Indian Financial System

THE FINANCIAL SYSTEM – NATURE, EVOLUTION AND STRUCTURE A financial system is an integral part of a modern economy. An effective system of payment for goods and services enables huge production and the specialization of labor in the economy. The word „system? means an ordered, organized and comprehensive assemblage of facts, principles or components relating to a particular field and working for a specified purpose. But the word system in the term „financial system? represents a set of closely held financial institutions, financial services and financial instruments or claims.

Capital formation in any country is carried out through the various components of the economy. These components are different in their nature, role and functions but finally work as interrelated sub-parts of a structure for the development of the economy. This arrangement of financial institutions, markets and the instruments is called the financial system of a country. Hence, the financial system of a country can be defined as a set of organizations, instruments, markets, services and methods of operations, procedures that are closely interrelated with each other.

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The financial system can also be explained as a methodical arrangement in the economy that helps to pool the resources from the surplus sectors and redistributes them to the deficit sectors. Some analysts say that the financial system is a group of various units that are continuously engaged in gathering the monetary resources in the economy to allocate them to the needful areas. Each and every entity in the system will address some specific issues and functions meeting the prescribed regulations. A well-developed financial system indicates a strong economy.

If the financial system is efficient the mobilization of savings and the allocation of collected resources is also efficient. Money, finance and the credit function are the main concerns of the financial system of any country. Money is a medium of exchange in the financial system. Finance is the aggregate resources of the economy, which are of monetary nature and include equity and debt funds of an individual, company, state or government. Credit represents the sum of money, which was taken from other economic units as a debt and is usually returned with interest.

In a macro sense the financial system can be described as a collection of markets, institutions, laws, regulations and techniques through which bonds, stocks and other securities are traded, interest rates determined and the financial services produced and delivered. The way the financial system of a country is tuned and developed has its own importance and effect on the manner in which it develops. Prerequisites of an Efficient Financial System The basic requirements for any financial system to be efficient are: Efficient monetary system; Facilities for the creation of the capital; and Efficient financial markets.

An efficient monetary system indicates an efficiency medium of exchange for goods and services. It is the unit of measurement in the economy. For the exchange function to be effective, there must be a unit of measurement and account for determining the prices. This must be acceptable in the international markets also. Proper means of payment should exist whatever be the volume of the transactions. Indian Financial System 3 The system should have the facilities to create capital to meet the demands of the economy.

The capital will be necessary to undertake the production activities. The financial system helps to meet such demands by mobilizing the savings of the surplus units to the demanding units. The third important feature of a financial system is the developed financial markets and methodologies, which facilitate the process of transfer of resources and the conversion of financial claims into money. Over years, the financial markets have manifested into round the clock global powerhouses that drive a country? economic progress by supplementing funds from a variety of sources. Today? s markets (in most developed countries) have achieved high level of sophistication in terms of trade, settlement and sale of financial instruments. The role of intermediaries has become all the more important in some areas while in others it has been diminishing (for example, individuals trading stocks). The markets that we see today have taken number of decades if not centuries, to develop and progress and reach the present stage.

Evolution of the Financial System Complexities in the functions of the financial system, especially when the requirements of the savers and those of the borrowers did not match, created a need to enhance the financial system and its functions. The main considerations of the savers were safety of funds, returns and liquidity. On the other hand, the needs of the borrowers were relatively diversified. Their concern related to the cost and the term for which the funds were available. These varied requirements of he lenders and the borrowers led to a mismatch in periods – lending period being different from the needs of the borrower. Similarly, the risk exposure and the corresponding returns did not suit the lender. These factors created a need to develop the financial system in such a way that it matched the requirements of the borrowers and lenders. This led to the evolution of the financial system thereby widening the scope of its operations. Proper allocation of funds is essential to transact business and develop the economy.

And to enable proper allocation of resources, various financial markets were developed. Accordingly, to match the transactions taking place in these financial markets, various financial instruments were created. Over a period of time, these developments made the operations of the financial system complex. Specialized services were offered in these markets with newer and better instruments, which further enhanced the necessity of specialized intermediaries to perform the various financial transactions. Thus, evolved the various market intermediaries.

Yet, another feature of the financial system that needs to be understood is the manner in which the funds flow. In an environment where the borrowers and lenders are easily accessible to each other, the financial system will be in a disintermediation stage i. e. , there will not be any intermediary involved for the funds to flow from the saver to the ultimate borrower. Contrary to such a situation will be the intermediation stage where the financial system will have a few specialized intermediaries enabling the transfer of funds from the savers to the borrowers.

However, now a days the financial requirements are so varied and large that the system generally operates through both the intermediation and the disintermediation mechanisms. Irrespective of how the transfer of funds takes place, it is the central bank of the country along with the government, which generally regulates the financial system by regulating the markets, instruments and players operating in it. With such revolutionary changes taking place in the financial system and with the broadening of its operations, the impact of the same on the economy will be tremendous.

This enhances the need for a closer examination of the network between the various financial markets, intermediaries and the financial assets available in these markets. Overview of Banking 4 The Indian financial system has undergone tremendous changes in its evolution to the present stage. The growth in the economy indicates the growth in the financial system. The efficiency of the financial system is a key indicator of, how the resources are being mobilized and used for the needy sector.

The evolution or the growth of the financial system in any economy can be classified into three major phases: Active government intervention, Partial liberalization, and Total liberalization. With a view to develop the economy the government actively controls the financial sector. This is the first phase, which began, in the Indian financial sector soon after the independence. This process involved tremendous growth in the financial sector with too many drawbacks and anomalies. This resulted into the second phase, which focused on reducing the complexity of the regulatory structure and rationalizing the system.

This second phase continued till the early nineties. The third stage of the process, called as the liberalization era, was started in the 1990s. Institutions were given more independence and autonomy to bring out the effective self-regulation. Segments of the Financial System The financial system can be segmented into two parts namely, the organized and the unorganized sector. The organized system represents the structure of nationalized banking, co-operative banks, and development banks set up by the government through various enactments and regulations. This includes the private sector also.

The government/Reserve Bank of India controls this sector. The unorganized sector comprises of individual moneylenders, bankers, pawnbrokers and traders, etc. The non-banking companies, which do not comply with the RBI regulations, also come under this classification. The financial system prevailing after the independence consisted of individual moneylenders. The money was provided from their own resources. Then followed a phase of chit funds and the indigenous bankers. Then came the co-operative banking system followed by the joint stock banks set up under the Companies Act.

The consolidation and the nationalization resulted in the emergence of commercial banking and subsequently the development banks and financial institutions. Now with the prudential regulations and liberalization, universal banking is set to takeover the financial sector. Thus the system is progressing towards the universal banking system from the ancient barter system. Many forces like industrialization, urbanization and liberalization have made this progress possible. Structure of a Financial System The structure of a typical financial system is shown in figure 1.

Figure 1: Structure of a Financial System Source: Supplement to Business Environment, ICMR. Indian Financial System 5 The main components of a financial system include the financial institutions, claims or instruments and financial services, shown here: Financial Institutions These include organizations like banks, finance companies, insurance companies, co-operative societies and other institutions, which help inculcate the habit of pooling the savings in the people. These institutions also provide credit or finance to the constituents of the economy. Different institutions have different responsibilities and activities.

The financial institutions can be classified based on the degree of specialization and the type of activities they are involved in. These financial institutions can be regulatory, non-regulatory, intermediaries, non- intermediaries and others. The financial institutions also can be classified into various categories based upon their creation and their customers. One of the classifications divides the institutions into banking and non-banking organizations. The major distinguishing feature between these two is that the banking institutions form part of the payment mechanism of the country.

They can create money through deposits that occupy a major portion in the economy? s money supply. By creating liabilities on their part banks can disburse credit to the people whereas the non-banking institutions can disburse the credit only through the resources made available to them by the savers. Commercial banks, co-operative banks, regional rural banks form the banking system in India. Examples of the banks are the various public, private and foreign banks like SBI, GTB, ABN Amro Bank, etc. Examples of non-banking organizations are UTI, LIC, GIC, etc.

Another classification views these financial institutions as intermediaries and non-intermediaries based upon their level of liaison between the savers and borrowers. Intermediaries are the institutions that form a proper channel within the financial system to ensure the transfer of funds from savers to borrowers. With the developments in the financial markets and whole system the scope of operations of the intermediaries has changed a lot from the traditional function of transferring the funds from borrowers to lenders.

The government through special Acts to serve specific purposes, which may not be fulfilled efficiently by the private institutions, creates non-intermediary institutions. IDBI, IFCI and NABARD are the examples of the non-intermediary institutions and all the commercial banks are intermediaries. THE FUNCTIONS OF FINANCIAL INTERMEDIARIES When we talk about the business institutions, we are referring to two types of the institutions, namely financial and non-financial institutions. The non-financial institutions engage in non-financial activities like manufacturing, utility provision, etc.

Whereas, the financial institutions are engaged in providing financial services which include other services like exchanging financial assets on behalf of the customers, providing investment advise, creating market opportunities for the issuers, etc. The intermediaries play an important role in stimulating the markets and providing the necessary impetus for their all round development. They form the crucial link between the issuer of financial claims and the party that assumes the risk. The financial intermediaries are institutions that assist both sides of the market by providing a host of services to facilitate the financial transactions.

The various services provided by the financial intermediaries include, providing assistance in evaluating investment proposals, offering diversified investments in large number of projects for their investors? or clients and monitoring such projects on an ongoing basis, helping businesses in raising finances by structuring a variety of instruments, providing consultancy and customized services, etc. Overview of Banking 6 Over the years, intermediaries have emerged as important players in the markets and many important deals cannot be finalized without them.

Sophistication has been brought in operations and many countries regulate operations in the best interests of their economies. The financial intermediaries offer their services both to the firms and as well as to the individual investors. The following characteristics broadly describe their way of approach and functioning: 1. Offering professional and individually tailored support and advising their clients on a variety of issues like taxation, money matters, etc. , with the help of specialists. 2. Extending global expertise to their clients in various countries. . Having access to sophisticated technologies and resources to undertake their functions and offering a range of comprehensive and integrated products and services. 4. Pro-active support and assistance at all stages of their client? s financial requirements. 5. Having an active presence on all the world? s key financial markets. 6. Providing security, discretion and high service quality. Types of Financial Intermediaries Financial intermediaries can be classified into two types namely, depository institutions and non-depository institutions.

The classification is significant in that it highlights the different roles played by these two sets of intermediaries and their importance in the financial markets. DEPOSITORY INSTITUTIONS 1. Commercial Banks. 2. Saving and Loans Institutions. 3. Credit Unions. NON-DEPOSITORY INSTITUTIONS 1. Finance Companies. 2. Mutual Funds. 3. Security Firms Investment Bankers, Brokers, and Dealers. 4. Pension Funds. 5. Insurance Companies. The Role of Depository Institutions These institutions play an important role in the development of the financial markets.

Depositories mainly include commercial banks, Savings and Loan Institutions (S&Ls), and credit unions. The depositories play a crucial role of channelizing savings into the economy and thereby provide scope for the economic growth of the country. Depository institutions play a key role in transmitting the monetary policy to the financial markets, borrowers and depositors, and ultimately to the real economy. Commercial banks and savings banks being constituents of this system hold a large share of the nation? money stock in the form of various types of deposits and provide for their transfer to effect the payments. Depository institutions directly lend these funds to consumers and businesses for a full range of purposes. They also lend them indirectly by investing in securities. Thus depository institutions provide funds to serve the interests of the society by safeguarding their monies and acting as an important source for the investment community. The extent to which the depository agencies are active propels the markets to great heights by providing other allied activities without any hindrance.

Indian Financial System 7 Keeping in view their importance, the depository institutions are highly regulated because of the important role they play in the country? s financial system. Demand deposit accounts are the principal means that individuals and business entities use for making payments and implementing the government monetary policy. Because of their important role, depository institutions are offered special privileges such as access to federal deposit insurance and to a government entity that provides funds for liquidity or emergency needs.

Non-depository Institutions FINANCE COMPANIES Finance companies cater to the wide and varied segments of society. They cater in multiple ways to both the business as well as to the consumer communities. In a way they are called as department stores of consumer and business credit. Finance companies handle a range of business, which include, automobile finance, purchase of business equipment, home appliances, etc. , either through their outlets or sale counters. Depending upon the segment they serve, finance companies can be classified as consumer finance companies, sales finance companies and commercial finance companies.

Although the differentiation is more or less theoretical, now-a-days every finance company has its presence in all the business segments. Let us briefly study the three types of finance companies. The consumer finance companies (for example, GE Countrywide) make personal cash loans to individuals. The majority of their loans are home equity loans to support the purchase of cars, home appliances, etc. With the advent of finance companies, loans are easily available to the consumers. In recent times consumer companies have identified new segments of business areas, which are growing at a rapid pace.

Some of the areas identified include, medical expenses, educational loans and loans for vacation. As consumer finance companies are aggressive in granting loans, bad debts are also an integral part of the business. Often loans granted by these companies are considered to be riskier than other consumer installment loans and therefore generally carry steeper charges than those assessed by most other lending institutions. Even the level of loan defaults in some finance companies is of alarming proportion.

Sales finance companies (for example, Bajaj Capital) make direct loans to consumers by purchasing installment paper from dealers selling automobiles and other consumer durables. Many of these firms are captive finance companies (for example, GM, Ford, Motorola, Bajaj) controlled by a dealer or a manufacturer. The main motive in establishing these finance companies is to promote sales of the sponsoring firm by providing credit on attractive terms. Commercial finance companies (for example, GE Capital) focus principally on extending credit to business firms.

Most of these companies provide accounts receivable financing and factoring services to small-or medium-sized manufacturers and wholesalers. In order to fund their operations, finance companies access finances through a variety of sources that include debt finance, loans borrowed from banks, commercial paper, debentures sold primarily to banks, insurance companies, and non-financial firms, capital contributed by the parent company, etc. The absence of a network of branch offices has put many finance companies at a disadvantage in reaching the household borrower thus hampering market penetration.

As a result, both banks and non-bank thrifts have been able to capture a larger share of the consumer loan market at the expense of finance companies due to their extensive branch network. Overview of Banking 8 MUTUAL FUNDS Mutual funds can be described as a single portfolio of stocks, bonds, and/or cash managed by an investment company on behalf of many investors. The investment company (AMC) is responsible for the management of the fund, and it sells shares in the fund to individual investors.

When an individual invests in a mutual fund, he or she becomes a part owner of a large investment portfolio, along with other shareholders of the fund. The fund managers? job is to regularly look into the performance of the investments made and bring about changes and invest new funds collected from investors. Everyday, the fund manager counts the value of all the fund? s holdings and figures out how many shares have been purchased by shareholders, and then calculates the Net Asset Value (NAV) of the mutual fund, the price of a single share of the fund on that day.

If the investor wants to buy shares, he should send the requisite money, and new shares will be issued at the most recent price. There are two types of mutual funds: open-end and closed-end mutual funds. Open and closed-end funds pool investor? s money and are managed by professionals to maximize diversification within a set strategy. The difference lies in how the fund is structured in terms of ownership. An open-end fund issues and redeems shares on demand, whenever investors put money into the fund or take it out.

The total assets of these types of funds grow and shrink as money flows in and out when investors buy or sell. A closed-end fund is different as it issues a set number of shares in an initial public offering and trades them on an exchange. Its share price is determined not by the total value of the assets it holds, but by investor demand for the fund, as these funds are traded in the open market. Depending upon the investment objectives, there are different kinds of mutual funds. Some mutual funds invest exclusively in equities, others in debt instruments.

Even within an asset class, there are funds with different objectives. If the fund invests exclusively in equities, then its main emphasis is on growth and capital gains. If it invests in debt the emphasis is on earning a steady return with least risk. If the emphasis of the fund is the combination of growth and income, then a balanced fund is the right choice. If the investor tries to achieve maximum diversification, the latest development is that of index funds, which mimic the underlying index they follow. Examples include Sensex Dependent Index Fund, etc.

If the importance is on the maturity and liquidity, then the Money Market Mutual Funds (MMMF) best suit the requirement. INSURANCE COMPANIES Insurance companies play an important role in the financial markets as non-depository institutions. Insurance companies basically make payment for a price (premium) if a certain event occurs to the policyholders or to their dependents. Insurance companies in other words provide the security and help to live freely without any tension by collecting small amounts in the form of premium with a promise to indemnify when loss or damage occurs.

There are two types of insurance companies – life insurance companies, and property and casualty insurance or general insurance companies. The principal business of life insurance companies is to insure the policyholder against death. When the policyholder dies, a life insurance company agrees to make either a lumpsum payment or a series of payments to the beneficiary. Life insurance is not the only type of insurance sold by these companies. Today a major proportion of the business of life insurance companies provides retirement benefits too.

In the case of the general insurance business, the insurance companies insure the policyholder against any loss sustained by him in daily course of life. Examples of general insurance are home insurance, fire insurance, automobile insurance, etc. General insurance contracts are for a short-term not extending beyond twelve months with some exceptions. Life insurance policies are long-term contracts extending to the entire life of the policyholder. Indian Financial System 9 The insurance companies have vast resources at their disposal in the form of premium amounts collected from the policyholders.

They play an active role in the financial markets by investing their assets in a variety of financial instruments. They play an active role in both the secondary and primary markets and are also active in bond markets. INVESTMENT BANKING Investment bankers are financial institutions and individuals who assist companies in raising capital, often through a private placement or public offering of company stock. Sometimes they are referred to as brokers or dealmakers. They market large amounts of new securities on behalf of governments, government agencies and companies.

Companies frequently use investment bankers to help identify available financing options and obtain introductions to funding sources. Some also look to investment bankers for assistance in building a business plan or prospectus to raise capital. Others seek up-to-date advice on the conditions of fund raising. Investment bankers also vary in quality, resources, experience and contacts. They are exposed to the company? s industry and the type of financing it needs, can often help it raise funds. If they are unfamiliar with the company? industry or the type of financing being sought, they may actually hinder a company? s financing efforts. As investment bankers have the ability to underwrite (or sell) the company? s stock their services become indispensable especially at the time of a public issue. Investment bankers charge for their services. Some charge fixed rates, others work on a percentage commission on the total capital raised by the company. Some of the world famous investment bankers are, Merrill Lynch, Salomon Brothers, Morgan Stanley Dean Witter, Nomura Securities, etc.

They specialize in the design and issuance of financial contracts. They often perform the brokerage function of bringing together buyers and sellers of securities. Apart from advising on how to raise finances, they intermediate in other services like, providing transaction services, financial advice, screening and certification, origination, issuance, and guaranteeing. Often when a new issue of securities involves substantial risk, several investment bankers come together to form a syndicate to bid for and market the issue, thus spreading the risk.

Investment bankers also give advice on the best terms and times to sell new securities and how to finance corporate mergers and acquisitions. Box 1: Merchant Bankers and NBFC Norms RBI clarified that merchant banking companies, which are registered with the SEBI, are exempted from meeting the recent RBI norms for NBFCs. It also exempted stock exchange and stock broking companies as they are registered with SEBI. These companies will be regulated by SEBI. This clarification follows the announcement from SEBI that companies, which carry activities as merchant bankers fall within the purview of RBI, are not eligible for registration under SEBI.

Conditions for availing this exemption are: 1. Such companies have to carry on the merchant banking in accordance with the SEBI guidelines. 2. They can acquire any securities only as part of their merchant banking business. 3. They do not carry on any other financial activity which falls under the RBI purview. 4. They do not accept/hold deposits. SEBI insisted on separating the fund based and fee based activities under separate companies rather than having one single company do both activities. Source: ICFAI Research Team.



SECURITY BROKERS Security brokers or dealers are intermediaries who help companies and investors find one another. Many entrepreneurs hire brokers to help them raise money in the hope, that by doing so, they will reduce the amount of time they will have to spend in fund raising. In some cases, brokers can provide companies with valuable introductions that lead to financing. Some brokers can explain alternative sources of funding and help structure viable financing packages. Companies when entering into contracts with the stockbrokers should be careful.

They should make their agreements explicit and put them in writing. The agreements should define what the broker? s responsibilities are, when he is entitled to a commission, how much the commission will be, and when his assignment expires. Security brokers have different ways of charging like, some prefer to work on a contingency fee or other prearranged fee. LEASING COMPANIES Leasing represents a specialized financial institution that provides the access to productive assets such as airplanes, automobiles, machinery, etc.

The leased assets allow the businesses to use them at a lower cost than borrowing or owning them. Both the parties involved in the lease agreement will benefit through the arrangement. The party that gives assets on lease called as a lessor will get a regular stream of inflows in the form of lease rentals from the lessee and also tax benefits by depreciating the asset. The company or household which has taken the asset on lease benefits as a lessee by getting the asset at a lower cost than borrowing or owing it. Numerous independent leasing companies serve national, regional and local markets.

Competition is intense in this industry because of the entry of scores of banks and bank holding companies, insurance companies, manufacturing companies and firms that have either opened leasing departments or formed subsidiary leasing companies. Some of the advantages of leasing industry are summarized as shown below: a. Lower cost: Leasing conserves capital as the lease payments which are paid either on a monthly or quarterly or half-yearly basis are less than monthly purchase payments of the asset. FormattedFormatted Indian Financial System 11 b. Offers flexibility: Payments can be matched to budgetary levels.

Based on the business conditions, cash flow, equipment needs, tax situation etc. , the lease option can be exercised by the parties. c. Convenience: Leasing provides on-the-spot, one-stop financing for a total solution. Hardware, software, maintenance and asset management can be included in the lease. d. Eliminates risk: The equipment can be returned at the end of the lease without regard for its book value or the expense of proper disposal. Thus it eliminates the risk of obsolescence. e. Provides for off balance sheet services. f. Protects against inflation g.

Offers improved Return on Assets (ROA). MORTGAGE BANKS Mortgage bankers commit themselves to take on new mortgage loans used to fund the construction of homes, offices, buildings and other structures. They carry these loans for a short time until the mortgages can be sold to a long-term lender such as an insurance company or savings bank. As in the case with other dealer operations, the financial risks to the mortgage banker are substantial. An increase in interest rates sharply reduces the market value of the existing fixed rate mortgage banks to turn over their portfolio.

They arrange lines of credit from commercial banks to backstop their operations. These firms also service the mortgage loans they sell to other lenders, collecting loan payments and inspecting mortgaged property. PENSION FUNDS The funds that are dedicated to protecting individuals and families against loss of income in the retirement years by allowing them to set aside and invest a portion of their current income are called as pension funds. Due to increased life expectancy, the importance of pension funds has become all the more relevant.

These pension plans place the current savings of an employer in a portfolio of stocks, bonds and other assets in the expectation of building an even larger pool of funds in the future and paying him either in lump sum or on monthly basis when he retires. Thus pension plans bring in regularity into the life of an employer when he retires. In recent times pension funds have been growing most rapidly. Especially in developed markets like the US, Germany, the UK, etc. , pension funds play an important role in the financial markets.

Pension funds are long-term investments with limited need for liquidity. As the main contributors to these funds are employers who invest a fixed amount of their salary regularly they do not encounter any problem in supply of funds. Similarly the outflow to the investors is predefined in the contracts. Thus pension fund holders can accordingly plan their investments. With the kind of inflows and outflows the pension funds are bestowed with, investors feel encouraged to invest their monies in diverse sources like equities, long-term debt, real estate, etc.

The returns can also be earned by the funds in a decent manner without any rush to divest investments, as the maturity obligations are known previously. As performance of these funds and their solvency has many social implications many governments have taken keen interest to see that they make prudent investments and stringently follow the norms laid out by the regulators. Due to various regulations laid out especially in the US, during the last decade pension funds have received flak for their rather conservative investment policies resulting in low returns. Although existing regulations emphasize conservatism in Overview of Banking 12 nvestments, private pension funds have been under pressure both from the management and the employees of sponsoring companies to be more liberal in their investment policies. Thus some pension funds have been compelled to abandon their conservative investment policies and aim for better returns and invest in moderate to risky avenues or instruments. With the increasing popularity of pension funds, many players have shown keen interest to open new pension plans. A plan sponsor can do one of the following with the pension assets under its control. i. Use in-house staff to manage all the pension assets, or distribute the pension assets. i. Distribute the pension assets to one or more money management firms to manage or else combine the above two strategies. Other players, such as trust departments of commercial banks, insurance companies, private equity investment entities, are also into the business of running pension funds. Pension funds protect individuals and families against loss of income in their retirement years by allowing workers to set aside and invest a portion of their current income. A pension plan places current savings in a portfolio of stocks, bonds, and other assets in the expectation of building an even larger pool of funds in the future.

In this way, the pension plan member can balance planned consumption after retirement with the amount of savings set aside today. The pension funds operating in the US offer two types of plans to choose from. One is called „defined-contribution plan? and the other is called „defined-benefit plan?. In a defined-contribution plan, the plan sponsor is responsible only for making specified contributions to the plan on behalf of qualifying participants. The amount contributed is often a percentage of the employee? s salary or a percentage of profits.

The plan does not guarantee any specific amount at retirement. The other plan namely defined-benefit plan includes those in which the sponsor agrees to make certain specified amount to the qualifying employees at retirement or, in case of death, before retirement. In determining the payments to be made under this plan the pension funds consider the length of service and earnings of the employee. Along with life insurers, private pension funds accumulate the long-term liabilities that are capable of funding the durable assets so critical to real capital accumulation.

In addition, private pension funds, along with mutual funds, are the only two major financial intermediaries to have steadily growing market share since the early 1950s. This growth has caused pension funds to be called upon increasingly to play a role in corporate governance as representatives of their millions of beneficiaries. Historically, private pension funds have been passive investors, but over the years pension funds have started raising their voice when they invested substantial funds in corporate issues such as executive compensation, excessive management, „shirking and perking? and potential conflicts of interest of executives, etc. Pension funds are long-term investments with limited need for liquidity. Their incoming cash receipts are known with considerable accuracy because a fixed percentage of each employee? s salary is usually contributed to the fund. At the same time, cash outflows are not difficult to forecast, because the formula to figure benefit payments is stipulated in the contract between the fund and its members. Indian Financial System 13

This stipulation encourages pensioners to purchase common stock, long-term bonds, and real estate and to hold these assets on a permanent basis. In addition, interest income and capital gains from investments are exempt from federal income taxes, and pension plan members are not taxed on their contributions unless cash benefits are actually paid. Although favorable taxation and predictable cash flows favor longer-term, somewhat riskier investments, the pension fund industry is closely regulated in all its activities in many countries.

For example, in the US, the Employer Retirement Income Security Act (ERISA) requires all the US private pension plans to be funded, which means that any asset held plus investment income must be adequate to cover all promised benefits. ERISA also requires all investments to be made in a “prudent” manner, usually interpreted to mean that they be invested in highly diversified holdings of high-grade common stock and government securities, and only limited real estate and speculative investments. In the US as of 1998, approximately 50% of private pension fund assets were invested in corporate stock.

Corporate bonds ranked a distant second with about 10%. Many of the largest pension funds also hold substantial real estate investments for asset diversification and as a hedge against inflation. The key financial intermediation services provided by pension funds include transaction services, screening and certification, and monitoring. Box 2: RBI Group Considers Setting up of Primary Regulator An Advisory Group constituted by the Reserve Bank of India has recommended that it should think about setting up of a primary regulator with clearly assigned roles and responsibilities to co-ordinate between different regulators in the country.

The group after examining the present practices has found that certain urgent changes are necessary in areas of corporate governance, internal control systems and management of risks. One of the important recommendations made by the group in respect to corporate governance was related to the constitution of bank boards and their accountability. There was some overlap in RBI? s role as owner/regulator/supervisor, which should be corrected, the group suggested. Discussions between management-boards on quality of internal controls should be institutionalized, the RBI group recommended.

The group said given the level of complexity and development of Indian banking sector, the level of compliance with the standards and codes was of a high order. On core principles, the advisory group said the apex bank should gradually move towards setting bank specific capital ratios based on their individual risk profiles. The public sector character of the banks remains an important consideration. The group added that the RBI should consider introduction of measures by which clear accountability could be fixed on individual directors and/or the board for non-performance and/or negligence of their duties.

Advanced risk management capabilities must be in place in all banks latest by March 31, 2003 and the apex bank may assist banks in hastening introduction of scientific risk management systems, it added. A more formal and rigorous assessment of boards? performance must be undertaken by the regulator, which should adopt rating of the boards? performance with the provision that if the rating falls below a certain specified level prompt corrective action should be triggered.

The group said RBI should consider moving over to a risk-based approach to supervision as early as possible and also introduce meeting with banks’ boards and external auditors. Source: ICFAI Research Team. Overview of Banking 14 FINANCIAL INSTRUMENTS Financial assets/instruments represent the financial obligations that arise when the borrower raises funds in the financial market. In exchange for the funds lent, the supplier will have a claim on the income/wealth of the borrower who may be a corporate, a government body or a household.

This financial claim will be packaged in the form of a certificate, receipt or any other legal document. Financial assets play a key role in developing the financial markets in particular and the financial system in general. Their importance to the system can be understood while distinguishing financial assets from the real assets. All assets are financed by liabilities as advocated by the accounting concept. While the assets can be either financial or real the liabilities will be either in the form of savings or financial liabilities.

Financial assets represent the obligations on the part of their issuer. Hence, all financial assets will be equal to the financial liabilities. The assets will be funded either by using savings or by borrowings. Since borrowings represent financial liabilities, the accounting equation can be altered as: Assets = Liabilities Financial Assets + Real Assets = Financial Liabilities + Savings Since financial assets equal financial liabilities, the real assets will be financed by savings. This relationship has the following implicit assumptions. i.

There are no external borrowings in the system. ii. Financial liabilities include stock issued to the outsiders. From the above equation, it can be understood that the surplus funds of an economic unit will either be used by the saver to purchase a real asset or will be lent to other economic units to buy real assets. Thus, all real asset purchases within the system will be made from the savings in the system. An important aspect to be noted here is the process through which savings are transformed into real assets since they have an important bearing on the economic progress.

This can be explained by the fact that savings can be transformed into real assets for consumption purpose or they can also be transformed into real assets through the investment channel. Though these two activities, i. e. , consumption and investment are essential to the economy, using excess of savings for consumption purpose will be detrimental to the economic progress since it will result in scarcity of funds for the investment. While both demand and supply are necessary for economic growth, the deployment of savings should be such that it ensures equilibrium.

It thus implies that stimulation of savings into financial assets for ultimately purchasing real assets promotes the role of the financial markets in the system. Types of Financial Assets The majority of financial assets used worldwide are in the form of deposits, stocks and debt. DEPOSITS Deposits can be made either with banking or non-banking firms. In return, the lender will receive a certificate in case of a fixed deposit and a checking account in case of a savings/current deposit. These serve as a payment mechanism for the supplier of funds. Interest will be earned on such deposits except current deposits.

STOCKS Indian Financial System 15 When financial assets are in the form of stock, they represent ownership of the issuing company. Due to this right to ownership, the holder of the stocks will have a share in the firms? profits. DEBT Unlike the stocks, financial assets in the form of debt create an obligation on the borrower to repay the amount borrowed. The debt instrument will be a contract entered into by the borrower of funds with the lender of funds, to repay the amount borrowed after a predetermined period and at a certain rate of interest.

If an asset serves as a collateral to the borrowing, then the holder of the debt instrument will have a priority claim on the asset. Within this broad classification, financial innovations have brought about a variety of instruments. Stocks are thus preferred stocks and common stocks, with the latter having voting rights. In case of debt instruments, the classifications are much more varied depending on the issuer of securities and other terms and conditions present in the contract for example, gilt-edged securities are the debt instruments issued by the government.

Other classifications of the debt instruments are: fixed/floating rate bonds, negotiable/non-negotiable instruments, redeemable/ irredeemable bonds, convertible/non-convertible bonds, etc. Further, these instruments, both stock and debt, enable the issuer to raise funds in domestic and foreign currencies. There is a certain amount of uncertainty attached to future cash flows. This makes lending a risky business. To compensate for this risk and the uncertainty attached to future cash flows, suppliers of funds will be provided income in the form of dividends, interest, etc.

Thus, issuers of the financial assets can mobilize the requisite funds from the financial markets by promising future income to the subscribers of the financial assets. Designing of the Financial Products The ability of an issuer to fulfill the promise of future cash flows depends mainly on his inherent financial strength. The financial assets are rated to indicate the safety levels (levels of risk) by specialized rating agencies. Apart from the safety, suppliers of funds also expect to earn good returns. And since risk and return are positively correlated, financial assets having greater risk generally carry higher yields and vice versa.

With this basic understanding, the suppliers will deploy their funds into the financial markets by selecting the financial asset that matches their risk-return preferences. Liquidity is also an important criterion for asset selection. Suppliers of funds generally deploy their surplus funds into such financial assets until the time they are needed. And when the need arises, the lenders of funds should be able to liquidate the financial assets held by them whenever they intend to do so. These three basic features of the financial instruments – returns, risk and liquidity – have a major impact on the financial system.

Firstly, the variety of financial assets with varying risk-return profiles influence the interest rate structure of the economy. Secondly, the liquidity offered by these financial assets will influence the amount of funds that can be mobilized from the markets. In addition to these features, instruments are being designed with various other features to suit the issuer as well as to attract the investor. Listed below are the considerations of the issuer while designing the instrument and that of the investor while investing in the financial instrument.



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