax concessions:

The borrower can get tax concessions in case of leasing equipments. The total amounts of
rent paid on leased equipment are deducted from the gross income. In case of immediate
purchase, interest on the loan and the depreciation are deducted from the taxable income.

Hire-purchase Finance Companies:

(a) Hire purchase finance company means any company which is carrying on the main
business of financing, physical assets through the system of hire-purchase.
(b) In hire-purchase, the owner of the goods hires them to another party for a certain
period and for a payment of certain installment until the other party owns it.
(c) The main feature of hire-purchase is that the ownership of the goods remains with the
owner until the last installment is paid to him. The ownership of goods passes to the user only
after he pays the last installment of goods.

19
(d) Hire-purchase is needed by farmers, professionals and transport group people to buy
equipment on the basis of hire purchase.
(e) It is a less risky business because the goods purchased on hire purchase basis serve as
securities till the installment on the loan is paid.
(f) Generally, automobile industry needs lot hire-purchase finance.
(g) The problem of recovery of loans does not occur in most cases, as the borrower is
able to pay back the loan out of future earnings through the regular generation of funds out of
the asset purchased.
(h) In India, there are many individuals and partnership firms doing this business. Even
commercial banks, hire-purchase companies and state financial corporations provide hire-
purchase credit.

Housing Finance Companies:

(a) A housing finance company means any company which is carrying on its main
business of financing the construction or acquisition of houses or development of land for
housing purposes.
(b) Housing finance companies also accept the deposits and lend money only for housing
purposes.
(c) Even though there is a heavy demand for housing finance, these companies have not
made much progress and as on 31st March, 1990 only 17 such companies here reported to the
RBI.
(d) The ICICI and the Canara Bank took the lead to sponsor housing finance companies,
namely, Housing Development Corporation Ltd. and the Canfin Homes Ltd.
(e) All the information about the Housing finance companies is available with the
National Housing Bank. Housing finance companies also have to compulsorily to register
themselves with the Reserve Bank of India.
(f) National Housing bank is the apex institution in the field of housing. It promotes
housing finance institutions, both on regional and local levels.

Investment Companies:
(a) Investment company means any company which is carrying on the main business of
securities.
(b) Investment companies in India can be broadly classified into two types:
(1) Holding Companies:
(i) In case of large industrial groups, there are holding companies which buy shares
mainly for the purpose of taking control over another institution.
(ii) They normally purchase the shares of the institution with the aim of controlling it
rather than purchasing shares of different companies.
(iii) Such companies are set up as private limited companies.

(2) Other Investment Companies:

(i) Investment companies are also known as Investment trusts.
(ii) Investment companies collect the deposits from the public and invest them in
securities.
(iii) The main aim of investment companies is to protect small investors by collecting their
small savings and investing than in different securities so that the risk can be spread.
(iv) An individual investor cannot do all this on his own, due to lack of expertise in
investing. Hence, investing companies are formed for collective investing. Companies are
formed for collective investments of money, mainly of small investors.

20
(v) Another benefit of an investment company is that it offers trained, experienced and
specialised management of funds.
(vi) It helps the investors to select a financially sound and liquid security.
Liquid security means a security which can be easily converted into cash.
(vii)In India investment trusts are very popular. They help in putting the savings of people
into productive investments.
(viii)Some of the investment trusts also do underwriting, promoting and holding company
business besides financing.
(ix)These investments trusts help in the survival of business in the economy by keeping the
capital market alive, active and busy.

Loan company:

(a) A loan company means any company whose main business is to provide finance
through loans and advances.
(b) It does not include a hire purchase finance company or an equipment leasing company
or a housing finance company.
(c) Loan company is also known as a ―Finance Company".
(d) Loan companies have very little capital, so they depend upon public deposits as their
main source of funds. Hence, they attract deposits by offering high rates of interest.
(e) Normally, the loan companies provide loans to wholesalers, retailers, small-scale
industries, self-employed people, etc.
(f) Most of their loans are given without any security. Hence, they are risky.
(g) Due to this reason, the loan company charges high rate of interest on its loans. Loans
are generally given for short period of time but they can be renewed.

Mutual Benefit Financial Company:

(a) They are the oldest form of non-banking financial companies.

(b) A mutual benefit financial company means any company which is notified under
section 620A of the Companies Act, 1956.
(c) It is popularly known as "Nidhis".
(d) Usually, it is registered with only very small number of shares. The value of the
shares is often Rs. 1 only
(e) It accepts deposits from its members and lends only to its members against tangible
securities.
Chit-fund Companies:
History:

The chit fund schemes have a long history in the southern states of India. Rural unorganized
chit funds may still be spotted in many southern villages. However, organized chit fund
companies are now prevalent all over India. The word is Hindi and refers to a small note or
piece of something. The word passed into the British colonial ―lexicon‖ and is still used to
refer to a small piece of paper, a child or small girl

How Chit Fund Help?

Chit Funds have the advantage both for serving a need and as an investment. Money can be
readily drawn in an emergency or could be continued as an investment.

21
Interest rate is determined by the subscribers themselves, based on mutual decisions and
varies from auction to auction.
The money that you borrow is against your own future contributions.
The amount is given on personal sureties too; unlike in banks and other financial institutions
which demand a tangible security.
Chit funds can be relied upon to satisfy personal needs. Unlike other financial institutions,
you can draw upon your chit fund for any purpose - marriages, religious functions, medical
expenses, just anything...
Cost of intermediation is the lowest.

(a) Chit funds companies are one of the oldest forms of local non-banking financial
institution in India.
(b) They are also known as "kuries".
(c) These institutions have originated from south India and are very popular over there.
(d) A chit fund organisation is an organisation of a number of people who join together
and subscribe (contribute) amounts monthly so that any members who is in need of funds can
draw the amount less expenses for conducting the chit. It is an organisation run on co-
operative basis for the benefit of the members who contribute money, the funds are used by
them as and when a particular member needs it.
(e) It helps the persons who save money regularly to invest their savings with good
chances of profit.
(f) Chit funds have many defects as the rate of return given to each member is not the
same.
(g) It differs from person to person, this leads in improper distribution of gains and losses.
(h) Also, the promoters of these funds do everything for their own benefit to get
maximum income.
(I) Hence, the banking commission has made suggestions to pass uniform chit funds laws
for the whole of India.

Residuary Non-banking Companies:

(a) The term "residue" means a small part of something that remains. As the meaning of
the term shows, a residuary company is one which does not fall in any of the above
categories.

(b) It generally accepts deposits by operating different schemes similar to recurring

deposit schemes of banks.
(c) Deposits are collected from a large number of people by promising them that their
money would be invested in banks and government securities
(d) The collection of deposits is done at the doorsteps of depositors through bank staff,
who is paid commission.
(e) These companies get the funds at low cost for longer terms, at they invest them in
investments which generates good amount of return.
(f) Many of these companies operate with very small amount of capital.
(g) They have some adverse (bad) features, such as:
(ii) Some do not submit periodic returns to the regulatory authority.
(iii) Some of them do not appoint banks, etc.

22
Q10) Growth of NBFCs

Deep understanding of the Customers segment:

NBFC‘s have strongly focused on unorganized & Under-served segments of the economy,
which led the companies to create a niche for themselves through frequent interactions with
their Customer segments & deeply understanding needs. They are ensuring last-mile delivery
& enhanced customer experience of products & services.

Customized product offerings by NBFC‘s:

Several NBFCs have focused on a limited line (or often a mono-line set of products) to serve
the target customer segment. Armed with a thorough comprehension of their target segment,
NBFCs have customized product offerings to address unique characteristics of the customer
segment and focus on meeting the right needs. Several NBFCs are adopting non-standard
pricing models for product lines, in-line with the customer profile and inherent risk of
lending.

Leveraging Technology for Improved Efficiency and Enhanced Experience:

The use of technology is helping NBFCs customize credit assessment models and optimize
business processes, thereby reducing the time to market and helping improve customer
experience. NBFCs are investing in data analytics and artificial intelligence to build robust
relationships with their target customer segments.

Wider and Effective reach:

NBFCs are now reaching out to Tier-2, Tier-3 and Tier-4 markets, distributing loans across
several customer touch-points, building a connected channel experience, that provides an
omnichannel seamless experience with 24/7 sales and service, as the consumers of today
evolving and accessing digital media like never before, NBFCs have embarked on new and
better ways to engage with the customer.

Co-lending Arrangements:
NBFCs have been tying up with multiple alternative lenders with digital platforms and
commercial banks as well, which has been adding to their targeted customer base.

Robust Risk Management:

Given their focus on lending to the sub-prime customer segment, and regulatory disadvantage
(SARFEASI, DRT, and capital adequacy requirements) in comparison to commercial bank
lenders, NBFCs are ensuring enhanced governance through a proactive, robust and agile risk
management model.

While in 2018-19, though concerns surrounding the sector due to debt defaults amidst
temporary asset liability mismatches arose, the inherent strength of the NBFC sector, coupled
with the RBI's continuing vigil on the regulatory and supervisory front, will ensure that the
growth of the sector is sustained and liquidity fears are allayed," RBI said in its annual report
on 'Trends & Progress of Banking in 2017-18', released Friday.

23
The report said the NBFC sector, with a size of around 15 percent of the commercial banks'
combined balance sheet, has been growing robustly in recent years, providing an alternative
source of funds to the commercial sector in the face of slowing bank credit.

The financial performance of these shadow-banks, including profitability, asset quality and
capital adequacy, improved during FY18 as they weathered the transient effects of
demonetisation and GST implementation, the report noted.

Category-wise, the balance sheet of NBFCs-NDSI expanded by 13.4 percent, while the
balance sheet of deposit- taking NBFCs registering robust growth at 24.4 per cent in 2017-18
on account of a sharp rise in loans and advances.

Retail loans of NBFCs grew at a robust 46.2 percent during 2017-18-on top of a growth of
21.6 percent during 2016 -17-reflecting upbeat consumer demand, especially in the vehicle
loans segment

The non-bank lenders' profitability improved during 2017-18 and 2018-19 (up to September)
mainly due to an increase in fund-based income

Ind-Ra expects NBFCs to witness margin pressures in FY20. Over the years, NBFCs have
increased reliance on short-term borrowings, while reducing on-balance sheet liquidity. This
was done to shore up profitability, which had been reeling under the pressure of higher credit
cost and falling yields. However, the recent liquidity crisis has given rise to funding
challenges, which may prompt NBFCs to overhaul their balance sheets, at least partially, by
replacing short-term borrowings with long-term funds. In terms of passing on the rise in
funding cost, Ind-Ra believes retail NBFCs are better placed than wholesale NBFCs. Housing
finance companies will face contraction in their margins in the large ticket housing segment.
Earlier, the margin pressure had been partly offset through higher yields on non-housing loan
books; however, this segment is likely to face growth-related challenges in FY20.

Ind-Ra expects NBFCs to register tepid growth in FY20 due to slower traction in segments
such as auto and real estate. The current capital buffers and internal accruals are estimated to
be sufficient to take care of the resultant growth requirements. Ind-Ra‘s stress test for the
standalone higher-rated NBFCs shows reasonable resilience in the event of short-term
liquidity tightness and a spike in delinquencies; the stress case equity buffers would largely
remain comfortable in such a scenario.

The government has a strong focus on promoting entrepreneurship, and therefore they can
help the NBFC sector in the Indian economy to realize their full potential and attain greater
efficiency while performing the duties.

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Q11) Regulation of NBFCs.-

The main business activity of the NBFCs is to raise capital funds from public depositors and
investors and then lend to borrowers as per the rules and regulations prescribed by the
Reserve Bank of India. NBFCs are becoming an alternative to the banking and financial
sector. In NBFC there is a requirement of minimum net owned fund of Rs. 2 Crore.

The Regulatory Requirements of NBFC in India

NBFCs can commence its operations only after obtaining ―Certificate of Registration‖ from
the RBI.

NBFC Registration Requirements

The company must be registered as a public limited company or private limited company in
India.
The company must have a minimum net owned fund of Rs.2 Crore.
*Provided that, net owned funds should be calculated according to the last audited balance
sheet of the company.

For a minimum period of 12 months and a maximum period of 60 months, NBFCs are
allowed to accept/renew public deposits.
 NBFCs cannot accept deposits repayable on demand.
 NBFCs can offer interest rates not higher than the ceiling rate prescribed by RBI from
time to time.
 Offering gifts/incentives or any other additional benefit to the depositors is not
allowed.
 There is a requirement of minimum investment grade credit rating.
 Repayment of deposits by NBFCs is not guaranteed by RBI.
 Furnishing hard copies of the list of documents with the regional office of the RBI.
 What are the types of NBFCs on the basis of liabilities and activities?
 Based on Liabilities:
 Deposit Accepting NBFCs (NBFCs-D) [Deposit Taking]
 Non-Deposit NBFCs (NBFCs-ND) [Non-Deposit Taking]
 Systematically Important NBFCs-ND (NBFCs-ND-SI)
 Others NBFCs-ND
 Based on Activities:
 Asset Finance Company (AFC)

Asset Finance Company is a type of company which involves in financing physical assets
such as automobiles, material handling equipment and industrial machines supporting
economic activity.

Equipment Leasing Company

Equipment Leasing Company is a financial institution carrying on its principal business of
the activity of leasing of equipment.

Hire Purchase Finance Company

Hire Purchase Finance Company is a financial institution carrying on as its principal business
the activity of hire purchase transactions.

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Investment Company (IC)
Investment Company is a type of financial institution whose principal business is related to
the acquisition of securities.

Loan Companies (LC)

Loan Company is a type of institution which provides finance in the form of loans or
advances. They obtain funds by taking deposits from the public and give loans to small-scale
traders.

Infrastructure Finance Company (IFC)

Infrastructure Finance Company is a type of NBFC with Net Owned Fund of Rs.300 Crore,
Credit rating ‗A‘ or equivalent credit rating, CRAR of 15% and 75% in infrastructure loans.

Systemically Important Core Investment Company (CIC-ND-SI)

Systematically Important Core Investment Company (assets Rs. 100 crore and above) is a
company which has deployed at least 90% of its assets in the form of investment in shares or
debt instruments or loans in group companies. 60% should be invested in equity shares or
those instruments which can be compulsorily converted into equity shares out of 90%. Such
type of companies accepts public funds.

Infrastructure Debt Fund (IDF-NBFC)

Infrastructure Debt Funds can be set up either as a trust or as a company and they are meant
to infuse funds into the infrastructure sector.

In case Infrastructure Debt Funds set up as a trust, it would be a mutual fund called as IDF-
MF regulated by SEBI. The mutual fund would issue rupee-denominated units of five years
of maturity to raise funds for the infrastructure projects.

In case Infrastructure Debt Funds set up as a company, it would be an NBFC which will be
regulated by the RBI. Such companies would be called IDF-NBFC. IDF-NBFC is a non-
deposit taking NBFC that has Net Owned Fund of Rs 300 crores or more and which invests
only in Public-Private Partnerships (PPP) and post-commencement operations date (COD)
infrastructure projects which have completed at least one year of satisfactory commercial
operation and becomes a party to a Tripartite Agreement.

Non-Banking Financial Company-Micro Finance Institution (NBFC-MFI)

NBFC-MFI is a non-deposit NBFC having it‘s 85% of assets in the form of microfinance.
Microfinance should be in the form of loan given to those who have an annual income of Rs.
60,000 in rural areas and Rs. 120,000 in urban areas. Loans should not exceed Rs. 50000 and
its tenure should not be less than 24 months.

Non-Banking Financial Company – Factors (NBFC-Factors)

There is an acquisition of receivables by way of assignment of such receivables or financing,
there against either by way of loans or advances or by the creation of security interest over
such receivables but does not include normal lending by a bank against the security of
receivables etc.

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NBFC-Factoring company should have a minimum Net Owned Fund of Rs. 5 Crore and its
financial assets in the factoring business should constitute at least 75 percent of its total assets
and its income derived from factoring business should not be less than 75 percent of its gross
income.

Housing Finance Company

Housing Finance Company is a type of company which is engaged in the principal business
of financing of acquisition or construction of houses which includes the development of plots
of lands for the construction of new houses.

Chit Fund Company

They collect deposits from members on a periodic basis and distribute these funds among
them as prizes. Members who enter into an agreement with chit Company subscribe for a
definite period. The Chit Fund Act, 1982 governs the operations of the Chit Fund Company
administered by the State Governments. While the deposit-taking activities are regulated by
the Reserve Bank of India.

Mutual Benefit Finance Company

Mutual Benefit Finance Companies also called ―Nidhis‖, are the non-banking finance
companies that enable its members to pool their money with a predetermined investment
objective. The main sources of funds are to share capital, member deposits, public deposits.

Residuary Non-Banking Company

Residuary Non-Banking Company is a type of NBFC having a principal business of the
receiving of deposits, under any scheme or arrangement or in any other manner and not being
an investment, asset financing, and loan company. These type of companies are required to
maintain investments as per directions of RBI, in addition to liquid assets.

What are the Documents Required for Registration as Type I – NBFC ND?
Following Documents required to be submitted to RBI along with the prescribed application
form for NBFC registration as Type I – NBFC for obtaining certificate and Registration from
RBI as NBFC

Certified copies of Certificate of Incorporation (COI) and Certificate of Commencement of

Business in case of public limited companies.
Certified copies of an extract of only the main object clause in the MOA relating to the
financial business.
A certified true copy of Board resolution stating that:
The company is not carrying on any NBFC activity/stopped NBFC activity and will not carry
on/commence the same before getting registration from RBI.
The UIBs in the group where the director holds substantial interest or otherwise has not
accepted any public deposit in the past /does not hold any public deposit as on the date and
will not accept the same in future
The company has formulated the ―Fair Practices Code‖ as prescribed by the RBI Guidelines.
The company has not accepted public funds in the past/does not hold any public fund as on
the date and will not accept the same in the future without the approval of Reserve Bank of
India.

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The company does not have any customer interface as on date and will not have any customer
interface in the future without the approval of Reserve Bank of India
Copy of Fixed Deposit receipt & bankers certificate of no lien indicating balances in support
of Net Owned Fund.
Audited financial statements along with directors & auditors‘ report from the date of
incorporation of the company, or for the last three years, whichever is less, in case of existing
companies.
Banker‘s report in respect of applicant company, its group/subsidiary/associate/holding
company/related parties, directors of the applicant company having a substantial interest in
other companies The Banker‘s report should be about the dealings of these entities with these
bankers as a depositing entity or a borrowing entity.
Note: Please provide bankers report from all the bankers of each of these entities and provide
the report for all the entities. The details of deposits and loans balances as on the date of
application and the conduct of the account should be specified.

What are the Documents Required for Registration as Type II – NBFC-ND?

Following Documents required to be submitted to RBI along with the prescribed application
form for NBFC registration as Type II – NBFC for obtaining certificate and Registration
from RBI as NBFC

Certified copies of Certificate of Incorporation (COI) and Certificate of Commencement of

Business in case of public limited companies.
Certified copies of an extract of only the main object clause in the MOA relating to the
financial business.
A certified true copy of Board resolution stating that:
The company is not carrying on any NBFC activity/stopped NBFC activity and will not carry
on/commence the same before getting NBFC registration from RBI.
The company has not accepted any public deposit, in the past (specify period)/does not hold
any public deposit as on the date and will not accept the same in future without the prior
approval of Reserve Bank of India.
The UIBs in the group where the director holds substantial interest or otherwise has not
accepted any public deposit in the past does not hold any public deposit as on the date and
will not accept the same in future.
The company has formulated ―Fair Practices Code‖ as per RBI Guidelines.
Copy of Fixed Deposit receipt & bankers certificate of no lien indicating balances in support
of Net Owned Fund
For companies already in existence, the Audited balance sheet, and Profit & Loss account
along with directors & auditors report or for the entire period the company is in existence, or
for last three years, whichever is less, should be submitted.
Copy of the certificate of the highest educational and professional qualification in respect of
all the directors.
Copy of experience certificate, if any, in the Financial Services Sector (including Banking
Sector) in respect of all the directors.
Banker‘s report in respect of applicant company, its group/subsidiary/associate/holding
company/related parties, directors of the applicant company having a substantial interest in
other companies The Banker‘s report should be about the dealings of these entities with these
bankers as a depositing entity or a borrowing entity.
Note: Please provide bankers report from all the bankers of each of these entities and provide
the report for all the entities. The details of deposits and loans balances as on the date of
application and the conduct of the account should be specified.

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In Addition following documents are required to be submitted by the NBFC-MFI applicant.
Certified True Copy of the Board resolution stating that:
(a) The company will be a member of all the Credit Information Companies and will be a
member of at least one Self-regulatory organization.

(b) The company will adhere to the regulations regarding pricing of credit, Fair Practices in
lending and non-coercive method of recovery as per RBI Guidelines.

(c) The company has fixed internal exposure limits to avoid any undesirable concentration in
specific geographical locations.

(d) The company is not licensed under Section 8 of the Companies Act, 2013.

In Addition following documents are required to be submitted by the NBFC-IDF applicant:

 No objection Certificate from RBI issued to NBFC-IFC for sponsoring the NBFC-
IDF.
 Copy of Tripartite Agreement between the concessionaire, the Project Authority, and
NBFC-IDF.
 Details of change in the management of the sponsor company during the last financial
year till date, if any, and reasons thereof.
 Source of startup capital of the company with documentary evidence.
 NBFC-IDF would raise resources through the issue of either Rupee or Dollar
denominated Bonds of minimum 5-year maturity.
 What will be the NBFC Registration Procedure?
 Acquire DSC and Din for directors
 File Name approval application
 An affidavit from directors to fulfill RBI compliance
 Draft MOA & AOA
 File incorporation forms with necessary documents
 Obtain a certificate of registration from Registrar of Companies
 Deposit Net Owned Funds in the bank account opened for company
 Apply for registration with RBI under RBI Act, 1934.
 Applicant Company has to file an online application with the RBI on its official
website.
 After this, an applicant will get a reference number to facilitate inquiry in the future.
 After this, it is required to submit the duplicate hard copies to the concerned regional
office of RBI.
 The regional office shall check the accuracy of all submitted documents.
 The regional office will send the application for NBFC license to the central office.
 The central office of RBI grants NBFC registration only when the applicant company
fulfills prescribed requirements under section 45-IA.
 NBFC must commence its business within 6 months from the date of Certificate of
Registration

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