UNIT 3 FINANCIAL INSTITUTION

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

loans, and deposits. It plays a crucial role in the economy by channelling funds from savers to borrowers,
facilitating the efficient allocation of resources, and supporting economic growth and development.
Institutions include banks, credit unions, insurance companies, and investment firms.
Roles Performed by Financial Institutions
 Economic Growth of the Nation
At the national level, financial institutions are subject to government regulation. They serve as an
agent of the government and develop the country’s economy. For instance, following government
regulations, financial institutions may extend a selective credit line with lower interest rates to
assist a struggling industry in resolving its problems.
 Capital Formation
Financial institutions offer financial services to investors who require external cash to raise their
capital stocks by accepting individual savings. Investors may want financial services to carry out
development plans by setting up new machinery, tools, and equipment; constructing a new
facility; and purchasing new transport vehicles, among other things. Financial institutions
contribute to the creation of capital in this way.
 Regulate Monetary Supply
The financial institution assists in controlling the amount of money in the economy. These
organizations keep the money supply stable and manage inflation. The Federal Reserve Bank
regulates the nation’s liquidity in several ways, including adjusting repo rates, participating in
open markets, and setting cash reserve ratios. To control liquidity, financial institutions
participate in the purchasing and selling of government assets.
 Banking Services
Commercial banks and other financial institutions assist their clients by offering savings and
deposit services. Additionally, they provide their clients with credit options, including overdraft
facilities, to meet their short-term funding needs. Additionally, commercial banks offer their
clients loans such as house loans, mortgages, personal loans, and loans for schooling.
 Pension Fund Services
Financial institutions assist people in retirement planning through the different types of
investment plans they offer. A pension fund is one of these investing possibilities. Employers,
banks, or other institutions contribute to the investment pool on behalf of the individual, who then
receives a lump sum or monthly income upon retirement.
 Intermediation
Financial institutions act as intermediaries between savers and borrowers. They collect funds
from individuals and businesses as deposits and then lend them to borrowers who need capital for
various purposes, such as starting a business or purchasing a home.
 Depository Services
Financial institutions provide depository services by accepting deposits from individuals and
businesses. They offer checking accounts, savings accounts, and other deposit products where
customers can securely store their money. These deposits may also earn interest.
 Credit Provision
Financial institutions extend credit to individuals and businesses through loans and credit lines.
They evaluate the creditworthiness of borrowers, determine interest rates, and provide financial
support for various needs, such as personal loans, mortgages, business loans, and working capital.
 Investment Services
Financial institutions offer investment services to help individuals and businesses manage and
grow wealth. They provide access to investment products such as stocks, bonds, mutual funds, and
other securities. They also offer advisory services to guide clients in making informed investment
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decisions.
 Risk Management
Financial institutions assist individuals and businesses in managing financial risks. They provide
insurance products, such as life insurance, health insurance, property insurance, and liability
insurance, to protect against potential losses and unforeseen events.
 Payment and Settlement Services
Financial institutions facilitate payment transactions between individuals and businesses. They
provide payment and settlement services such as processing electronic fund transfers, issuing
credit and debit cards, and managing payment systems to enable smooth and secure transactions.
 Asset Management
Financial institutions offer asset management services, where they manage investment portfolios
on behalf of clients. They provide expertise in selecting investment options, diversifying portfolios,
and monitoring market conditions to optimize returns and meet clients’ financial goals.
 Financial Advisory
Financial institutions provide financial advisory services to individuals and businesses. They offer
guidance on financial planning, retirement planning, tax planning, estate planning, and overall
wealth management. They assist clients in making informed financial decisions based on their
goals and risk tolerance.
ROLE OF DEVELOPMENT BANKS
1. Providing Funds
The persons who have the capability of starting a business but does not have requisite help approach to
financial institutions for help. These institutions help a large number of persons for taking up some
industrial activity.
2. Promotional activities
The promotional role of development banks is helpful in increasing the development of a country. They
create a new class of entrepreneurs and help the weaker sections of society to be a part of industrial
culture. With a view for a long term benefit to social development, banks have new capital schemes which
provide financial assistance to the novice entrepreneurs. They help in covering the expense and
manpower resources for undertaking the exercise of starting a new unit.
3. Assistance of Backward Units
The development bank encourages rustic and provincial development. They give money to beginning
organizations in reverse zones. Likewise, they help organizations which are in the venture in less-
developed regions.
4. Employment Generation
Financial institutions have helped both direct and indirect employment generation. They have employed
many people in their offices. These institutions help in creating employment by financing new and
existing industrial units.
5. Accelerating Industrialization
The setting up of more industrial units will generate direct and indirect employment, make available
goods and services in the country and help in increasing the standard of living. Financial institutions
provide requisite financial, managerial, technical help for setting up new units.
6. Development of Housing Sector
Development banks provide funding for the development of the housing sector. It refinances banks and
financial institutions which provide credit to the housing sector. It promotes and develops housing and
financial institutions.
7. Agriculture and Rural Development
It organizes the working of all monetary establishments that give credit to farming and rural
development. Development banks like the National Bank for Agriculture and Rural Development
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(NABARD) which give credit to the agriculture and furthermore for country advancement exercises.
8. Improve Foreign Trade
It gives Overseas Buyers Credit to purchase Indian capital merchandise. Likewise, urges abroad banks to
give account to the purchasers in their nation to purchase capital products from India.
9. Revival of Sick Units
Development banks help to resuscitate (fix) wiped out units. It encourages modernization, rebuilding,
and broadening of wiped out units by giving credit and different administrations. The public authority of
India (GOI) began the Industrial Investment Bank of India (IIBI) to help wipe out units. IIBI is the
principal credit and recreation foundation for a restoration of wiped out units.
10. Contribution to Capital Markets
The development bank helps in the growth of capital markets. They invest in equity shares and
debentures and mutual funds of several companies listed in India.
Some of the Development Banks in India
Industrial Finance Corporation of India (IFCI): this is for providing medium and long-term credit for
the needs of industrial units.
Industrial Credit and Investment Corporation of India (ICICI): it promotes private industry concerns
in the country and was set up as a private sector development bank.
Industrial Development Bank of India (IDBI): the IDBI’s it organizes the activities of other
development banks and term-financing institutions
Industrial Reconstruction Bank of India (IRBI)’: it provides financial assistance as well as to revive
and revitalize sick industrial units in both of the sectors.
Small Industries Development Bank of India (SIDBI): With a view to ensuring a larger flow of
financial and non-financial assistance to the small-scale sector.
State-Level Industrial Development Banks:(SFCs and SIDCs): there is a combination of financing
agencies and industrial development banks, focusing on backward regions for the development of
medium and small-scale industries in respective states.
A non-banking financial institution (NBFI) is also known as non banking financial company or Non
Banking Financial Corporation (NBFC). It is a financial entity that operates without a complete banking
license. It is not supervised by any national or international banking regulatory agency.
These financial institutions offer bank-related financial services including risk pooling, investing,
contractual savings, and market brokering. Examples include hedge funds, insurance firms, pawn shops,
cashier's cheque issuers, check cashing locations, payday lending, currency exchanges, and microloan
organizations.
Characteristics of Non-Banking Financial Institutions
Non-Banking Financial Institutions (NBFIs) have the following characteristics that differentiate them
from traditional banking institutions:
1. Lack of Banking License: NBFIs do not hold a banking license and are not allowed to accept
demand deposits from the public.
2. Regulatory Framework: They operate under a different regulatory framework, which is often
less stringent than that governing traditional banks.
3. Specialized Financial Services: NBFIs typically offer specialized financial services, including
investment, risk pooling, contractual savings, and market brokering, among others.
4. Credit Provision: They provide credit and loans to individuals and businesses, often catering to
sectors or clients not served by traditional banks.
5. Investment Opportunities: NBFIs offer various investment products and opportunities, such
as mutual funds, hedge funds, and private equity funds.
6. Risk Management: Through products like insurance, NBFIs offer risk management solutions to
individuals and businesses.
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Functions of Non Banking Financial Intermediaries
NBFIs help in making the economy more stable and efficient. They offer a various financial services
across different areas of the economy, meeting the needs of various groups of people. The following are
the key functions of Non-Banking Financial Institutions:
1. Credit Provision: They extend credit to individuals and businesses that might not meet the
stringent criteria of traditional banks, thereby filling a critical gap in the credit market. This
includes loans for real estate, personal loans, and business financing.
2. Investment Services: Offering investment opportunities to individuals and institutions through
the management of various funds such as hedge funds, private equity funds as well as mutual
funds. These services help investors with diversifying their portfolios beyond traditional bank
products.
3. Risk Management: Through insurance products, NBFIs provide risk management solutions to
individuals and businesses, covering several risks related to life, health, property, and casualty.
4. Savings and Retirement Planning: They offer products like annuities and mutual funds that help
individuals save for retirement and other long-term goals, often providing higher returns
compared to traditional savings accounts.
5. Payment and Settlement Systems: Some NBFIs offer payment processing and settlement
services, facilitating transactions between buyers and sellers in various markets.
6. Financial Advisory Services: Providing expert advice on mergers, acquisitions, restructuring,
and other financial transactions to businesses and individual investors.
7. Market Making and Liquidity Provision: By acting as market makers, some NBFIs contribute to
the liquidity and efficiency of financial markets, facilitating trading in stocks, bonds, and other
securities.
8. Peer-to-Peer Lending: Connecting borrowers directly with lenders through online platforms,
bypassing traditional banking channels, and often offering more competitive rates and terms.
9. Innovation and Financial Inclusion: NBFIs are often at the forefront of financial innovation,
developing new financial products and services that fulfil the requirements of consumers and
businesses. They promote financial inclusion by reaching potential customers who do not have
any banking experience.
Mutual Funds can be defined as money pooled by a large number of people (Investors) having one
common investment objective.
Features of Mutual Funds
 Investment flexibility: This is one of the most appealing features of mutual funds. To invest in
mutual funds, individuals can choose between SIP and lump sum payments.
 Great for portfolio diversification : Mutual funds can be invested evenly in high and low-risk
funds on people’s behalf to balance one’s profits and losses instead of putting all money into one
place. This gives individuals access to a diverse portfolio that can generate profits even during
economic downturns.
 Professional operation: To operate mutual funds, every fund house hires experts known as fund
managers. They analyse market trends and invest the money in shares or bonds based on the
scheme’s objectives.
 Tax benefits: Because of their great tax efficiency, mutual funds are a good long-term investment.
Investing in tax-saving funds while producing large returns might also result in income tax
deductions.
 Liquidity: In case of an emergency, people can withdraw or redeem money from the fund.
Depending on the scheme, people get the ransom in 3-4 business days in the form of liquid money.
Thus, mutual funds have adequate liquidity, since investors can redeem them at any moment.
 Minimal charges: Mutual funds are also accessible to people of all income levels. To invest in
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mutual funds, you must pay a tiny fee to your fund companies, known as the expense ratio. The fee
ratio and any extra charges may differ between investment companies. However, the fees are
lower than those of comparable managed funds.
Types of mutual funds :
1. Open-ended schemes are perpetual, and open for subscription and repurchase on a continuous
basis on all business days at the current NAV.
2. Close-ended schemes have a fixed maturity date. The units are issued at the time of the initial
offer and redeemed only on maturity. The units of close-ended schemes are mandatorily listed to provide
exit route before maturity and can be sold/traded on the stock exchanges.
3. Interval schemes allow purchase and redemption during specified transaction periods
(intervals). The transaction period has to be for a minimum of 2 days and there should be at least a 15-
day gap between two transaction periods. The units of interval schemes are also mandatorily listed on
the stock exchanges.
4. Equity Mutual Funds: Equity Mutual Funds can be defined as a pool of funds collected from
various investors and invested in a diversified portfolio of equities (stocks) across different sectors and
market capitalisations. Equity mutual funds are a popular investment option that offers individuals the
opportunity to invest in the stock market without directly buying individual stocks. It is consist of Multi
Cap Funds, Large Cap Mutual Fund, Mid Cap Mutual Funds, Small-Cap Mutual Funds, Value Mutual Funds,
Focused Fund, Dividend Yield Mutual Funds.
5. Debt Schemes Mutual Funds: Debt mutual funds are a category of mutual funds that primarily
invest in fixed-income securities such as government and corporate bonds, treasury bills, commercial
papers, and other debt instruments. These funds aim to provide regular income along with the
preservation of capital. It is consist of Overnight Fund, Liquid Mutual Fund, Ultra Short-Term Mutual
Funds, Low Duration Mutual Funds, Medium Duration Mutual Funds, Corporate Bond Debt Funds, and
Gilt Funds.
6. Hybrid Schemes Mutual Funds: Hybrid mutual funds, also known as balanced funds, are
investment vehicles that combine different asset classes within a single fund. These funds invest in a mix
of both equity and debt instruments to provide a diversified portfolio that aims to balance returns and
risks. It is consist of Balanced Fund, Aggressive Mutual Funds, Dynamic Mutual Funds, Arbitrage Funds,
and Equity Savings Schemes Funds.
7. Money Market Funds: Money Market Funds (MMFs) are defined as a type of fund that offers
investors an easily accessible way to manage their cash while preserving their invested capital
ADVANTAGES OF INVESTING IN MUTUAL FUNDS
1. Professional Management — Investors may not have the time or the required knowledge and
resources to conduct their research and purchase individual stocks or bonds. A mutual fund is managed
by full-time, professional money managers who have the expertise, experience and resources to actively
buy, sell, and monitor investments. A fund manager continuously monitors investments and rebalances
the portfolio accordingly to meet the scheme’s objectives. Portfolio management by professional fund
managers is one of the most important advantages of a mutual fund.
2. Risk Diversification — Buying shares in a mutual fund is an easy way to diversify your investments
across many securities and asset categories such as equity, debt and gold, which helps in spreading the
risk - so you won't have all your eggs in one basket. This proves to be beneficial when an underlying
security of a given mutual fund scheme experiences market headwinds. With diversification, the risk
associated with one asset class is countered by the others. Even if one investment in the portfolio
decreases in value, other investments may not be impacted and may even increase in value. In other
words, you don’t lose out on the entire value of your investment if a particular component of your
portfolio goes through a turbulent period. Thus, risk diversification is one of the most prominent
advantages of investing in mutual funds.
3. Affordability & Convenience (Invest Small Amounts) — For many investors, it could be more costly
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to directly purchase all of the individual securities held by a single mutual fund. By contrast, the
minimum initial investments for most mutual funds are more affordable.
4. Liquidity — You can easily redeem (liquidate) units of open ended mutual fund schemes to meet your
financial needs on any business day (when the stock markets and/or banks are open), so you have easy
access to your money. Upon redemption, the redemption amount is credited in your bank account within
one day to 3-4 days, depending upon the type of scheme e.g., in respect of Liquid Funds and Overnight
Funds, the redemption amount is paid out the next business day.
However, please note that units of close-ended mutual fund schemes can be redeemed only on maturity.
Likewise, units of ELSS have a 3-year lock-in period and can be liquidated only thereafter.
5. Low Cost — An important advantage of mutual funds is their low cost. Due to huge economies of scale,
mutual funds schemes have a low expense ratio. Expense ratio represents the annual fund operating
expenses of a scheme, expressed as a percentage of the fund’s daily net assets. Operating expenses of a
scheme are administration, management, advertising related expenses, etc. The limits of expense ratio for
various types of schemes has been specified under Regulation 52 of SEBI Mutual Fund Regulations, 1996.
6. Well-Regulated — Mutual Funds are regulated by the capital markets regulator, Securities and
Exchange Board of India (SEBI) under SEBI (Mutual Funds) Regulations, 1996. SEBI has laid down
stringent rules and regulations keeping investor protection, transparency with appropriate risk
mitigation framework and fair valuation principles.
7. Tax Benefits —Investment in ELSS upto ₹1,50,000 qualifies for tax benefit under section 80C of the
Income Tax Act, 1961. Mutual Fund investments when held for a longer term are tax efficient.
CREDIT CONTROL METHODS OF RBI
It is one of the important function of RBI for controlling supply of money or credit. There are 2 types of
methods employed by the RBI to control credit creation:
1. Quantitative method
2. Qualitative method
Quantitative method:
1. Bank rate: It is the rate of interest at which central bank lends funds to commercial banks. During
excess demand or inflationary gap, central bank increases bank rate. Borrowings become costly
and commercial banks borrow less from central bank. During deflationary gap central bank
decreases the bank rate. It is cheap to borrow from the central bank or the part of the commercial
banks which in turn the Commercial banks also decreases their lending rates.
2. Open market operations: The open market operations means buying and selling of bonds and
shares by RBI is open market. It is also called buying and selling of government security by the
central bank from the public and commercial banks.
Sale of securities
At the time of inflation the RBI starts selling of government securities in the market. The resources of
commercial bank are reduced and they are not in a position to lend more to the business community. This
reduces the investment and aggregate demand.
Purchase of securities
At the time of deflation the RBI starts buying securities from open market. The reserves of commercial
banks are raised and they lend more investment, output income and aggregate demand starts rising.
Legal Reserve Requirement: It is another method of RBI for controlling credit or supply of money. It
includes 2 types of methods such as:
3. Cash Reserve Ratio (CRR): It is the ratio of bank deposits that commercial bank has to keep with
the central bank. At the time of inflation the RBI increases the rate of CRR, similarly at the time of
deflation RBI decreases the rate of CRR.
4. Statutory Liquidity Ratio (SLR): Every bank required to maintain a fixed percentage of its assets
in the form of cash or other liquid assets called SLR. At the time of inflation the RBI increases the
SLR, similarly at the time of deflation RBI decreases the rate of SLR.
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Qualitative method:
1. Margin requirements: It is the difference between the market value of loan and the security
value of loan. At the time of inflation the margin requirement value decreases by RBI for
discouraging people and commercial banks for approaching more and more amount of loan. On
the other hand at the time of deflation the RBI increases the value of margin just to encourage
issuing of more amount of loan to the commercial banks and general public.
2. Moral suasion: It refers to written or oral advices given by central bank to commercial banks to
restrict or expand credit.
3. Direct Action: Sometimes the RBI directly takes action against the commercial banks. It takes
action to such type of commercial banks who are not following the rules regulation of RBI. It
cancels their registration or nationalization of commercial banks.
4. Rationing of credit: It is the related to limiting the amount of credit, which is issued by all the
commercial banks. RBI fixes the size of issuing the credit according to the requirement of the
country.
Asset Management Company (AMC) is defined as an enterprise that manages customers’ funds by
accumulating and investing them in various provisions such as stocks, real estate, bonds, and other
investments. AMCs not only manage portfolios of high-net-worth individuals (HNWI) but also look after
hedge funds, pension funds, mutual funds, index funds, and Exchange Traded Funds (ETFs) using funds
from small investors and combining them into a single consolidated portfolio.
1. Providing Profitable Investment: The main function of an AMC is to make the best use of client’s
asset in the most efficient, effective and profitable investment possible. So, as an initial step of
investment, AMCs do a thorough research on the market and then analyses the data and facts so as to
define the financial goals and objective. In this step of research and analysis, careful judgement of the risk
associated with each financial deal is looked into.
2. Allocation of Assets: The next step is the allocation of assets, i.e., selecting the assets and securities in
which investment would be carried on. After selection of assets, allocation of funds takes place to buy
those assets and securities. The returns earned from the investments are the profit on the investment and
those are shared between the fund manager and the investor.
3. Portfolio Building: Once, the market research and fund and asset allocation is conducted, it is time for
the portfolio building. The fund managers tries to design a diversified and strong portfolio which can
reap high profits for their clients. Lastly, after considering all the relevant factors, they take a decision to
either buy, sell or hold those assets or securities.
4. Performance Review: Finally, the last work of an AMC is to timely review their investments and take
justifiable decisions. This step can be called as the performance review. As the fund managers are using
funds from investors, so they are liable to respond to queries and decisions taken by them. The fund
managers should give proper justification as to why a particular asset is bought, sold or kept at holding
position.