Financial Institutions and Markets: Structure Growth and Innovations [6 ed.] 9352605411, 9789352605415
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Table of contents :
Title
Contents
Part 1 Overview
1 The Nature and Role of Financial System
2 An Introduction to Security Analysis
3 An Overview of the Indian Financial System
4 Financial Sector Reforms
Part 2 Financial Regulations and Regulatory Institutions in India
5 Financial Regulations in India
6 The Reserve Bank of India
7 Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
Part 3 Banking Institutions
8 Commercial Banks
9 Co-operative Banks
Part 4 Non-Bank Financial Intermediaries and Statutory Financial Organisations
10 Small Savings, Provident Funds and Pension Funds
11 Insurance Companies
12 Mutual Funds
13 Miscellaneous Non-Bank Financial Intermediaries
14 Non-Bank Statutory Financial Organisations
Part 5 Financial Markets
15 Call Money Market
16 Treasury Bills Market
17 Miscellaneous Short-Term Financial Markets
18 Bond Market
19 Stock Market
20 Derivatives Market
Part 6 International Dimensions of Financial Markets
21 Foreign Exchange Market
22 Foreign Capital Flows
Part 7 Interest Rates
23 Theories of the Level and Structure of Interest Rates
Glossary
References
Index
Citation preview
Financial Institutions and Markets Structure, Growth and Innovations Sixth Edition
About the Authors Laxman Madhao Bhole retired as Professor (Economics) from the Department of Humanities and Social Sciences, Indian Institute of Technology Bombay, in the year 2005. After graduating from Poona University in 1965, he obtained his MA in Economics from Bombay University in 1967 and PhD from Bombay University in 1971. After that, he joined Sydenham College, Bombay, where he taught for two years. He then joined IIT Bombay in 1973 and was the Head of the Department of Humanities and Social Sciences during 1989–1992. He was awarded Maharashtra Government Open Merit Scholarship, Ford Foundation Scholarship and UGC Fellowship for his studies at various levels. He visited the Institute for Studies in Economic Development, Naples, Italy, for six months on an Italian Government scholarship. He has been teaching economics for more than
Economic Thought (2000), Collected Papers on Money, Interest, and Monetary Policy (2007), Collected Papers on Credit and Finance (2007), Collected Papers on Gandhian Thought (2007), Unemployment, Inequality, Entrepreneurship, and other Collected Papers (2007), Gandhi’s Hind Gandhi and Vinoba Bhabe (2016). His current areas of teaching and research include Gandhian
Jitendra Mahakud is Associate Professor of Economics and Finance at the Department of Humanities and Social Sciences, Indian Institute of Technology Kharagpur. He is also a joint faculty his Masters and M Phil in economics from the Central University, Hyderabad, he obtained his PhD
Financial Institutions and Markets Structure, Growth and Innovations Sixth Edition
L. M. Bhole Professor of Economics (Retired) Department of Humanities and Social Sciences Indian Institute of Technology Bombay
Jitendra Mahakud Associate Professor of Economics and Finance Department of Humanities and Social Sciences Indian Institute of Technology Kharagpur
McGraw Hill Education (India) Private Limited CHENNAI McGraw Hill Education Offices Chennai New York St Louis San Francisco Auckland Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal San Juan Santiago Singapore Sydney Tokyo Toronto
McGraw Hill Education (India) Private Limited Published by McGraw Hill Education (India) Private Limited
Financial Institutions and Markets: Structure, Growth and Innovations, 6e Copyright © 2017 by McGraw Hill Education (India) Private Limited No part of this publication may be reproduced or distributed in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise or stored in a database or retrieval system without the prior written permission of the publishers. The program listings (if any) may be entered, stored and executed in a computer system, but they may not be reproduced for publication. This edition can be exported from India only by the publishers, McGraw Hill Education (India) Private Limited Print Edition
E-Book
Managing Director: Kaushik Bellani Portfolio Lead—B&E: Nikhil Wadhera Portfolio Manager—B&E: Shivkant Singhal Content Development Lead: Shalini Jha Senior Content Developer: Laxmi Singh Production Head: Satinder S Baveja Copy Editor: Taranpreet Kaur Assistant Manager—Production: Suhaib Ali General Manager—Production: Rajender P Ghansela Manager—Production: Reji Kumar from sources believed to be reliable. However, neither McGraw Hill Education (India) nor its authors guarantee the accuracy or completeness of any information published herein, and neither McGraw Hill Education (India) nor its authors shall be responsible for any errors, omissions, or and its authors are supplying information but are not attempting to render engineering or other professional services. If such services are required, the assistance of an appropriate professional should be sought. Typeset at The Composers, 260, C.A. Apt., Paschim Vihar, New Delhi 110 063 and printed at
Preface to the Sixth Edition
Financial Institutions and Markets: Structure, Growth and Innovations
undergraduate and post graduate students in mind, with the updated information, this edition
for better understanding of theoretical concepts. While carrying out the revision, the approach has been not only to incorporate all the latest information and emerging trends, but also to retain the relevant information of the past.
Additions/Revisions
●
●
●
services has been expanded. ● ●
Discussion on economic analysis, industry analysis and company analysis has been further elaborated.
●
and demonetisation and its impact on Indian economy have been introduced in the overview ●
vi
Preface to the Sixth Edition
●
the theories of regulation, regulatory approaches, multiple verses single regulator and also ●
on Liquidity Adjustment Facility (LAF) has been revised. A summary of report by the expert ●
●
chapter. ●
●
●
●
The discussion on types of instruments in small savings media has been elaborated. The section on provident funds has been updated and discussion on the architecture of the New Pension System (NPS) has been introduced. The features of NPS have also been expanded. Features of NPS Swavalamban and Atal Pension Yojana have been included. Data on NPS and various pension schemes has been updated. Discussion on principles of insurance has been introduced in the chapter on Insurance. The data and policy developments related to the insurance sector in India have been revised. The chapter on mutual fund has been updated with the inclusion of elaborate discussion performance evaluation, hedge fund and systematic investment plan.
●
have been highlighted. The discussion on credit rating agencies in India has been expanded. ● ●
Preface to the Sixth Edition ●
vii
Chapter on Treasury Bills has been reviewed introducing the discussion on cash management bill, types of auctions held in issuing treasury bills and calculation of the yield of the treasury bills.
●
●
Considering the current trend and interest of the students, chapters on Government Securities
●
bond investments, valuation of bond, yield measures and yield curves. Further, this chapter
securities has been introduced with suitable examples. ●
●
section on pricing of the derivative instruments has been revised with the inclusion of many mathematical derivations and numerical examples. ●
●
●
(FDI) and Foreign Institutional Investment (FII) has been expanded. A new section on FDI in retail sector in India has been introduced. Section on the theories of term structure interest rates has been expanded and the chapter on interest rates in India has been restructured, and updated in the light of recent data and policy measures.
Learning Aids ● ● ●
Updated Glossary and Index. New box items within chapters for better understanding of the concepts.
viii
Preface to the Sixth Edition
Acknowledgements
Similarly, Mrs Seba Mohanty and Mr Gaurav Gupta helped us to collect data and prepare tables for Gupta, Mrs Lopamudra Satpathy and Mr Sunil Sangwan for helping us in collecting information to
while carrying out the revision.
L. M. Bhole Jitendra Mahakud
Preface to the First Edition
understood much better, and they can be analysed more realistically if he has a good understand
primarily in India, but wherever appropriate the reference has also been made to the situation in certain other economies such as the USA and the UK. since the beginning of economic planning. It was but natural that this development should
subject in the sense that they have tended to concentrate their attention on the discussion of
While doing so, it combines the factual and analytical aspects of the discussions in a balanced manner.
x
Preface to the First Edition
money, bill of exchange, of and the empirical evidence on the level and structure of interest rates have been discussed. ics. It may also serve as a reference or supplementary text in graduate and postgraduate courses in the areas just mentioned. Further, it can be expected to be useful to corporate researchers or
innovations and monetary policy to be included in the research project report to be submitted
the Curriculum Development Programme in the Indian Institute of Technology, Mumbai, for
him for the same.
available to me some of their publications. L. M. Bhole
Contents
Preface to the Sixth Edition Preface to the First Edition
v ix
PART 1 OVERVIEW 1.
The Nature and Role of Financial System 1.1 1.2 1.3
1.3–1.33
Introduction 1.3 Major Functions of the Financial System 1.3 Structure of the Financial System 1.4 1.3.1 Financial Institutions 1.5 1.5 1.6 1.3.5
1.6 Financial Instruments and Services 1.7 1.8 1.10
1.5
1.6
Financial System and Economic Development 1.11 1.5.1 Effects of Financial System on Saving and Investment 1.11 1.5.2 Theories of the Impact of Financial Development on Savings and Investment 1.12 Meaning and Process of Financial Development 1.19 1.6.1 Indicators of Financial Development 1.19 1.22 1.7.1 Cautionary View of Financial System in Development— 1.22
xii
Contents
1.8
Criteria to Evaluate Financial Sector 1.25 1.25 1.26 1.9.2 Financial Innovations 1.26 1.9.3 Financial Engineering 1.27 1.28 1.28 1.9.6 Disintermediation 1.28 1.28 1.29 1.29 1.9.10
Privatisation
1.29 1.29
Integration 1.29 Internationalisation and Globalisation 1.30 Summary 1.31 Key Terms 1.32 Questions 1.32 1.9.12 1.9.13
2.
1.30
An Introduction to Security Analysis 2.1
2.1–2.31
Introduction 2.1 2.2 2.2 2.5 2.5 2.6 2.6 2.6 Types of Yield 2.6 2.8 Capital Asset Pricing Model (CAPM) 2.9 2.5.1 Shortcomings of CAPM 2.10 Arbitrage Pricing Model (APT) 2.11 Fama and French Three Factor Model 2.11 Valuation of Securities 2.12 2.8.1 Value Concepts 2.12 2.3.5
2.5 2.6 2.7 2.8
Contents
2.8.2 2.8.3 2.8.5
2.9.1 2.9.2 2.9.3
xiii
General Principles of Valuation 2.13 Valuation of Bonds 2.15 2.16 Valuation of Convertible Securities 2.16 2.17 2.22 Fundamental Analysis 2.22 Technical Analysis 2.23 Basis for Technical Analysis 2.24 2.27 2.27
Summary 2.28 Key Terms 2.30 Questions 2.30
3.
An Overview of the Indian Financial System 3.1 3.2 3.3
3.1–3.36
Introduction 3.1 Macroeconomic Developments 3.2 Indian Financial System at Present 3.3 3.3 3.6 3.7
3.8 3.5 Overall Development of Financial Institutions in India 3.9 3.10 3.7 Financial Integration 3.11 3.8 Financial Volatility or Instability 3.13 3.8.1 Assessment of Financial Stability 3.15 3.9 Financial Inclusion 3.18 3.9.1 Measures of Financial Inclusion 3.18 3.19 3.9.3 Initiatives for Financial Inclusion 3.20 3.10 Consumer Credit 3.21 3.22 3.11.1 Investors Behaviour in Urban India 3.22 3.22
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Contents
3.12 Consolidation of Indian Financial System 3.23 3.23 3.25 3.25 Stability 3.30 3.17 Undesirable Elements of Financial Development 3.32 3.18 Quality of Financial Development 3.32 Summary 3.34 Key Terms 3.36 Questions 3.36
4.
Financial Sector Reforms
4.1–4.33
4.1 4.1 1991
4.4 4.5 4.5 4.7 4.10 4.12 4.14 4.15 4.18 4.21 4.26 4.27
Summary 4.31 Key Terms 4.32 Questions 4.32
Contents
xv
PART 2 FINANCIAL REGULATIONS AND REGULATORY INSTITUTIONS IN INDIA 5.
Financial Regulations in India 5.1
5.3–5.36
Introduction 5.3
5.3.1 5.3.3
5.4 5.5 Integrated Approach 5.5 5.5 The Functional Approach 5.5 5.6 5.6 5.7 5.7 5.10
5.5.3 5.5.5 5.5.6
Securities and Exchange Board Act, 1992 5.12 5.12 The Foreign Exchange Management Act, 1999 5.14 The Competition Act, 2002 5.17 5.19
5.5.8 5.5.9 5.5.10
Prevention of Money Laundering Act, 2002 5.20 The Micro, Small and Medium Enterprises Act, 2006 5.22 Payment and Settlement Systems (PSS) Act, 2007 5.23
5.5.12
2009 5.24 The Companies Act, 2013 2013
5.31
1999
5.32
5.28
5.33 5.34 5.34
xvi
Contents
Summary 5.35 Key Terms 5.35 Questions 5.35
6.
The Reserve Bank of India 6.1 6.2
6.1–6.39
Introduction 6.1 Organisation and Management 6.2 6.2 6.7 6.8
6.5 6.6
6.8
Techniques of Monetary Control 6.10 Monetary Policy Operations in India 6.13 6.6.1 Merits of LAF 6.18 6.25 Challenges to Monetary Policy in India 6.26
6.26 6.10 Monetary Policy in Other Countries 6.30 6.34 6.11.1 Advantages 6.34 6.11.2 Limitations 6.35 Performance 6.35 6.36 Summary 6.37 Key Terms 6.38 Questions 6.38
7.
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA 7.1–7.28 7.1 7.2
Introduction 7.1 Securities and Exchange Board of India (SEBI) 7.1 7.2.1 Constitution and Organisation 7.2 7.4 7.2.3 Powers, Scope, and Functions 7.5 7.6 7.9
Contents
7.2.6 7.2.8 7.3.1
xvii
Bonus Issue Guidelines of SEBI 7.10 7.10 Corporate Governance and SEBI 7.17 7.20 7.20
Structure and 7.21
7.24 7.25 7.25 Summary 7.27 Key Terms 7.28 Questions 7.28
PART 3 BANKING INSTITUTIONS 8.
Commercial Banks 8.1
8.3–8.76
Introduction 8.3 8.4 8.6 8.7 8.12 8.12 8.5.2
Income Statement 8.19 8.19 8.23 8.24 8.24 8.26 8.27 8.27 8.28 8.28
8.12.1
System of Cheque Clearances 8.28
xviii
Contents
8.29 8.29 8.30 8.31 8.33 8.34 8.35 8.38 8.38 8.42 8.43 8.15.1
Investments
8.44 8.45 8.48 8.51 8.53
8.56 8.57 8.58 8.20.1 8.20.2 8.20.3
Basel I 8.58 Basel II 8.59 Basel III 8.60 8.61 8.61 8.64 8.69 8.70
Summary 8.72 Key Terms 8.74 Questions 8.75
9.1 Co-operative Banks 9.1
9.1–9.21
Introduction 9.1 9.2 9.3
Contents
xix
9.4 9.6 9.13 9.19 Summary 9.20 Key Terms 9.21 Questions 9.21
PART 4 NON-BANK FINANCIAL INTERMEDIARIES AND STATUTORY FINANCIAL ORGANISATIONS 10. Small Saving, Provident Funds and Pension Funds
10.3–10.33
10.1 Introduction 10.3 10.2 Importance and Characteristics of Small Savings 10.3 10.3 Types of Instruments in the Small Savings Media 10.4 10.4 10.5 10.5 10.5 10.6 10.6 10.6 10.7 10.8 10.5 Provident Funds 10.10 10.5.1 General Provident Fund (GPF) 10.11 10.5.2 Contributory Provident Fund (CPF) 10.11 10.5.3 Employee Provident Fund (EPF) 10.12 10.12 10.13 10.7 Investment Pattern of PF Funds 10.13 10.8 Growth of PFs in India 10.14 10.8.1 Factors Promoting Growth of PFs in India 10.15
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Contents
10.9 Pension Funds
10.15 10.15 10.16
10.11 Management of Pension Funds 10.12 Pension System in India 10.17 10.13 Developments in Indian Pension Sector 10.18 10.20 10.20 10.21 10.15 Investment of NPS Funds 10.24 10.16 Challenges to NPS 10.25 10.26 10.18 Features of Atal Pension Yojana 10.27 10.19 Growth of NPS 10.28 Summary 10.32 Key Terms 10.33 Questions 10.33
11. Insurance Companies 11.1 11.2 11.3
11.5
11.1–11.31
Introduction 11.1 Meaning and Concepts 11.1 Principles of Insurance 11.2 11.3.1 Principle of Utmost Good Faith 11.2 11.3.2 Principle of Insurable Interest 11.2 11.3.3 Principle of Indemnity 11.2 11.3 11.3.5 Principle of Warranties 11.3 11.3.6 Principle of Cause Proxima 11.3 11.3.7 Principle of Contribution 11.3 11.3.8 Principle of Loss Minimisation 11.3 11.4 Nature of Life Insurance Policies 11.4 11.5 11.6 11.7
11.9
Insurer Solvency 11.8 11.9.1 Solvency I 11.9
Contents
xxi
11.11 11.12 11.12 11.12 11.12 11.13 11.11 Insurance Industry in India 11.13 11.11.1 Life Insurers in India 11.14 11.15 11.12 Policy Developments 11.16 11.13 Insurance Penetration and Density 11.20 11.21 11.25 Summary 11.29 Key Terms 11.30 Questions 11.31 11.9.2
Solvency II
12. Mutual Funds
12.1–12.26
12.1 Introduction 12.1 12.2 What is a Mutual Fund? 12.2 12.2.1 Advantages and Disadvantages of Mutual fund Investments 12.3 12.3 Mutual Funds and Economic Growth 12.5 12.5 12.6 12.6 Types of Schemes 12.7 12.7 12.9 12.6.3 Other Funds 12.11 12.7 Determinants of Mutual Fund Performance 12.14 12.8 Mutual Fund Performance Evaluation 12.14 12.16 12.10 Hedge Fund 12.21 12.10.1 Characteristics of Hedge Fund 12.22 12.10.2 Hedge Fund Strategies 12.22 12.11 Systematic Investment Plan (SIP) 12.24 12.24
xxii
Contents
Summary 12.24 Key Terms 12.25 Questions 12.26
13. Miscellaneous Non-Bank Financial Intermediaries
13.1–13.31
13.1 Introduction 13.1 13.1 13.3.1 13.3.2 13.3.3
13.3.5
13.3 Asset Finance Company (AFC) 13.3 Investment Company (IC) 13.5 Systemically Important Core Investment Company 13.6 13.6 Infrastructure Finance Company (IFC) 13.7 13.7 13.8 13.8
13.3.9
Mortgage Guarantee Companies (MGC) 13.9 (NOFHC)
13.9 13.9 13.10 13.10
13.6 Other NBFSCs in India 13.12 13.6.1 Housing Finance Companies 13.12 13.17 13.6.3 Venture Capital Funds (VCF) 13.18 13.20 13.21 13.22 13.22 13.25 13.25 13.28 13.9 Depository and Custodial Services 13.29
Contents
xxiii
Summary 13.30 Key Terms 13.31 Questions 13.31
14. Non-Bank Statutory Financial Organisations Introduction 14.1 Major NBSFOs Operating in India
14.1–14.25
14.2 14.2
14.3 14.3 14.4 Industrial Financial Corporation of India (IFCI) 14.7 National Industrial Development Corporation (NIDC) 14.9 14.9 Infrastructure Leasing and Financial Services Ltd. (IL&FS) 14.10 14.10 14.11 14.11 14.11 14.13 (SIIICs)
14.13 14.13 14.13 14.14 14.15 14.16 14.17 14.18 14.18
(NEDFC)
14.18
14.19 Features of Assistance Provided by NBSFOs 14.20
xxiv
Contents
Growth of Financial Assistance Sanctioned and Disbursed by AIFIs 14.22 Summary 14.24 Key Terms 14.24 Questions 14.24
14.21
PART 5 FINANCIAL MARKETS 15. Call Money Market
15.3–15.20
15.1 Introduction 15.3 15.4 15.4 15.4 15.5 15.5 15.5 15.6 15.6 15.8 15.9 15.9 15.10 vis-à-vis the United States and The Unided Kingdom
15.10 15.11 15.11 15.12 15.13 15.13 15.14 15.14 15.15 15.15
Contents
xxv
15.17 15.17 15.17 Summary 15.19 Key Terms 15.20 Questions 15.20
16. Treasury Bills Market
16.1–16.18
16.1 Introduction 16.1 16.2 Nature and Characteristics 16.1 16.2 16.3 16.4 16.5 16.6 Cash Management Bills (CMBs) 16.6 Ways and Means Advances (WMA) 16.6 16.6 16.8 16.8 How is the yield of a Treasury Bill Calculated? 16.8 16.5.1 16.5.2
16.9 16.10 16.13 16.14 16.15 Summary 16.16 Key Terms 16.17 Questions 16.17
17. Miscellaneous Short-Term Financial Markets
17.1–17.40
17.1 Introduction 17.1 17.2 17.2.1
17.3.1
What is a Commercial Paper? 17.2 17.8 17.14 Bill of Exchange 17.14
xxvi
Contents
How does a bill of exchange come into existence? 17.15 Historical Perspective of Bill Financing 17.15 17.17 17.3.5 Accommodation and Supply Bills 17.17 17.3.6 Acceptance 17.18 17.3.7 Maturity of a Bill 17.18 17.19 17.3.9 Purpose 17.19 17.19 17.20 17.3.12 Appraisal of the Schemes 17.21 17.23 17.24 17.3.15 Factors behind Underdevelopment 17.25 17.26 17.26 17.27 17.28 17.30 17.5.1 Nature and Types of Guarantees 17.30 17.5.2 Suppliers of Guarantees 17.31 Summary 17.37 Key Terms 17.39 Questions 17.39 17.3.2 17.3.3
18. Bond Market
18.1–18.52
18.1 Introduction 18.1 18.2 Basic Features of Bonds
18.2 18.2
18.2.2
Valuation of Bond
Value
18.4
18.3
18.4 18.6 18.8 18.8 18.9
xxvii
Contents
18.5.2
Principles of a Deep and Liquid GSM 18.11 18.12 18.14 18.20 18.25 18.34
18.5.8
Implications for Monetary Policy 18.36 18.38 18.39 18.40 18.41 18.43 18.45 18.47
Summary 18.49 Key Terms 18.50 Questions 18.51
19. Stock Market
19.1–19.51
19.1 Introduction 19.1 19.2 Theory of Equity Culture 19.1 19.2.1 The Case for Equity Culture 19.2 19.2.2 Examination of the Case for Equities 19.3 19.5 19.3.1 Ordinary Shares 19.5 19.3.2 Preference Shares 19.6 19.3.3 Private Equity 19.6 19.7 19.3.5
Two Stage Growth Model 19.8 19.9 19.9 19.10 19.14 19.15 19.15
xxviii
Contents
19.15 19.16 19.17 19.20 19.21 19.23 19.24 19.9.1 19.9.2 19.9.3 19.9.5 19.9.6
Listing of Securities 19.24 Security Groupings 19.24 Trading System 19.26 19.27 Short Selling 19.28 Settlement Cycle 19.29 19.30 19.30 19.37 19.40 19.44 19.46
Summary 19.49 Key terms 19.49 Questions 19.50
20. Derivatives Market 20.1 Introduction 20.1 20.2 Services Provided by Derivatives 20.2 20.3 Types of Derivatives 20.3 20.3.1 Forwards 20.3 20.3.2 Futures 20.3 20.3.3 Options 20.5 20.7 20.3.5 Warrants and Convertibles 20.9 20.3.6 Credit Derivatives 20.10 20.3.7 Weather Derivatives 20.10 20.3.8 Freight Derivatives 20.11 20.3.9 Property Derivatives 20.11
20.1–20.50
Contents
xxix
20.11 20.5 Valuation or Pricing of Derivatives 20.13 20.5.1 Pricing of Forward Contracts (Financial Assets) 20.13 20.5.2 Pricing of Future Contracts (Commodities) 20.15 20.5.3 Binomial Option Pricing Models 20.16 20.19 20.24 20.6.1 Major Policy Developments 20.25 20.31 20.32 20.35 20.40 20.11 Critique of Derivatives 20.42 20.11.1 Speculative Nature 20.42 20.43 20.11.3 Instability of the Financial System 20.43 20.44 20.11.5 Displacement Effect 20.45 20.45 20.11.7 Adverse Empirical Evidences 20.45 20.12 Critique of Introduction of Derivatives in India 20.46 Summary 20.48 Key Terms 20.49 Questions 20.49
PART 6 INTERNATIONAL DIMENSIONS OF FINANCIAL MARKETS 21. Foreign Exchange Market
21.3–21.39
21.1 Introduction 21.3 21.4 21.5 21.5 21.6 21.7
xxx
Contents
21.7 21.8 21.9 21.9 21.11 21.11 21.12 21.12 21.14 21.15 21.16 21.21 21.21 21.25 21.27 21.27 21.32 21.9.6 Euro and South Asian Currency 21.37 Summary 21.37 Key Terms 21.39 Questions 21.39
22. Foreign Capital Flows 22.1 Introduction 22.1 22.2 Uses and Determinants of Foreign Capital 22.2 22.3 Multilateral Financial Institutions 22.3 22.5 22.5 Components of Foreign Capital in India 22.8 22.13 22.6.1 Foreign Debt 22.13 22.19 22.28 22.28 22.29
22.1–22.39
Contents
xxxi
22.9 Sovereign Wealth Fund (SWF) 22.30 22.31 22.9.2 Development of SWFs 22.31 22.9.3 Some Facts about SWFs 22.33 22.35 22.35 Summary 22.37 Key Terms 22.38 Questions 22.39
PART 7 INTEREST RATES 23. Theories of the Level and Structure of Interest Rates
23.3–23.16
23.1 Introduction 23.3 23.2.1 23.2.2 23.2.3
23.4 The Classical Theory 23.4 The Loanable Funds Theory 23.6 The Keynesian Theory 23.6 23.7 23.8 23.9 23.9 23.11 23.12
23.5 Other Factors
23.13 23.14 23.14 23.14 23.15 23.15
Summary 23.15 Key Terms 23.16 Questions 23.16
xxxii
Contents
24. Interest Rates in India
24.1–24.23
24.1 24.2 24.2 24.2 24.3 24.4 24.6 24.7 24.9 24.10 24.11 24.12 24.12 24.13 24.14 24.16 24.16 24.17 24.19 24.19 24.20 24.21 Summary 24.21 Key Terms 24.23 Questions 24.23
Glossary
G.1–G.40
References
R.1–R.25
Index
I.1–I.14
List of Figures
CHAPTER 1
Development
1.13
CHAPTER 2 Figure 2.1
Concept of Beta
2.3
CHAPTER 6
CHAPTER 8 Figure 8.1
Mechanism of Credit Card Operation
8.9
xxxiv
List of Figures
CHAPTER 9
CHAPTER 10 Figure 10.1 Architecture of NPS
10.21
CHAPTER 11
CHAPTER 12 Figure 12.1 Organisation of Mutual Fund
12.5
CHAPTER 13
Service Sector Companies
13.26
CHAPTER 18 Figure 18.1 Types of Yield Curves
CHAPTER 19
18.8
List of Tables
CHAPTER 1
CHAPTER 3 Table 3.1
Macroeconomic Indicators
Table 3.5
Saving Behaviour of the Household Sector 1970–1971 to
Table 3.6
Financial Savings and Liabilities of Household Sector
CHAPTER 6
Table 6.3
Summary of Changes in Techniques of Monetary Control
3.2
xxxvi
List of Tables
Table 6.5
Developed Countries
6.31
Operating Procedures of Liquidity Management in Developing Countries
6.32
CHAPTER 7
CHAPTER 8 Table 8.1
Credit Card Operation Cycle
8.8
Table 8.2
Credit Card Transaction Process
8.8
Table 8.5
Growth of Overall Deposits and Credits of Commercial
and Credit
8.37
(Percentage to Total)
8.37
(Percentage to Total Liabilities)
8.38
(Percentage to Total Deposits)
8.39
List of Tables
Table 8.18
xxxvii
Outstanding Credit to Government and Other Sectors by
Basel III
8.61
CHAPTER 9
31 March, 2003 and 31 March, 2007
9.16
xxxviii
List of Tables
in India
9.17
CHAPTER 10 Table 10.1
Small Saving Schemes in Force in 2015–2016
Table 10.5
Investment Pattern of Provident Funds since
Table 10.8
Investment Guidelines for Government Sector NPS Schemes (Applicable to Government Sector and
Table 10.9
Investment Guidelines for Private Sector NPS {Applicable to E (Tier I and II), C (Tier I and II), and G (Tier I and II)}
10.25
NPS Growth (Scheme Wise Position)
10.28
NPS Growth (Subscriber Class Wise Position)
10.29
Table 10.12 Performance of Pension Fund Managers
10.7
10.29
Table 10.13 Funds of Central Government and State Government
Scheme E, C and G—Tier I and II
10.30
Table 10.15 Performance of Scheme NPS Lite
10.31
List of Tables
xxxix
CHAPTER 11 Table 11.1
Insurance Penetration and Density in India
11.20
Table 11.2
Insurance Penetration and Density of Select Countries in the Year 2015
11.21
Table 11.3
Total Life Insurance Premium (all values are in ` crore and
to total investments)
11.23
to total investments)
11.23
Table 11.7
Income of Life Insurance Companies (percentage to
Table 11.8
Expenses of Life Insurance Companies (percentage to
percentage to total)
11.26
(all values in percentage to total)
11.27
total income)
11.27
total expenses)
11.28
xl
List of Tables
CHAPTER 12 Table 12.1
Table 12.5
Number of Different Types of Schemes of Mutual Funds in India, 2002–2003 to 2015–2016
12.16
2006–2007 and 2015–2016
12.17
Management by Mutual Funds
12.18
Worldwide Net Assets, Number of Schemes and Net Sales of Mutual Funds
12.20
CHAPTER 13
Ownership
13.11
CHAPTER 14
List of Tables
Financial Assistance Sanctioned and Disbursed by
CHAPTER 15
CHAPTER 16
CHAPTER 17
xli
xlii
List of Tables
Table 17.3
Commercial Bill Financing in India (All Scheduled `
CHAPTER 18
Table 18.2
Ownership Pattern of Outstanding Government Securities
18.27
Table 18.3
Ownership Pattern of Government of India Dated Security
18.29
Government Securities 1951–2016 (Percentage)
18.30
Dated Security
18.31
Table 18.6
Yield and Maturity of Central Government Securities
CHAPTER 19 Table 19.1
Types of Public Issues on the Basis of Pricing Methods
19.12
List of Tables
xliii
CHAPTER 20 Table 20.1
Table 20.8
Explanation of the Concept of Moneyness for Call Option and Put Option
20.13
Compounding)
20.35
Settlement Statistics in F & O Segment
20.38
CHAPTER 21
xliv
List of Tables
Table 21.3
Foreign Exchange Turnover by Currency
21.17
Table 21.8
Effects of Foreign Exchange Intervention
21.22
in India
21.33
CHAPTER 22
Table 22.2
Currency Composition of External Debt
22.15
Table 22.3
External Debt on Government Account under External Assistance
22.15
Table 22.5
India’s External Debt Service Payments
22.17
Table 22.7
Indicators of Debt Sustainability for India
22.18
List of Tables
Table 22.8
Total Debt to Gross National Income of Select Countries
xlv
22.19
Table 22.11 Foreign Direct and Portfolio Investment to Selected Countries
22.21
Table 22.12 Volume of FII Investments in India
22.22
Table 22.13 Investments by Foreign Institutional Investors in Terms of Debt and Equity
22.23
Table 22.17 Current Permitted FDI Limits in Different Sectors
22.27
Table 22.18 Largest SFWs by Assets under Management (as on December 2015)
22.33
(percentage to total)
22.33
CHAPTER 24
Ex-Post
Part 1 Overview
CHAPTERS 1. Nature and Role of Financial System 2. Introduction to Security Analysis 3. An Overview of Indian Financial System 4. Financial Sector Reforms
The Nature and Role of Financial System
1
CHAPTER Learning Objectives LO 1 LO 2 LO 3 LO 4 LO 5 LO 6
1.1 INTRODUCTION The
1.2 MAJOR FUNCTIONS OF THE FINANCIAL SYSTEM
●
●
LO 1 Recognise the functions and structure of a financial system
1.4 ●
●
● ● ●
●
●
● ● ●
1.3 STRUCTURE OF THE FINANCIAL SYSTEM Financial System
Financial Institutions
Regulatory
Intermediaries
Financial Markets
Non-Intermediaries
Others
Organised
Unorganised
Money Market
Call Money
T-Bills
Primary Market
Figure 1.1
Capital Market
CDs, CBs and Others
Stock Market
Debt Market
Secondary Market
Derivative Market
1.5
Money
1.3.1 Financial Institutions
Banking and Non-Banking Institutions
1
Sayers, R.S., Modern Banking, Oxford University Press, Oxford, 1964.
Credit or loan is a Finance
1.6
Intermediaries and Non-Intermediaries
1.3.3 Financial Markets
Primary and Secondary Markets
Money and Capital Markets
1.7 2
1.3.5 Financial Instruments and Services 3
Financial Assets The
or
2
Sometimes, the analysts talk of the short-term (maturity period of a year or less), the medium-term (maturity period of 1, 3 or 5 years) and the long-term (maturity period of more than 3 or 5 years). The capital market, then, would be said to deal in medium- and long-term claims. 3 The term security sometimes causes some confusion. This is because it is used to describe two different, though fundamentally related, things or phenomena. Security, in one sense, is a document or certificate as evidence of loan (as in the case of bond or deposit) or supply of capital in some other form (as in the case of shares). However, the document may take many forms. For example, in the case of certain bank deposits, it may be a bank passbook only. Another meaning of security is a thing deposited or pledged as guarantee of the fulfilment of some undertaking or payment of loan, which can be forfeited in case of failure. It is interesting to note that the security in the former sense can be used as security in the latter sense.
1.8 Financial Securities
the
Financial Services
1.4 EQUILIBRIUM IN FINANCIAL MARKETS LO2 Know how the equilibrium price in the financial market is determined
perfect
1.9
Classical Theory Loanable Funds Theory The Keynesian Theory
Y
Y D
S
D
S¢
E
S
r r¢
E r
E¢ S
D
S
X (A)
Q
(B)
D D¢ E
S E
r
r
E¢
r¢
r¢
E¢
D
D
S
D¢
S (C)
X
Q1
Q
D
Y
S
Y
D
S¢
Q2
Q
X
(D)
Q
Q3
X
X = Volume of Funds and Y = Rate of Interest
Figure 1.2
SS
DD E
Q r
1.10
SS r to r¢
S¢S¢ DD
D¢D¢
1.4.1 Determinants of Supply and Demand for Funds
r¢
1.11
1.5 FINANCIAL SYSTEM AND ECONOMIC DEVELOPMENT LO 3 Identify the role of the financial system in economic development
1.5.1 Effects of Financial System on Saving and Investment
First Second
Third
4
Hermes Niles, “Financial Development and Economic Growth: A Survey of the Literature”, International Journal of Development Banking, January 1994.
1.12
1.5.2 Theories of the Impact of Financial Development on Savings and Investment
Prior Savings Theory
1.13
Economic Development
Savings and Investment or Capital Formation
Surplus Spending Economic Units
Deficit Spending Economic Units
Income Minus (Consumption + Own Investment)
Income Minus (Consumption + Investments)
Surplus or Savings
Deficit or Negative savings
Financial System
Figure 1.3
5
5
Schumpeter, J.A., The Theory of Economic Development, Oxford University Press, London, 1934, p. 102 (emphasis added).
1.14
● ● ●
●
●
‘Liability–Asset Transformation’:
●
‘Size Transformation’:
●
‘Risk Transformation’:
●
‘Maturity Transformation’:
6
6
For further and detailed discussion of these services, see Robinson, R.I. and Wrightsman, D., Financial Markets, McGraw-Hill, London, 1981, Chapter 1; Edmister, R.O., Financial Institutions, McGraw-Hill, New York, 1986, Chapter 1.
1.15 Credit Creation Theory
Theory of Forced Savings
First Second
Tobin or Portfolio Shift Effect
Third Income Distribution Effect
1.16
Classicals versus Keynesians
Financial Regulation Theory
ex ante
ex post
1.17 7
Financial Liberalisation Theory
7
Greenwald, B.C., and others. “Capital Market Imperfections and Regional Economic Development”, in Giovannini, A. (ed.), Finance and Development: Issues and Experience, Cambridge University Press, 1993.
1.18
Financial Regulations versus Liberalisation
8
Stiglitz, J.E., “Whither Reforms? Ten Years of Transition”, Annual World Bank Conference on Development Economics, 1999, p. 17.
1.19
1.6 MEANING AND PROCESS OF FINANCIAL DEVELOPMENT LO 4 Explain the meaning and process of financial development
1.6.1 Indicators of Financial Development
● ● ●
9
World Bank, Finance For Growth: Policy Choices In A Volatile World, Oxford University Press, New York, 2001, p. 10. World Bank, op. cit., pp. 23–24.
10
1.20 ●
●
●
●
● ●
●
●
●
●
●
●
Patterns of Relationships between Financial and Economic Development
●
1.21 ●
●
Financial Development and Economic Growth
m
m
X t = a1 + Â a1i ¥ X t - i + Â b1i ¥ Yt - i i =1 m
i =1 m
Yt = a2 + Â b2i ¥ Yt - i + Â a2i ¥ X t - i i =1
where X a2i of Yt 11
op. cit., pp. 126–127.
i =1
a i and Xt m
b
i
and b2i
1.22 Table 1.1 Granger-Causality Test between EG and FD Null Hypothesis
F- Statistics
Probability Value
FD does nor Granger-cause EG
3.256*
0.001
EG does nor Granger-cause FD
2.924*
0.015
Note:
1.7 FINANCIAL SECTOR AND ECONOMIC DEVELOPMENT: A CAUTIONARY APPROACH LO 5 Understand a cautionary view of the role of the financial system in development
1.7.1 Cautionary View of Financial System in Development—Reasons
1.23 First
12
Tobin, James, “On the Efficiency of the Financial System”, Lloyds Banks Review, 153, 1984.
1.24
Second
Third
13
Peter, E.E., Chaos and Order in Capital Markets, John Wiley, New York, 1991; and Fractal Market Analysis, John Wiley, New York, 1994.
1.25
1.8 CRITERIA TO EVALUATE FINANCIAL SECTOR
1.9 FINANCIAL DEVELOPMENT: SOME CONCEPTS
14
Erb, Richard, D., “Economic Growth and Development: The Roles of a Financial Sector”, Lecture at Rajiv Gandhi Institute for Contemporary Studies, New Delhi, Undated, pp. 12–22.
1.26
1.9.1
15
Functional or
1.9.2 Financial Innovations
15
See Tobin James, op. cit.
1.27
1.9.3 Financial Engineering
16
For implications of financial innovations, see Bhole, L.M., Impacts of Monetary Policy, Himalaya Publishing House, Bombay, 1985, pp. 240–62. 17 Finnerty, J.D., “Financial Engineering in Corporate Finance: An Overview”, Financial Management, Winter, 1988, p. 16.
1.28
1.9.4 Financial Revolution
1.9.5
1.9.6
Disintermediation
1.9.7 Broad, Wide, Deep and Shallow Markets
1.29
1.9.8 Financial Repression
1.9.9 Financial Reforms, Financial Liberalisation and Deregulation
1.9.10 Privatisation
1.9.11 Prudential Regulation
1.9.12 Integration
1.30
1.9.13 Internationalisation and Globalisation
1.9.14 Securitisation
1.31
SUMMARY ◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
1.32 ◆
◆
◆
◆
◆
◆
◆
◆
◆ ◆
KEY TERMS
QUESTIONS
1.33
An Introduction to Security Analysis
2
CHAPTER Learning Objectives LO 1 LO 2
Identify risk and its various types Recognise the concept of return or yield and its types
LO 3 LO 4 LO 5
Understand risk-return trade-off and the capital asset pricing model (CAPM) Discuss arbitrage pricing model and Fama and French three factor model
LO 6
securities can be valued Compare the two broad approaches used for common stock analysis, that is, fundamental analysis and technical analysis
LO 7
2.1 INTRODUCTION
bare elements of security analysis, that is, (a) (i) concepts and types of return and risk, (ii) risk-return tradeoff; (b) the methods of valuation of bonds, preference shares (PSs), common stock and convertible securities (CS), (c) the analysis of common stocks, that is, fundamental and technical analysis, and (d) the concept of 1
1
For further insight, see Jones, C.P., Investments: Analysis and Management, Second Ed., John Wiley, New York, 1988; Chandra, P., Financial Management, Fourth Ed., Tata McGraw-Hill, New Delhi, 1997; Farrel, J.L., Jr., Portfolio Management, Second Ed., McGrawHill, New York, 1997; Reilly and Brown, Analysis of Investments and Management of Portfolios, Chapters 11–14, 10th Edition, Cengage Publication, Delhi, 2012.
2.2
Financial Institutions and Markets
2.2 CONCEPT OF RISK Certainty is a situation wherein the value the variable can take is uncertainty probability distribution of values is not known, but the experts can have a feel
LO 1 Identify risk and its various types
Risk objective probability is one
measures the risk of the security relative to other securities in a portfolio; the way securities vary with each the discussions on risk invariably and implicitly refer to only the uncertainty of outcomes and not to all (types
2.2.1 Types of Risk
Systematic versus Unsystematic Risk
is called systematic risk market risk’ or ‘ not related to the overall market variability is called unsystematic risk
’;
An Introduction to Security Analysis
2.3
Market Risk (Beta) b) as a Beta indicates the
Alternatively, it is the slope of the regression line relating a higher (than 1) beta is more volatile than the market, and the asset with a lower (than 1) beta would rise or fall more
b>1 Security Return
B (45 degree line) represents b = 1 which means that for every one percentage change in the market return, on an average, the security return also will change by 1 percent, that is,
b=1 b
2
D0 (1 + g1 ) 1 + ¥ Pn t (1 + rcs ) (1 + rcs ) n
where Pn = Dn+1 rcs 2), D0 = Current dividend; 1= its supernormal growth rate; n = number of years of supernormal growth; Pn = price of stock at the end of super-normal growth period which is based on the dividend growth rate of 2 from n It has been suggested by some that the industrial life-cycle framework in which the pioneering stage, the maturity stage, and the stability stage are characterised by varying growth rates can help investors to ascertain
stock at any point in future would be a function of dividends to be received thereafter, its price today is best
E
is the dividend payout ratio, and E k be the rate of return on retained earnings, which
PVcs =
(1 - b) E rcs - bK
Relative Valuation Models relative valuation, the value of an asset is derived from
7
Example is provided in Chapter 19.
An Introduction to Security Analysis
2.19
We also assume that a comparison of multiples will allow us to identify these errors, and that these errors
with some basis, that errors made by mistakes in pricing individual stocks in a sector are more noticeable and earnings ratio of 10, when the rest of the sector trades at 25 times earnings are clearly undervalued and that
Categorising Relative Valuation Models multiples across companies, while others compare the multiple of a company to the multiples it used to trade
I. Fundamentals versus Comparables
Using Fundamentals:
Using Comparables:
II. Cross-Sectional versus Time Series Comparisons In most cases, analysts price stocks on a relative basis by comparing the multiple it is trading to the multiple
2.20
Financial Institutions and Markets
Cross-sectional Comparisons:
Comparisons across time:
historical norms and the overall market increases, you would expect most companies to trade at much higher Earnings Multiples
Book Value or Replacement Value Multiples While markets provide one estimate of the value of a business, accountants often provide a very different
book value ratio that emerges can vary widely across industries, depending again upon the growth potential
value is not a good measure of the true value of the assets, an alternative is to use the replacement cost of the
An Introduction to Security Analysis
2.21
Revenue Multiples An alternative approach, which is far less affected by accounting choices, is to use the ratio of the value of
for every page hit (on the website), largely because they have no sense of what high, low or average is on
The Four Basic Steps to Using Multiples
2.22
Financial Institutions and Markets
2.9 ANALYSIS OF COMMON STOCKS
2.9.1 Fundamental Analysis
LO 6 Compare the two broad approaches used for common stock analysis, that is, fundamental analysis and technical analysis
Fundamental analysis is the examination of the underlying forces that affect the wellbeing of the economy,
analysts believe that the stock is either over- or undervalued and the market price will ultimately gravitate
analysing fundamental analysis such as (i)
Economic Analysis
reduces the supply of funds for expansion of business, and due to increase in the interest rate, the cost
8
For detailed analysis please see Reilly and Brown, Analysis of Investments and Management of Portfolios, Chapters 11–14, 10th Edition, Cengage Publication, Delhi, 2012.
An Introduction to Security Analysis
2.23
Industry Analysis
9
(i) business cycle and various industries, (ii) economic changes and alternative industries, (iii) evaluation of Company Analysis
is a company which is consistently defensive company
2.9.2 Technical Analysis
underlying economic variables which affect the company and the markets are not considered important in this
9
Reilly and Brown, Analysis of Investments and Management of Portfolios, Chapters 11–14, 10th Edition, Cengage Publication, Delhi, 2012.
2.24
Financial Institutions and Markets
2.9.3 Basis for Technical Analysis Price Discounts Everything
the sum knowledge of all the participants, including traders, investors, portfolio managers, buy-side analysts,
Price Movements are not Totally Random
Overall Trend
Support
An Introduction to Security Analysis
2.25
Resistance
Momentum Momentum is usually measured with an oscillator such as moving average convergence divergence
Buying/Selling Pressure
Relative Strength
(ii) maturity or stage of current trend, (iii) reward to risk ratio of a new position, and (iv) potential entry levels
Map the Trends
Spot the Trend and Go with It
Find the Low and High of It
2.26
Financial Institutions and Markets
Know How Far to Backtrack
Draw the Line
Follow that Average
Learn the Turns
Know the Warning Signs
Trend or Not a Trend
An Introduction to Security Analysis
2.27
plotting the direction of the ADX line, the trader is able to determine which trading style and which set of
2.10
EFFICIENT MARKET HYPOTHESIS LO 7 Review efficient market hypothesis
particular), do so under the assumption that the securities they are buying are worth more than the price that they are paying, while securities that they are selling are worth less than the
2.28
Financial Institutions and Markets
past price movements, which includes rates of return, trading volume, other market-generated information, security market information, it implies that past rates of return should not have any relationship with future
movements but also all the public information such as stock prices, earnings and dividend announcements, rights issues, technological breakthroughs, price to earnings ratios, dividend yield ratios, price to book value
that investors who base their decisions on any important new information after it is public, should not derive
is on insider trading, in which a few privileged individuals, for example, directors are able to trade in shares,
SUMMARY ◆
◆
Although, strictly speaking, risk and uncertainty are not the same, they are regarded synonymous in
◆
While the standard deviation or variance of return measures the security risk taken singly, covariance
◆
An Introduction to Security Analysis
2.29
◆
◆
vis-a-vis with a higher than 1 beta is more risky than the market, and the asset with a lower than 1 beta is less risky
◆
bond, realised, expected, holding period, basic, current, redemption, dividend, earnings, nominal, real, ◆
◆ ◆
◆
◆
◆
◆
◆ ◆
◆
◆
◆
◆
2.30
Financial Institutions and Markets
KEY TERMS Systematic Risk Arbitrage Pricing Model Country Risk Interest Rate Risk Fundamental Analysis
Default Risk Unsystematic Risk Dividend Capitalization Model
Capital Asset Pricing Model Market Risk Relative Valuation Model
Yield Current Yield Currency Risk Revenue Multiples
Yield to Maturity Earnings Multiples Intrinsic Value
Dividend Yield Financial Risk
QUESTIONS
`
` `
An Introduction to Security Analysis
2.31
An Overview of the Indian Financial System
3
CHAPTER
Learning Objectives LO 1 LO 2
Identify major changes that have occurred in the saving and investment trends markets in India
LO 3 LO 4 LO 5 LO 6 LO 7 LO 8 LO 9
Review Demonetisation and its impact in India
3.1 INTRODUCTION
3.2
Financial Institutions and Markets
following chapters.
3.2 MACROECONOMIC DEVELOPMENTS
Table 3.1 Macroeconomic indicators Indicators Growth rate of GDP at factor cost at constant price percent (Percent) Gross savings/GDP Gross capital formation/GDP
1980–81 1990–91 2000–01 2010–11 2011–12 2012–13 2013–14
2014–15
7.2
5.3
8.9
6.7
5.4
6.3
7.1
7.2
17.8
22.9
23.7
33.7
31.3
33.8
33.0
33.0
22.0
25.5
24.6
39.8
38.8
39.4
36.2
35.9
18.2
10.3
7.2
9.6
8.9
7.4
6.0
2.0
Reserve money growth rate
17.4
13.1
8.1
19.1
3.6
6.2
14.4
11.3
Broad money growth rate
18.1
15.1
16.8
16.1
13.5
13.6
13.4
10.9
Aggregate deposits of commercial banks/GDP
26.10
33.80
44.40
66.90
66.90
67.80
68.40
68.30
Bank credit/ GDP
17.50
20.40
23.60
50.60
52.20
52.90
53.20
52.30
6.0
9.1
9.2
6.9
7.8
6.9
6.7
7.0
–0.6
4.1
6.4
3.2
4.1
3.4
3.3
3.0
Export/GDP
4.6
5.8
9.9
15.0
17.0
16.8
17.1
15.5
Import/GDP
8.9
8.8
12.6
22.4
27.4
27.5
25.0
22.6
—
—
0.64
2.21
2.05
2.59
1.51
3.96
Foreign exchange reserves/ GDP
0.39
0.49
4.74
15.58
16.32
16.14
17.33
18.83
—
—
Market capitalisation of equity market/GDP
58.9
186.3
Source: RBI, Handbook of Statistics, SEBI, Annual Reports, Various Issues
140.9
136.8
149.4
190.3
An Overview of the Indian Financial System
3.3
3.3 INDIAN FINANCIAL SYSTEM AT PRESENT
appropriate chapters to know the full details in this respect.
3.4 TRENDS IN SAVING AND INVESTMENT trends should be noted. We may do so by studying either the net or gross saving
the volume and rates of total saving and investment and the sectoral distribution of saving. Table 3.4 shows that the contribution of the private corporate and
LO 1 Identify major changes that have occurred in the saving and investment trends
differs from many other countries where ‘household savings play a minor role with corporations generally compensate where the corporations share falls below the median.1
1
Newlyn, W.T., The Financing of Economic Development, Clarendon Press, Oxford, 1977, p. 12. This study of 32 countries showed that the median for the share of corporations was 50 percent and that for the government was 20 percent.
Banking
Non-banking
Insurance Regulatory Development Authority (IRDA) Pension Fund Regulatory Development Authority (PFRDA)
Investment Information and Credit Rating Agency of India Limited (ICRA)
Export Credit and Guarantee Corporation (ECGC) Shipping Credit and Investment Company of India (SCICI) Tourism Finance Corporation of India (TFCI) Credit Rating Information Services of India Limited (CRISIL) Credit Analysis and Research (CARE)
Export and Import Bank of India (EXIM Bank) National Bank for Agriculture and Rural Development (NABARD) Deposit Insurance and Credit Guarantee Corporation (DICGC)
Industrial Finance Corporation of India (IFCI)
Mutual funds
Other private insurance companies
Life Insurance Corporation of India (LIC) General Insurance Company (GIC)
Commercial banks (i) Public sector banks (ii) Private banks (iii) Foreign banks Securities and Exchange Board Co-operative banks Provident and pension funds of India (SEBI)
Reserve Bank of India (RBI)
Regulatory
Financial institutions
deposits Commercial papers ULIPs
Government-dated bonds Commercial bills
Treasury bills
American depository receipts Global depository receipts special drawing rights
schemes Derivatives Trade credit market Foreign exchange Financial market derivatives Commodity derivatives FDI
deposits market Governmentdated Securities market Corporate bond market Public sector unit bonds market Stock market
Commercial papers market
Loan syndicating Depository services Market making
Factoring
Brokerage
Deposit insurance Rediscounting
Hire purchasing
Leasing
Debentures
Merchant banking Underwriting
Preference shares
Collateral borrowings and lending market Term money market Treasury bills market
Credit rating
services
Convertible shares
Ordinary shares
instruments
Call money market
Financial markets
3.4 Financial Institutions and Markets
3.5
An Overview of the Indian Financial System
Items
2006–07
2014–15
179
148
1. Public sector banks (PSBs) (No.)
27
25
2. Private sector banks (No.)
26
26
3. Foreign banks (No.)
29
42
133
56
5. Scheduled co-op. banks (No.)
69
73
6. Scheduled urban co-op. banks (No.)
53
54
7. Scheduled State co-op. banks (Nos.)
16
19
71839
125672
1. Scheduled commercial banks (SCBs) (No.)
4. Regional rural banks (No.)
8. Bank branches (No.)
15
10.3
10. Deposits of scheduled commercial banks (` billion)
26119.33
88989.01
11. Credits of scheduled commercial banks (` billion)
19311.89
64998.29
12. Per capita deposits of scheduled commercial banks (`)
23468
68576
13. Per capita credits of scheduled commercial banks (`)
17355
50089
40
47
466
605
23
18
997
1710
45
201
19. Listed companies (No.)
6049
5805
190
226103
21. Average daily BSE turnover in 2015 (` crore)
3797
3518
12797
17818
23. Life Insurance Companies (No.)
16
24
24. General Insurance Companies (No.)
15
24
14. Mutual funds (No.)
16. Stock exchanges (No.) 17. Foreign institutional investors (No.) 18. Venture capital funds (No.)
22. Average daily NSE turnover in July 2015 (` crore)
Source: RBI, annual reports, basic statistical returns; SEBI, annual reports; IDRA annual reports.
Year
Public sector savings
Private sector savings
Household savings
Total savings
Total capital formation
1
2
3
4
5
1950–51
2.07
0.89
6.55
9.51
9.31
1960–61
3.19
1.57
6.83
11.59
14.27 (Contd.)
3.6
Financial Institutions and Markets 1970–71
3.40
1.41
9.51
14.32
15.15
1980–81
4.10
1.56
12.11
17.77
19.17
1990–91
1.82
2.59
18.53
22.93
26.03
2000–01
–1.34
3.72
21.30
23.68
24.26
2005–06
2.41
7.51
23.53
33.44
34.65
2006–07
3.56
7.88
23.15
34.60
35.66
2007–08
4.99
9.40
22.42
37.82
38.11
2008–09
0.96
7.41
23.64
32.02
34.30
2009–10
0.16
8.35
25.18
33.69
36.48
2010–11
2.56
7.95
23.51
34.02
36.84
2011–12
1.30
7.18
22.33
30.81
35.00
2012–13
2.15
9.35
19.93
31.45
36.63
2013–14
1.99
10.44
18.18
30.61
32.28
2014–15
0.92
11.11
18.67
32.30
33.54
Source: RBI, Handbook of Statistics, Various Issues.
upsurge in foreign direct investment. The higher investment was able to absorb the domestic savings and also
2
3.4.1 Household Sector Saving 3
development in India; it would also enable us to understand better certain concepts widely used in discussions
2
Bhole, L.M,, Impacts of Monetary Policy, op. cit., pp. 48–58. The term investment really refers to the act of purchasing physical or real assets for the purpose of utilising them in the productive activity. However, layman and even knowledgeable persons quite often use that term in the case of purchases of financial assets also. In order to distinguish the meanings, we would call the latter financial investment. 3
An Overview of the Indian Financial System
3.7
they would be used unproductively or be wasted. The
Table 3.5 Saving behaviour of the household sector 1970–1971 to 2014–2015 Items
1970– 1980– 1990– 2000– 2005– 2009– 2010– 71 81 91 01 06 10 11
2011– 12
2012– 2013– 2014– 13 14 15
1
2
3
4
5
6
7
8
9
10
11
30.93
45.57
43.82
48.00
47.29
45.35
40.72
34.58
32.20
36.80
30.89
2. Currency
16.82
13.41
10.61
6.32
8.93
9.79
12.70
11.39
10.88
7.96
10.54
3. Bank deposits
35.73
45.80
31.88
38.27
45.48
40.22
50.77
55.22
56.13
60.51
46.63
3.18
3.12
2.18
1.21
0.09
1.87
0.47
2.18
1.68
2.38
2.61
savings
4. Non-banking deposits 5. LIC fund
9.81
7.55
9.50
13.68
14.29
26.25
19.46
19.79
17.77
16.04
19.50
6. PF and pension fund
23.22
17.51
18.94
20.55
10.60
13.12
13.07
14.26
12.10
10.64
16.11
7. Claims on govt.
4.98
5.88
13.38
15.76
14.92
4.39
2.74
–2.85
–0.69
0.59
0.07
8. Shares and debentures
3.22
3.40
8.44
4.50
5.80
4.53
0.16
–0.47
4.27
2.52
4.18
9. UTI
0.66
0.26
5.84
–0.38
–0.08
0.00
0.00
0.00
0.00
0.00
0.00
2.37
3.08
–0.77
0.07
–0.04
–0.18
69.42
71.12
66.16
72.12
70.29
79.59
10. Trade debt 11. Financial institutions (3 + 5 + 6 + 9)
0.63 83.3
0.47
0.31
0.37
0.32
89.27
86.00
87.19
82.24
Note:
Sources: RBI, Handbook of Statistics, Various Issues.
3.4.2 Trends in Institutionalisation and Securitisation What has been the trend in India of the institutionalisation securitisation
3.8
Financial Institutions and Markets
the process of disintermediation and securitisation. It has been argued that as a result of the deepening of
3.4.3 Household Sector Liabilities
only in the sense that its savings exceed its investment but also in the sense that the excess of saving over
savings to national income varied between 0.9 to 18 percent. This table further shows that banks are the
An Overview of the Indian Financial System
3.9
and the individuals are not responsible for any increase in the debt burden and the risk of insolvency of the been responsible for putting India into the debt trap. Table 3.6 Financial savings and liabilities of household sector 1970–1971 to 2014–2015 Year
GFS/GDP
TFL/GDP
NFS/GDP
BA/TFL
LFI/TFL
LAG/TFL
LANCCS/TFL
1
2
3
4
5
6
7
1970–71
4.43
1.24
3.19
86.12
6.42
11.67
–4.23
1980–81
8.10
2.34
5.75
88.16
5.18
4.30
2.33
1990–91
10.05
1.58
8.47
80.16
12.45
6.59
0.78
2000–01
11.37
1.46
9.91
80.04
14.91
4.15
0.88
2005–06
15.82
4.98
10.84
95.54
4.57
–0.26
0.15
2006–07
17.80
6.58
11.22
96.83
3.31
–0.23
0.08
2007–08
15.49
3.77
11.71
95.38
4.61
–0.13
0.13
2008–09
12.91
2.91
10.01
94.58
5.38
–0.12
0.15
2009–10
15.28
3.14
12.14
95.57
4.37
–0.07
0.12
2010–11
13.85
3.57
10.29
96.77
3.16
–0.03
0.093
2011–12
10.66
3.14
7.52
96.50
3.12
0.27
0.091
2012–13
10.69
3.32
7.36
93.36
6.50
0.05
0.07
2013–14
10.63
3.04
7.59
85.39
14.36
0.18
0.05
2014–15
10.18
2.56
7.62
81.30
18.44
0.18
0.06
Note:
Gross domestic product. Sources: RBI, Handbook of Statistics, Various Issues.
3.5 OVERALL DEVELOPMENT OF FINANCIAL INSTITUTIONS IN INDIA LO 2 Understand the overall development of financial institutions and financial markets in India
3.10
Financial Institutions and Markets
respectively. The number of commercial banks has increased and their operations in the rural sector have also
stronger in the future. The insurance sector has grown by many folds as the private companies are allowed to
The importance of mutual funds has increased due to the entry of private companies into this sector. Mutual funds increase the alternative modes of investments for the common man through which the people can invest hire purchase companies and investment companies have increased and their role in the development process
autonomy has come to the forefront and it has been seemingly granted a little higher degree of autonomy.
4
3.6 OVERALL DEVELOPMENT OF FINANCIAL MARKETS IN INDIA
4
Fischer, Stanley, ‘‘Financial System Soundness’’, Finance and Development, March 1997, p. 17.
An Overview of the Indian Financial System
3.11
claims in India have always been narrow and they are more so now. They are dominated by institutional
ownership of corporate securities and even units of mutual funds and their operations on stock exchanges in the real sense of those terms. The derivatives market is comparatively new and not much developed in Stock Exchange.
3.7 FINANCIAL INTEGRATION LO 3 Explain financial integration, financial volatility and financial inclusion
inter alia
3.12
Financial Institutions and Markets
April 1993 to March 2000 RREPO RREPO
Call
TB 91 TB 364 Yield 10
CDs
CPs
FR 1
FR 3
FR 6
EXCH LBSES
1.00
Call
0.35
1.00
TB91
0.44
0.61
1.00
TB364
0.32
0.40
0.90
1.00
Yield 10
0.04
0.46
0.57
0.49
1.00
CDs
0.30
0.32
0.45
0.41
0.38
1.00
CPs
0.39
0.54
0.81
0.75
0.57
0.71
1.00
FR1
0.27
0.80
0.45
0.33
0.46
0.47
0.63
1.00
FR3
0.28
0.68
0.47
0.32
0.56
0.58
0.65
0.97
1.00
FR6
0.30
0.61
0.48
0.36
0.60
0.62
0.68
0.91
0.98
EXCH
0.03
–0.04
–0.23
–0.38
–0.06
–0.19
–0.31
–0.25
0.12
0.13
1.00
LBSES
–0.37
–0.10
–0.24
–0.34
–0.05
–0.40
–0.28
0.32
–0.28
–0.30
0.35
RREPO
1.00
Call
0.86
1.00
TB91
0.86
0.95
1.00
TB364
0.84
0.92
0.99
1.00
Yield 10
0.79
0.89
0.96
0.98
1.00
CDs
0.78
0.91
0.94
0.93
0.93
1.00
CPs
0.85
0.90
0.96
0.95
0.92
0.96
1.00
FR1
0.63
0.67
0.61
0.55
0.54
0.62
0.68
1.00
FR3
0.69
0.63
0.60
0.54
0.52
0.66
0.77
0.97
1.00
FR6
0.70
0.65
0.63
0.55
0.57
0.68
0.73
0.95
0.99
1.00
1.00
April 2000 to March 2015
1.00
EXCH
0.31
0.24
0.18
0.11
0.04
0.27
0.30
0.63
0.65
0.69
1.00
LBSES
–0.33
–0.25
–0.22
–0.16
–0.14
–0.29
–0.35
–0.58
–0.63
–-0.73
–0.71
Notes:
are based on monthly data.
1.00
An Overview of the Indian Financial System
3.13
integration. Integration of the foreign exchange market with the money market and the government securities foreign exchange market intervention can be carefully coordinated with monetary management encompassing
with money market segments.
The foreign business of domestic commercial banks and foreign banks’ business in India has increased. The number of foreign collaborations in India and Indian collaborations and joint ventures abroad also
the possible growth of derivatives markets in India. Many people are demanding that derivative securities should also be introduced in India at the earliest. These securities are also known as hybrid securities which
and other relevant laws.
3.8 FINANCIAL VOLATILITY OR INSTABILITY
3.14
Financial Institutions and Markets
●
●
Economic instability is a broader term and it refers to marked ups and downs in the economic system as a was the business cycles. These different types of instabilities are closely interrelated and impact each other.
●
moving up and down in far wider ranges than before.
● ● ●
Computerised tools have made it easier to trade large amounts of stocks continuously Increasing political uncertainty is unnerving the market
● ●
The existence of asymmetric information problem
● ● ●
Herd behaviour on the part of investors Excessive speculation
● ● ●
Instability of commodity prices.
An Overview of the Indian Financial System
outside the country.
mechanism before they precipitate a crisis.
building a consensus in favour of continuing reforms in the medium to long run.
3.8.1 Assessment of Financial Stability
inter alia
3.15
3.16
Financial Institutions and Markets
an estimate of the change in the value of the portfolio due to a sudden change in the risk factors. The stability
that can be used to understand the behaviour of the system with respect to the main vulnerabilities. Once
duration. Duration is a measure of the percentage change in the value of the portfolio for a unit change in the interest rate and is a good measure only for small changes in the interest rate. Stress testing normally
institutions. The change in net open position due to a change in exchange rate can help determine the sensitivity of the position to exchange rate risk. The net open foreign exchange position is relatively easy to measure
These models estimate the impact of failure of one institution on the other institutions in the system. These types of models have already been applied to interbank markets but can also be adopted for other types of markets. 5
5
GOI, RBI, (2009) Report on India’s Financial Sector an Assessment.
An Overview of the Indian Financial System
3.17
advisory panels will prepare separate reports covering each of the above aspects. To provide the panels representing mainly regulatory agencies and the government in all the above subject areas which have
6
The scheme is in place to undertake ‘structured’ and ‘discretionary’ actions against those banks that exhibit
sector has been found to be less than satisfactory.
The key indicators of the life insurance segment show a reasonably comfortable position as regards to
6
The detail data and analysis have been provided in the chapters 8, 15, 18, 19 and 20.
3.18
Financial Institutions and Markets
as well as other entities to manage their interest rate risk more than any other instrument. The notional principal outstanding in respect of interest rate swaps has increased. Interest rate deregulation has made
poor transparency and an absence of pricing of spreads against the benchmark yield curve.
3.9 FINANCIAL INCLUSION
in particular at an affordable cost in a fair and transparent manner by mainstream institutional players. In 8 The concept
capacities besides augmenting domestic demand on a sustainable basis driven by income and consumption
exclusion in India is visible in the form of high population per bank branch and low proportion of the debit cards.9
3.9.1 Measures of Financial Inclusion
7
Address delivered by Shri S.S. Mundra, Deputy Governor, Reserve Bank of India at the BRICS Workshop on Financial Inclusion in Mumbai on September 19, 2016. 8 A good is considered a public good if it meets the conditions of ‘non-rivalness’ in consumption and non-excludability. 9 Keynote address delivered by Shri Harun R. Khan, Deputy Governor, Reserve Bank of India at the symposium on ‘Financial inclusion in Indian Economy’ organised by the Indian Institute of Public Administration, Bhubaneswar on June 30, 2012.
An Overview of the Indian Financial System
3.19
ensuring adequacy and availability awareness of such services and ensuring affordability and accessibility
minimalist approach
expanded approach. The
product and entrepreneurial credit product while pursuing the objective of greater inclusion. The expanded
One of the broad
usage of the banking system.10
business correspondents and so on. The third parameter seeks to determine the usage of banking services
product is used for measuring this dimension.
3.9.2 Reasons of Financial Exclusion in India
of independent documentary proof of identity and address can be a very important barrier in having a bank account especially for migrants and slum dwellers. 10
Sarma, M. (2008) ‘Index of financial inclusion’ Working Paper No. 215, Indian Council for Research on International Economic Relations.
3.20
Financial Institutions and Markets
3.9.3 Initiatives for Financial Inclusion11
on the supply side. ●
enhancing access of banking services. ●
●
● ●
` accounts not exceeding ` ●
●
●
●
and remittances. ●
11
Address delivered by Shri S.S. Mundra, Deputy Governor, Reserve Bank of India at the BRICS Workshop on Financial Inclusion in Mumbai on September 19, 2016.
An Overview of the Indian Financial System
3.21
●
holding with assistance to credit linkage for trainees’. ●
investment and seed capital for availing productive credit. ●
●
balance of ` `
`
3.10 CONSUMER CREDIT
availability of choice in buying consumer durables due to globalisation have contributed to this new culture. Consumers are now in a position to
coming together to make attractive credit offers to the potential buyers. They have come up with new schemes
3.22
Financial Institutions and Markets
frauds also.
3.11 RETAIL INVESTORS IN INDIA
●
●
constitute about 11 percent of total households. The percentage of investors is nearly 20 in urban areas while it is much
LO 4 Describe how the financial system is influenced by the risk-return-liquiditypreferences and confidence of investors
●
●
3.11.1 Investors Behaviour in Urban India ●
●
region. The allocations are still in avenues such as commercial bank deposits and real estate.
●
choice for savings. ● ●
3.11.2 Investors Behaviour in Rural India ●
the mutual fund market. ●
●
The level of savings increases with educational attainment and asset holdings.
An Overview of the Indian Financial System
3.23
3.12 CONSOLIDATION OF INDIAN FINANCIAL SYSTEM
be driven by the objective of leveraging the synergies arising from the process
LO 5 Summarise the consolidation of business entities, through mergers and acquisitions
3.13 DEVELOPMENT OF FINANCIAL MARKET INFRASTRUCTURE
changes in the payment and settlement systems. While leading to greater necessitated increased emphasis on integrity of the various systems to maintain
LO 6 Show how the development of financial market infrastructure has led to significant changes in the payment and settlement systems
risks.
software changes and has also entered into arrangements with three banks to function as settlement banks
3.24
Financial Institutions and Markets
and settlement arrangement for OTC rupee derivatives is proposed to be put in place. The modalities for operationalising the clearing and settlement system for the OTC rupee interest rate derivatives would be
transactions valued at around ` valued at ` million transactions valued at `
Table 3.8 Payment system indicators Items
Volume (Millions)
Value (` Billion)
2013–14
2014–15
2015–16
2013–-14
2014–15
2015–16
A. SIFMIs
83.7
95.7
101.4
1355822
1426488
1545672
A.1 RTGS
81.1
92.8
98.3
734252
754032
824578
A.2 TFMC
2.6
3.0
3.1
621570
672456
721094
B. Retail Payments
3627.4
4620.9
6945.2
143748
154129
177752
B.1 Paper Clearing
1257.3
1195.8
1096.4
93316
85439
81861
B.2 Electronic Clearing
1108.3
1687.4
3141.6
47856
65366
91408
B.3 Card Payments
1261.8
1737.7
2707.2
2575
3325
4484
Notes:
An Overview of the Indian Financial System
3.25
3.14 DEMONETISATION IN INDIA AND ITS IMPACT Demonetisation is the act of stripping a currency unit of its status as legal tender. Demonetisation is necessary whenever there is a change of national currency. The old unit of currency must be retired and replaced with a new currency unit.12 The success of demonetisation depends upon the implementation of the
●
LO 7 Review Demonetisation and its impact in India
The basic objective of demonetisation is to reduce the amount of black money in circulation and to
might lead the government to reduce tax rate in the future. ●
forced savings deposits and lower interest rate create opportunities for more investment in the future.
not necessary that demonetisation will produce big savings in the banking system in the medium term. ●
investment opportunities in the market which also help to increase the return of the investors. ●
●
●
negative impact on the growth process in the short run. The process works in the following way: Consumption Ø Ø Employment Ø Tax Revenue Ø Ø
●
3.15 RISKS TO FINANCIAL SYSTEM The impact of oil prices can be assessed both in the short and the long run. In
12
http://www.investopedia.com/terms/d/demonetisation.asp
LO 8 Determine various risks to financial system
3.26
Financial Institutions and Markets
assumed to be further reduced or eliminated.
countries. Several studies have attempted to empirically measure the impact of rise in crude oil prices in the international
countries has made it is easier for contagion of crisis to travel from one part of the world to the other in
An Overview of the Indian Financial System
3.27
with money from investors with a hope of receiving back initial investment and a healthy return. The hedge hedging their investment against adverse market movements. These funds are typically organised as private partnerships and often located offshore for tax and regulatory reasons. Hedge funds are largely restricted
The general modus operandi
discourages reckless risk taking.
3.28
Financial Institutions and Markets
many funds have set up the same trade. Hedge funds may also create excess volatility risks by making trades leading to overreaction of prices to diverge from fundamental values.
hedge funds in creating destabilising conditions. Hedge funds have been charged to have played a pivotal baht was
over impact of external developments on domestic interest rates. To the extent there is a rise in domestic
An Overview of the Indian Financial System
3.29
balance sheets would be exposed to credit risk. Increase in interest rates in general could impact housing
global growth. This would entail a reduction in export opportunities and reduction in investment demand
border assets denominated in foreign currencies in increasing volumes. Though the assets denominated in assets because of higher returns. The returns could vary across countries due to differential interest rates or faster appreciation of assets in some countries. The differential interest or appreciation rate sometimes
increase in an unsustainable manner and lead to further rise in assets prices in these countries to the levels
3.30
Financial Institutions and Markets
3.16 RECENT GLOBAL FINANCIAL MARKET DEVELOPMENTS: LESSONS FOR FINANCIAL STABILITY LO 9 Review recent global financial market developments and undesirable elements of financial development
trust and credibility along with the availability of transparent information. The transparency of the
about underlying risks is a critical component in the market’s ability to differentiate and properly price
important to carefully consider the appropriate amount and type of disclosure needed to ward off such episodes in future.
behaviour of new market participants. This would appear to be the best way to deal with the fact that
receive the same ratings. provide reliable market prices also needs to be examined. Investors may have to consider the associated
An Overview of the Indian Financial System
3.31
oversight and governance structures. investors to maintain high credit standards and strengthen risk management systems in better times as well as bad times. There is also a need for maintaining enhanced vigilance to be able to respond
situations where collaterals are not fully marked to market since such information may not be available
be addressed.
be attributed to a number of factors pervasive in both housing and credit markets. Causes include the
to recession in the information technology and out sourcing industry.
3.32
3.17
Financial Institutions and Markets
UNDESIRABLE ELEMENTS OF FINANCIAL DEVELOPMENT
this context.
13
banks are not allowed to operate in a big way in the stock markets and they are expected to channelise subsidiaries and mutual funds for channelising funds mainly to the big companies through the stock market.
3.18 QUALITY OF FINANCIAL DEVELOPMENT
and underhand deals. 13
See for example, Das-Gupta, A, ‘Personal Taxation and Private Financial Savings’, Economic and Political Weekly, February 10, 1990.
An Overview of the Indian Financial System
3.33
There are many cases where certain people have controlling interests in many companies without having
evolved as a result of interest rate policy and tax policy. The savers belonging to tax brackets have been in a
of markets and insensitivity of brokers. The stock market has gone through a series of security scams which
after 1991 have somewhat changed this picture for the better. Even investments in small savings media and
3.34
Financial Institutions and Markets
stability of banks and other institutions have become one of the major concerns and goals of the public policy.
regulations and guidelines. We have thus witnessed a ‘paradox of deregulation’ in recent years in India
contributed to the problem of overdues and defaults.14
Indian evidence.
SUMMARY ◆
◆
Macroeconomic development indicators have improved largely in the period of liberalisation. Money tremendously.
◆
◆
◆
14
India differs from many other countries where ‘household savings play a minor role with corporations generally playing the dominant role in the accumulation of national surplus’.
Kahlon, A.S., ‘Institutional Credit and Overdues’, Economic and Political Weekly, February 2, 1991.
An Overview of the Indian Financial System
3.35
◆ ◆ ◆
that has been predominant in India. ◆
◆
and ‘unorganised’ markets or the ‘busy’ and ‘slack’ seasons have become very much blurred now. The number of foreign collaborations in India and Indian collaborations and joint ventures abroad also
◆
the introduction of the policy of liberalisation and globalisation. The stock markets in particular are ◆
◆
◆
needed by all sections of the society in general and vulnerable groups such as weaker sections and institutional players. ◆
and so on. ◆ ◆
of total households. ◆
◆
Demonetisation is the act of stripping a currency unit of its status as legal tender and it has both positive
◆
KEY TERMS
Institutionalisation Securitisation
Monetary Instability Economic Instability Stress Testing
Consumer Credit Demonetisation Market Micro Structure
3.36
Financial Institutions and Markets
QUESTIONS
Financial Sector Reforms
4
CHAPTER Learning Objectives LO 1 LO 2 LO 3 LO 4
4.1 INTRODUCTION The
4.2 NEED FOR FINANCIAL REFORMS LO 1 Identify the need for financial reforms
1
Government of India, Report of the Committee on the Financial System (Narasimham Committee), Bombay, November 1991. For appraisal of this report see Bhole, L M, “Proposals for Financial Sector Reforms in India— An Appraisal”, Vikalpa, July–September 1992.
4.2
Financial Institutions and Markets
Financial Sector Reforms
Second-generation reforms
et. al.
4.3
4.4
Financial Institutions and Markets
4.2.1 Main and Sub Objectives of Financial Reforms Introduced in 1991
Financial Sector Reforms
4.5
4.3 MAJOR REFORMS AFTER 1991 LO 2 Recall the major reforms after 1991 and their impact
4.3.1 Systemic Policy Reforms ●
●
●
●
4.6
Financial Institutions and Markets
●
●
●
●
● ●
●
●
●
` ●
●
●
●
●
●
Financial Sector Reforms ●
●
●
●
● ●
●
● ●
● ● ●
●
● ● ●
●
4.3.2 Banking Reforms ●
` ●
●
4.7
4.8 ●
●
● ●
● ●
● ●
● ●
●
●
● ●
●
● ●
●
Financial Institutions and Markets
Financial Sector Reforms
●
●
●
●
●
●
●
●
●
●
●
●
●
●
●
lok adalats
4.9
4.10
Financial Institutions and Markets
●
●
●
●
●
4.3.3 Primary and Secondary Stock Market Reforms `
●
●
●
●
● ● ●
●
●
●
●
`
`
Financial Sector Reforms ● ●
●
●
●
●
●
●
●
●
●
●
●
●
● ●
4.11
4.12
Financial Institutions and Markets
●
●
● ● ●
● ● ●
4.3.4 Government Securities Market Reforms ●
● ●
●
●
●
●
●
●
●
●
●
Financial Sector Reforms ● ●
● ●
●
●
●
●
●
●
●
● ●
● ●
● ●
●
●
4.13
4.14
Financial Institutions and Markets
●
●
●
●
●
●
●
●
4.3.5 ●
●
●
●
●
Derivatives Market Reforms
Financial Sector Reforms ●
● ●
●
●
●
. .
4.3.6 External Financial Market Reforms ● ●
●
●
●
●
●
●
4.15
4.16
●
●
●
●
●
● ● ●
●
●
● ●
● ●
●
●
Financial Institutions and Markets
Financial Sector Reforms
●
●
●
●
●
viz ●
●
●
● ●
●
●
4.17
4.18
Financial Institutions and Markets
●
●
4.3.7 Recommendations of Raghuram Rajan Committee on Financial Sector Reforms ●
●
●
●
●
●
●
● ● ●
●
●
Financial Sector Reforms ●
●
●
●
●
●
●
●
●
●
4.19
4.20
Financial Institutions and Markets
●
●
●
●
Establishment of NITI Aayog:
New 5-Year Foreign Trade Policy (FTP) for 2015 2020:
Financial Sector Reforms
4.21
Gold Monetisation Scheme:
Pradhan Mantri Jan Dhan Yojana (PMJDY):
4.4 IMPACT OF FINANCIAL REFORMS
inter alia
2
Also see Bhole, L.M., “A Perspective on Financial Restructuring in India” in Atmanand (ed.), Globalisation and Dimensions of Management in India, Shipra, New Delhi, 1997; “Futures, Options, and Other Financial Innovations in India”, Productivity, July-September 1994; and “The Indian Capital Market at Crossroads”, Vikalpa, April–June 1995.
4.22
Financial Institutions and Markets
mutatis mutandis
viz
Financial Sector Reforms
`
`
4.23
4.24
Financial Institutions and Markets
Financial Sector Reforms
ad nauseam
4.25
4.26
Financial Institutions and Markets
4.5 VIEWS FROM ABROAD AGAINST FINANCIAL LIBERALISATION
viz
LO 3 Review critically some of the views from abroad against financial liberalisation
Financial Sector Reforms
4.27
viz
de facto
laissez faire
4.6 FUTURE CHALLENGES FOR INDIAN FINANCIAL SECTOR LO 4 Understand the challenges facing the Indian financial sector
●
`
3
See Bhole, L.M., op. cit.; and Rangarajan, C., “Financial Sector Reforms: The Indian Experience”, Reserve Bank of India Bulletin, July 1997, pp. 556–557.
4.28
Financial Institutions and Markets
●
viz.
●
●
inter alia
●
●
Financial Sector Reforms
●
●
●
●
4.29
4.30
●
●
●
●
●
Financial Institutions and Markets
Financial Sector Reforms ●
●
SUMMARY ◆
inter alia ◆
◆
◆
◆
◆
◆
4.31
4.32
Financial Institutions and Markets
◆
◆
◆
KEY TERMS
QUESTIONS
Financial Sector Reforms
4.33
Part 2 Financial Regulations and Regulatory Institutions in India Financial regulation is necessary because in its absence economic cost increases due to the
CHAPTERS 5. Financial Regulations in India 6. The Reserve Bank of India 7. Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
Financial Regulations in India
5
CHAPTER Learning Objectives LO 1 LO 2
Know several theories of regulation Recognise the four regulatory approaches
LO 3 LO 4 LO 5
Compare single versus multiple regulators
limitations
5.1 INTRODUCTION
per se
5.4
5.2 THEORIES OF REGULATION There are several theories that attempt to explain regulation in general and
LO 1 Know several theories of regulation
Structural regulation concerns the regulation of Conduct regulation is used to regulate the Social regulation 1
Traditional economic theory suggests that there are three main purposes of regulation such as (i) to constrain the use of monopoly power and the prevention of serious distortions to
2
Public Interest Theories of Regulation
market failure
3
Chicago Theory of Regulation proposed
1
Johan den Hertog, 2010, Review of Economic Theories of Regulation, Discussion Paper Series 10–18, Tjalling C. Koopmans Research Institute, Utrecht School of Economics, The Netherlands. 2 Markus Brunnermeier, Andrew Crocket, Charles Goodhart, Avinash D. Persaud and Hyun Shin, 2009, The Fundamental Principles of Financial Regulation, Geneva Reports on the World Economy 11. 3 A market failure is a situation where scarce resources are not put to their highest valued uses.
5.5
5.3 REGULATORY APPROACHES There are four regulatory approaches such as Integrated Approach Twin Peaks Model Functional Approach and Institutional Approach
5.3.1 Integrated Approach
5.3.2 The Twin Peaks Approach
5.3.3 The Functional Approach
LO 2 Recognise the four regulatory approaches
5.6
5.3.4 The Institutional Approach
5.4 SINGLE VERSUS MULTIPLE REGULATORS4 LO 3 Compare single versus multiple regulators
The arguments in favour of a ●
●
●
●
●
●
●
The arguments against the idea of a single regulator are as follows: ●
●
4
Y.V. Reddy, 2001, Issues in choosing between single and multiple regulators of financial system, Address given at the Public Policy Workshop, at ICRIER, New Delhi on 22 May, 2001.
5.7 ●
●
5.5 ACTS RELATED TO FINANCIAL SECTOR REGULATIONS IN INDIA LO 4 Discuss in detail various acts related to financial sector regulations in India
5.5.1 The Banking Regulation Act, 19495 ●
●
hundies
● ●
5
http://resource.cdn.icai.org/35285bos24910cp23.pdf; https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/BANKI15122014.pdf
5.8 ●
●
●
●
●
●
particulars of the extent and value of his holding of shares and any change in such holding or any ●
●
●
5.9 ●
●
●
●
● ●
●
conducted in a manner detrimental to the interest of the depositors then in consultation with the central
●
●
●
5.10
●
●
5.5.2 The Securities Contracts (Regulation) Act, 19566 vide
●
●
●
and demutualisation
●
vide ●
●
6
http://www.sebi.gov.in/acts/contractact.pdf; http://resource.cdn.icai.org/41058bos30846cp20.pdf Sec. 2(aa) defines corporatisation as the succession of a recognized stock exchange, being a body of individuals or a society registered under the Societies Registration Act, 1860, by another stock exchange, being a company incorporated for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities carried on by such individuals or society. 8 Under Sec. 2(a)(b), demutualisation is the segregation of ownership and management from the trading rights of the members of a recognized stock exchange in accordance with a scheme approved by the Securities and Exchange Board of India. 7
5.11
●
●
●
●
badlas
●
●
●
●
●
●
5.12
5.5.3 Securities and Exchange Board Act, 19929 ●
●
●
●
●
●
●
5.5.4 The Depositories Act, 199610 ●
9
http://resource.cdn.icai.org/41057bos30846cp19.pdf; http://www.sebi.gov.in/cms/sebi_data/attachdocs/1456380272563.pdf http://www.sebi.gov.in/acts/act03a.pdf; http://www.rna-cs.com/an-insight-into-the-depositories-act-1996
10
5.13 ●
●
●
register the transfer of the security in the name of the transferee on getting the intimation from the ●
the details of the allotment to the depository and then the depository enters the name of the allottee in its ● ●
●
●
●
●
●
5.14
●
5.5.5 The Foreign Exchange Management Act, 199911 ●
●
●
●
● ●
●
11
http://dor.gov.in/Foreign_Exchange_acts; http://resource.cdn.icai.org/35283bos24910cp21.pdf
5.15 ●
●
●
●
●
●
●
●
●
●
5.16 ●
declaration containing true and correct material particulars as well as the full export value and if not
●
●
●
●
●
●
5.17
5.5.6 The Competition Act, 200212 ●
●
competition13 for enforcing and implementing the competition policy whose central economic goal is the protection
●
●
12
http://resource.cdn.icai.org/35284bos24910cp22.pdf; http://lawmin.nic.in/ld/P-ACT/2003/The%20Competition%20Act,%202002.pdf 13 Competition is the situation in which firms or sellers independently strike for the buyer’s patronage in order to achieve a particular business objective, for example, profit, sales or market share (World Bank, 1999). 14 The Competition Commission of India is an expert body functioning as a market regulator to prevent and regulate anti-competitive practices in the country. 15 The Competition Appellate Tribunal is a three member quasi-judicial body headed by a Supreme Court judge or the chief justice of the High Court for hearing and disposing of the appeals against any order passed by the Competition Commission.
5.18
●
●
●
●
●
●
●
●
16
According to Sec. 2(c), cartel is an association of producers, sellers, distributors, traders or services providers who by agreement among themselves limit or control the production, distribution, sale or price of goods and services. 17 Tie-in arrangement requires the purchaser of goods to purchase some other goods as a condition of such purchase.
5.19 ●
●
●
5.5.7 The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 200218 ●
●
●
●
●
●
●
18
http://resource.cdn.icai.org/35285bos24910cp23.pdf ; http://www.drat.tn.nic.in/Docu/Securitisation-Act.pdf
5.20 ●
●
●
●
●
5.5.8 Prevention of Money Laundering Act, 200220 viz
●
●
●
21 ●
19
viz
The issuing of marketable securities backed by a pool of existing assets into marketable securities is known as securitization. http://resource.cdn.icai.org/35286bos24910cp24.pdf; http://finmin.nic.in/law/moneylaunderingact.pdf 21 Money laundering is the process of conversion of proceeds of crime into legitimate money. In the PMLA 2002, Money laundering has been defined as ‘any process or activity connected with proceeds of crime including its concealment, possession, acquisition or use and projecting or claiming it as untainted property’. 20
5.21
●
or is actually involved in any process or activity connected with the proceeds of crime including its
●
●
●
●
●
●
●
5.22
●
5.5.9 The Micro, Small and Medium Enterprises Act, 200622 ●
well as enhancing the competition and also empowers the central government to provide instruction and
●
●
●
●
●
22
http://ibcham.org/Documents/MSME%20Act%202006.pdf
5.23 ●
23 ●
5.5.10 Payment and Settlement Systems (PSS) Act, 200724 ●
●
●
●
●
●
23
The Micro and Small Enterprise Facilitation Council consists of three to five members with Director of Industries of the state government, one or more representative of associations of micro and small scale enterprise, one or more representative of banks and financial institutions lending to micro and small enterprise and one or more persons having knowledge of industry, finance, law, trade or commerce. 24 https://rbi.org.in/scripts/FAQView.aspx?Id=73; https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/86706.pdf
5.24 entities operating payment systems or the foreign entities are also allowed to operate a payment system
●
●
●
●
or direct it to perform such acts as are necessary in the interest of the smooth operation of the payment
●
5.5.11 Issue of Capital and Disclosure Requirements Regulations Act, 200925 ●
25
http://resource.cdn.icai.org/41057bos30846cp19.pdf; http://www.sebi.gov.in/guide/sebiidcrreg.pdf; http://www.sebi.gov.in/cms/sebi_ data/attachdocs/1456380272563.pdf
5.25 ●
●
●
●
●
●
5.26 ●
●
●
●
●
●
●
●
●
●
5.27 ●
●
●
●
●
●
5.28
●
●
5.5.12 The Companies Act, 201326 ●
●
●
●
●
26
http://www.mca.gov.in/Ministry/pdf/CompaniesAct2013.pdf; http://resource.cdn.icai.org/38523bos28158mod2-cp6.pdf
5.29
capital of ` private limited company Public limited company Subsidiary company
Listed company unlisted company Government company Foreign companies
Dormant company Nidhi
●
●
5.30 ●
●
●
shares
●
●
27
Sweat equity shares are issued by a company to its directors or employees at a discount or for consideration, other than cash, for providing know-how or making available rights in the nature of intellectual property rights or value additions.
5.31
●
`
`
●
5.5.13 The Pension Fund Regulatory and Development Authority Act, 201328 ●
●
●
28
http://npstrust.org.in/images/PFRDA20132326723328.pdf
5.32
any employment either under the central government or under any state government or in any regulated
●
●
the order to investigate the affairs of such intermediary or persons associated with the pension fund and if
5.5.14 Insurance Regulatory and Development Authority of India Act 1999
29
The details are provided in Chapter 10 of this book.
5.33
5.6 FINANCIAL SELF-REGULATION
developing economies are thus increasingly oriented toward mechanisms to
LO 5 Explain the concept of financial self-regulation, its features, benefits and limitations
5.34
5.6.1 Basic Features of Financial Self-Regulation
5.35
SUMMARY per
◆
se ◆
◆ ◆
◆
◆
◆
KEY TERMS Chicago Theory of Regulation Conduct Regulation Multiple Regulator
QUESTIONS
5.36
(xiii)
The Reserve Bank of India
6
CHAPTER Learning Objectives LO 1 LO 2 LO 3 LO 4 LO 5 LO 6 LO 7
Know the organisation, management and functions of the RBI Understand Monetary Policy of the RBI and various techniques of Monetary Control Explain Monetary Policy Operations in India Discuss Market Stabilisation Scheme (MSS) and challenges to Monetary Policy in India Review the report of the expert committee to revise and strengthen the Monetary Policy Framework in India Compare the monetary policy operations of some developed and developing countries Describe the autonomy of the Central Bank
6.1 INTRODUCTION the apex institution, it has been guiding, monitoring, regulating, controlling and promoting the destiny of the
the
6.2
Financial Institutions and Markets
6.2 ORGANISATION AND MANAGEMENT The governor and all the deputy governors of the bank are appointed by the
functions of the local boards are to advise the central board on matters referred
LO 1 Know the organisation, management and functions of the RBI
India to regulate the issue of bank notes and keeping of reserves with a view to securing monetary stability the major objectives of RBI are as follows: (i) To maintain monetary stability so that the business and economic life can deliver welfare gains of a
(vi) To regulate the overall volume of money and credit in the economy with a view to ensure a reasonable
6.3 FUNCTIONS OF RBI
(i) Note Issuing Authority: The RBI has, since its inception, the sole right or authority or monopoly of
The Reserve Bank of India
6.3
the Bank issues notes in the following denominations: ` of the Bank is not only to put currency into or withdraw it from circulation but also to exchange notes and
and rupee coins across the country, the Reserve Bank has authorised selected branches of banks to establish
The currency chests have been established with State Bank of India, six associate banks, nationalised banks,
The Bank can issue notes against the security of gold coins and gold bullion, foreign securities, rupee coins,
this system was abandoned and a minimum value of gold coin and bullion and foreign securities as a part of (ii) Government Banker:
withdrawal of funds by cheques, making payments as well as receipts and collection of payments on behalf
this amount is `
`
ways and means
6.4
Financial Institutions and Markets
(iii) Management of Public Debt: The Reserve Bank manages the public debt and issues new loans on behalf
management policy aims at minimising the cost of borrowing, reducing the roll-over risk, smoothening the maturity structure of debt and improving depth and liquidity of government securities markets by developing the Reserve Bank takes into account a number of factors, such as, the amount of central and state loans (iv) Bankers’ Bank: special relationship with commercial and cooperative banks, and the major part of its business is with these
Inter-bank accounts can also be settled by transfer of money through electronic fund transfer system, such
(v) Supervising Authority: The RBI has vast powers to supervise and control commercial and cooperative the following powers: (a) to issue licences for the establishment of new banks; (b) to issue licences for the setting up of bank branches; (c) to prescribe minimum requirements regarding paid-up capital and reserves, transfer to reserve fund and maintenance of cash reserves and other liquid assets; (d) to inspect the working of banks in India as well as abroad in respect of their organisational set-up, branch expansion, mobilisation planning, manpower planning and training and so on; (e) to conduct ad hoc investigations, from time to time, into complaints, irregularities and frauds in respect of banks; (f) to control methods of operations of banks so that they do not fritter away funds in improper investments and injudicious advances; (g) to control
(vi) Exchange Control (EC) Authority: One of the essential functions of the RBI is to maintain the stability
The Reserve Bank of India
6.5
or manage the exchange rate between the rupee and other currencies, (c) to manage exchange reserves, and
The objective of exchange control is primarily to regulate the demand for foreign exchange within the limits
exchange control which is imposed both on receipts and payments of foreign exchange on trade, invisible scope of exchange control in India has steadily widened and the regulations have become progressively more
reserves, and it is vested with the responsibility of managing the investment and utilisation of the reserves
bank also manages the investment of reserves in gold accounts abroad and the shares and securities issued in the foreign exchange market, and as the stabiliser of that market and the rupee exchange rate has become
(vii) Formulating Prudential Norms:
6.6
Financial Institutions and Markets
(viii) Promoter of the Financial System:
(ix) Regulation and Supervision of Payment System:
towards integrating the payment system with the settlement systems for government securities and foreign
settlement of trade in foreign exchange, government securities and other debt instrument, it has set up the
(DPSS) was constituted to assist the BPSS in performing its functions (x) Promoter of the Financial System and Economic Development:
(a) Agricultural Sector:
supply of agricultural credit, the bank has been working to strengthen cooperative banking structure
The Reserve Bank of India
6.7
(b) Industrial Finance: The role of the bank in diversifying the institutional structure for providing
providing short-term and long-term funds to the agricultural and rural sectors, to small-scale industries,
(c) Credit Delivery: The Bank has evolved and put into practice the consortium, co-operative and practice of inter-institutional participation, of expertise pooling and of geographical presence, it has
acceptable system of lending, so that the banking business grows in a healthy manner and without cut(xi) Regulator of Money and Credit: The function of formulating and conducting monetary policy is of
6.4 MONETARY POLICY OF THE RBI1 The objectives of monetary policy in India were (a) to accelerate economic development in an environment of reasonable price stability, (b) to develop appropriate institutional set-up to aid this process, and (c) to help in achieving credit, monetary policy has been encouraging sectoral and overall development,
LO 2 Understand Monetary Policy of the RBI and various techniques of Monetary Control
policy may be said to be controlled expansion of bank credit and money supply, with special attention to takes place in the light of price variations without affecting the output, particularly the industrial output 1
See also Bhole, L.M., Impacts of Monetary Policy, op. cit., pp. 5–27 and pp. 263–88.
6.8
Financial Institutions and Markets
Further, it has come to be believed that by achieving reasonable price stability, it is possible to (a) avoid
2
the aim of monetary policy in general and interest rate policy in particular has been to restrain inessential
to deregulate interest rates, to ease operational constraints in the credit delivery system, to introduce new
6.4.1 Monetary Policy Framework3
In practice, the nature of the framework is contingent upon two
monetarists, believe in discretionary monetary policy and have refrained from prescribing any rigid monetary
2
Rangarajan, C., “Issues in Monetary Management”, Indian Economic Association, Presidential Address, 1988, pp. 5–7. See also ‘Monetary Policy Framework in India: Experience with Multiple-Indicators Approach’ Speech by Deepak Mohanty, Executive Director, Reserve Bank of India, delivered at the Conference of the Orissa Economic Association in Baripada, Orissa, on 21 February, 2010. 4 Bernanke, Ben S. ‘Constrained Discretion and Monetary Policy’. Remarks before the Money Marketeers of New York University, New York, February 3, 2003. 3
The Reserve Bank of India
6.9
detailed monetary targets set for relatively short horizons are likely to become counter-productive, in the authorities have also realized that money supply cannot be the only control variable of monetary policy as it is Thus, the problem of curbing monetary expansion is that, there are two major elements which are virtually outside our control, namely, (a) the increase in monetary supply corresponding to inward remittances of foreign exchange, and (b) In order to achieve the objectives of monetary policy which are not under the direct control of central banks,
of the stable relationship among money, output and prices made many central banks of developed countries to targeting was adopted in many developing countries such as Brazil, China, Indonesia, Korea, Malaysia, Peru,
targeting framework, both in developed and developing countries triggered a search for alternate monetary
The RBI regards money supply and the volume of bank credit as the two major intermediate variables, but own, it changes because of certain underlying developments with regard to bank credit, and the expansion
to reduce bank borrowings from itself and to encourage the liquidation of their earlier obligations in an , supporting reasonable stability in the demand function for money, broad money (M ) formally emerged as 6
5
RBI, Report of the Committee to Review the Working of the Monetary System, Bombay, 1985. Technically, in a simple form, if expected real GDP growth is 6 percent, the income elasticity of demand for money is 1.5 and a tolerable level of inflation is 5 percent, the broad money (M3) expansion target can be set at 14 percent (M3 growth = 1.5 ¥ 6 + 5 = 14%) 6
6.10
Financial Institutions and Markets
mechanism of monetary policy with interest rate and the exchange rate gaining importance vis-à-vis quantity variables approach, information content from a host of quantity variables such as money, credit, output, trade, capital
Bank also gives the projection for broad money (M ), which serves as an important information variable, so as to make the resource balance in the economy consistent with the credit needs of the government and augmented multiple indicators approach
6.5 TECHNIQUES OF MONETARY CONTROL Many techniques of monetary control—some old and well known, others specially devised and adapted-have
(a) Open Market Operations (OMOs): OMOs are the market operations conducted by the Reserve Bank
(b) Bank Rate:
(c) rediscounting of bills of exchange and promissory notes, and loans and advances to scheduled commercial 7
Reserve Bank of India (1998), The Working Group on Money Supply: Analytics and Methodology of Compilation (Chairman: Dr. Y.V. Reddy).
The Reserve Bank of India
6.11
This technique has been (d) Direct Regulation of Interest Rates: This technique allows the central bank to directly regulate the During the period of liberalization most of the interest rates such as industrial debenture rates, bank lending rates, deposit rates and other interest rates came to be deregulated or market-determined, and therefore, this (e) Cash Reserve Ratio (CRR): The CRR refers to the cash which banks have to maintain with the RBI as
(f) Statutory Liquidity Ratio (SLR). It is the percentage of total deposits, banks have to invest in government
Bank is in a position to insulate a part of the government debt from the open market impact because banks are (g) Direct Credit Allocation and Credit: This technique controls the distribution or allocation of credit
the RBI has been asking banks to achieve a certain prescribed credit–deposit ratio in respect of their rural
(h) Selective Credit Controls (SCC):
have been used particularly to prevent speculative hoarding of sensitive commodities such as paddy, rice, wheat, pulses, oil-seeds, oils and vanaspati, cotton sugar, gur
ex ante (i) Credit Authorisation Scheme (CAS):
8
For details regarding eligible transactions, parties, purposes, maturity of bills for RBI accommodation, and the duration of accommodation, see RBI, Functions and Working, Bombay, 1983, pp. 58–61. 9 See also Bhole, L.M., “Administered Interest Rates in India”, Economic and Political Weekly, June 22–29, 1985.
6.12
Financial Institutions and Markets
end-use of credit is for genuinely productive purposes, (d) to ensure that large borrowers do not pre-empt or monopolise scarce bank credit, and (e) to ensure that credit is supplied in accordance with the needs of
or the entire banking system exceeded a stipulated level, the bank would require prior authorisation of the
` capital, and ` two crore and above in the case of term loans, had to be submitted to the RBI for post-sanction
(j) Fixation of Inventory and Credit Norms: The RBI has been, through the appointment of various committees, continuously reviewing and studying the working of commercial banks in respect of different
inventories by industrial units, and (vi) payments period in respect of trade credit of industrial units tended
new methods of bank lending for purposes of credit appraisal for determining the volume of credit, and for required to advance credit for working capital to different industries in the light of inventory norms laid these norms from time to time in the cases of different industries, and banks had to implement the new norms
(k) Process of Credit Planning: each bank is required to prepare realistic annual credit budget incorporating estimates of volume and growth
discussions, the RBI tries to ensure that actual credit operations of banks and their credit plans resemble, so
10
See National Credit Council, Report of the Study Group on the extent to which credit needs of industry and trade are likely to be inflated and how such trends could be checked, Bombay, 1969; RBI, Report of the Study Group to frame guidelines for follow-up of bank credit, Bombay, 1975; and RBI, Report of the Working Group to review the system of cash credit, Bombay, 1979.
The Reserve Bank of India
6.13
(l) Moral Suasion: takes the form of writing letters and holding discussions between the RBI and the banks about trends in the
(m) Liquidity Adjustment Facility (LAF): scheduled commercial banks (SCBs) (excluding RRBs) and primary dealers to avail of liquidity in case of requirement or park excess funds with the RBI in case of excess liquidity on an overnight basis against the
Repo or ready forward contact is an instrument for borrowing funds by selling securities with an agreement to repurchase the said securities on a mutually agreed future date at
overall effect of the repo transaction would be borrowing of funds backed by the collateral of government
6.6 MONETARY POLICY OPERATIONS IN INDIA In India, as in most countries, monetary policy framework has evolved in
LO 3 Explain Monetary Policy Operations in India
For analytical convenience, viz
Formative Phase (1935–1950): During this period, the emphasis was on administering the supply of and
11
RBI, 2014, Government Securities Market in India—A Primer Report of the Working Group on Operating Procedure of Monetary Policy (Chairman: Deepak Mohanty) http://www.rbi.org.in/scripts/ BS_PressReleaseDisplay.aspx?prid=24063. 12
6.14
Financial Institutions and Markets
policy, the bank rate was used Development Phase-I (1951–1970):
Development Phase-II (1971–1990):
monetary system and carry out the necessary changes in the institutional set-up and framework of monetary targeting framework with feedback from the real sector and with broad money as the nominal anchor evolved
by a number of other structural rigidities in the system such as the skewed distribution of liquidity and the Early Reform Phase (1991–1997): Following the Report of the Committee on Financial System (Chairman:
bearing on monetary management with exchange rate liberalisation—the rupee became fully convertible on
Liquidity Adjustment Facility Phase (1998-2014): The Narasimham Committee on Banking Sector inter alia, suggested that for orderly movement of interest rates in the interbank call
The Reserve Bank of India
6.15
would periodically, if not necessarily daily, reset its repo and reverse repo rates which would in a sense provide
(a) was withdrawn and replaced by a
Liquidity Concepts Autonomous Liquidity
(i) the government adjusted for OMOs and repo operations, (ii) banks (other than credit to scheduled commercial banks), (iii) the commercial sector (other than credit to PDs), and (iv) foreign assets net of liabilities (other than scheduled (i) treasury bills, (ii) dated securities, and (iii) non-marketable securities (such as ad hoc TBs funded into non-transferable special securities)
6.16
Financial Institutions and Markets
Discretionary Liquidity
(b) RBI credit to scheduled commercial banks, and (c) RBI credit to primary dealers netted for cumulative Net Liquidity
viz
support to PDs was continued but at an interest rate linked to the variable rate in the daily repo auctions as
and liquidity support to PDs was made available at the repo rate, thereby completely delinking the standing
The Reserve Bank of India
6.17
the management of day-to-day liquidity and in response to suggestions from market participants, the Second
portfolio for absorption of liquidity and reverse repo auctions, that is, buying of government securities for injection of liquidity on a daily basis, thereby creating a corridor for the call money rates and other short-term
Consequently, the operating policy rate alternated between repo and reverse repo rates depending upon the
corridor which often led the implicit target rate (call rate) breaching the upper and lower limits under liquidity
marginal standing facility (MSF) was instituted under which scheduled
Rate of interest X + 50 bps
Marginal Standing [This standing facility is available up to 1 per cent of banks’ NDTL Facility (Ceiling) against collateral of government securities from required SLR securities]
x [Liquidity against excess SLR securities and export credit refinance facility for banks and liquidity facility for PDs]
X-50 bps [Liquidity absorption by the Reserve Bank of India against government securities]
Policy Rate (Repo Rate) Overnight Call Rate (Target Rate) Reverse Repo Rate (Floor) Liquidity
Figure 6.1 Current liquidity adjustment facility framework in India.
6.18
Financial Institutions and Markets
The new operating procedure is expected to improve the implementation and transmission of monetary
6.6.1 Merits of LAF
combined with OMOs and bank rate changes have become the major technique (operating procedure) of
Table 6.1 Open market operation of RBI, 1951–2016 (Amount in ` crore)
Year
1951–52 1955–56 1959–60 1970–71 1975–76 1980–81 1985–86 1990–1991 1995–1996 2000–2001 2005–2006 2006–2007 2007–2008 2008–2009 2009–2010 2010–2011 2011–2012 2012–2013 2013–2014 2014–2015 2015–2016
Purchases
Sales
Net sales(–)/net purchase(+)
(1)
(2)
(3)
61 22 23 207 680 454 882 2291 1645 4471 740 720 13510 104480 85399 78799 142272 166095 71633 22744 94554
55 38 84 313 1187 796 2613 2238 1131 23795 4653 5845 7587 9932 9931 11575 8187 11548 19343 86761 42284
+6 –16 –61 –106 –507 –342 –1731 +53 +514 –19324 –3913 –5125 +5923 +34548 +75468 +67224 +134086 +154547 +52290 –64017 +52270
Source: RBI, RCF, various issues and RBI, Handbook of Statistics, various issues.
Total operation (4) 116 60 107 520 1867 1250 3495 4529 2776 28266 5393 6565 21097 114412 95330 90374 150459 177643 90976 109505 136838
The Reserve Bank of India
Table 6.2
6.19
Major monetary policy rates and reserve requirements (Percentage)
Effective dates
Bank rate
Repo
Reverse repo rate
Cash reserve Marginal Statutory liquidity ratio standing facility ratio
15-04-2016
6.75
6.25
5.75
4.00
6.75
20.5
15-07-2013
10.25
—
—
—
10.25
—
3-05-2013
8.25
7.25
6.25
—
8.25
—
19-03-2013
8.50
7.50
6.50
—
8.50
—
9-02-2013
—
—
—
4.00
—
—
29-01-2013
8.75
7.75
6.75
—
8.75
—
3-11-2012
—
—
—
4.25
—
—
22-09-2012
—
—
—
4.50
—
—
11-08-2012
—
—
—
—
—
17-04-2012
9.00
8.00
7.00
—
9.00
23.00
10-03-2012
—
—
—
4.75
—
—
13-02-2012
9.50
—
—
—
—
—
28-01-2012
—
—
—
5.50
—
—
25-10-2011
—
8.50
7.50
—
9.50
—
16-09-2011
—
8.25
7.25
—
9.25
—
26-07-2011
—
8.00
7.00
—
9.00
—
16-06-2011
—
7.50
6.50
—
8.50
—
3-05-2011
—
7.25
6.25
—
8.25
—
17-03-2011
—
6.75
5.75
—
—
—
25-01-2011
—
6.50
5.50
—
—
18-12-2010
—
—
—
—
—
2-11-2010
—
6.25
5.25
—
—
—
16-09-2010
—
6.00
5.00
—
—
—
27-07-2010
—
5.75
4.50
—
—
—
2-07-2010
—
5.50
4.00
—
—
—
24-04-2010
—
—
—
6.00
—
—
20-04-2010
—
5.25
3.75
—
—
—
19-03-2010
—
5.00
3.50
—
—
—
27-02-2010
—
—
—
5.75
—
—
13-02-2010
—
—
—
5.50
—
—
—
— 24.00
7-11-2009
—
—
—
—
—
21-04-2009
—
4.75
3.25
—
—
25.00
5-03-2009
—
5.00
3.50
—
—
—
17-01-2009
—
—
—
5.00
—
—
5-01-2009
—
5.50
4.00
—
—
—
—
(Contd.)
6.20
Financial Institutions and Markets
8-12-2008
—
6.50
5.00
—
—
—
8-11-2008
—
—
—
5.50
—
3-11-2008
—
7.50
—
—
—
24.00 —
25-10-2008
—
—
—
6.00
—
—
20-10-2008
—
8.00
—
—
—
—
11-10-2008
—
—
—
6.50
—
—
30-08-2008
—
—
—
9.00
—
—
30-07-2008
—
9.00
—
—
—
—
19-07-2008
—
—
—
8.75
—
—
5-07-2008
—
—
—
8.50
—
—
25-06-2008
—
8.50
—
—
—
—
12-06-2008
—
8.00
—
—
—
—
24-05-2008
—
—
—
8.25
—
—
10-05-2008
—
—
—
8.00
—
—
26-04-2008
—
—
—
7.75
—
—
10-11-2007
—
—
—
7.50
—
—
4-08-2007
—
—
—
7.00
—
—
28-04-2007
—
—
—
6.50
—
—
14-04-2007
—
—
—
6.25
—
—
31-03-2007
—
7.75
—
—
—
—
3-03-2007
—
—
—
6.00
—
—
17-02-2007
—
—
—
5.75
—
—
31-01-2007
—
7.50
—
—
—
—
6-01-2007
—
—
—
5.50
—
—
23-12-2006
—
—
—
5.25
—
—
31-10-2006
—
7.25
—
—
—
—
25-07-2006
—
7.00
6.00
—
—
—
8-06-2006
—
6.75
5.75
—
—
—
24-01-2006
—
6.50
5.50
—
—
—
26-10-2005
—
6.25
5.25
—
—
—
29-04-2005
—
—
5.00
—
—
—
27-10-2004
—
—
4.75
—
—
—
2-10-2004
—
—
—
5.00
—
—
18-09-2004
—
—
—
4.75
—
—
14-06-2004
—
—
—
—
—
—
31-03-2004
—
6.00
—
—
—
—
25-08-2003
—
—
4.50
—
—
—
14-06-2003
—
—
—
4.50
—
—
29-04-2003
6.00
—
—
—
—
— (Contd.)
The Reserve Bank of India 19-03-2003
—
7.00
—
—
—
—
7-03-2003
—
3-03-2003
—
7.10
—
—
—
—
—
5.00
—
—
16-11-2002
—
—
—
—
4.75
—
—
12-11-2002
—
7.50
—
—
—
—
29-10-2002
6.25
—
5.50
—
—
—
27-06-2002
—
—
5.75
—
—
—
15-06-2002
—
—
—
5.00
—
—
28-03-2002
—
8.00
—
—
—
—
5-03-2002
—
—
6.00
—
—
—
29-12-2001
—
—
—
5.50
—
—
3-11-2001
—
—
—
5.75
—
—
23-10-2001
6.50
—
—
—
—
—
7-06-2001
—
8.50
—
—
—
—
28-05-2001
—
—
6.50
—
—
—
19-05-2001
—
—
—
7.50
—
—
30-04-2001
—
8.75
—
—
—
—
27-04-2001
—
9.00
6.75
—
—
—
10-03-2001
—
—
—
8.00
—
—
2-03-2001
7.00
—
—
—
—
—
24-02-2001
—
—
—
8.25
—
—
17-02-2001
7.50
—
—
—
—
—
12-08-2000
—
—
—
8.50
—
—
29-07-2000
—
—
—
8.25
—
—
22-07-2000
8.00
—
—
—
—
—
22-04-2000
—
—
—
8.00
—
—
8-04-2000
—
—
—
8.50
—
—
2-04-2000
7.00
—
—
—
—
—
20-11-1999
—
—
—
9.00
—
—
6-11-1999
—
—
—
9.50
—
—
8-05-1999
—
—
—
10.00
—
—
13-03-1999
—
—
—
10.50
—
—
2-03-1999
8.00
—
—
29-08-1998
—
—
—
29-04-1998
9.00
—
—
11-04-1998
—
—
—
—
—
—
—
—
—
3-04-1998 28-03-1998 19-03-1998
10.00 — 10.50
— 11.00 — 10.00 — 10.25 —
—
—
—
—
—
—
—
—
—
—
—
—
—
—
6.21
(Contd.)
6.22
Financial Institutions and Markets
17-01-1998
11.00
—
—
10.50
—
— —
6-12-1997
—
—
—
10.00
—
22-11-1997
—
—
—
9.50
—
25-10-1997
—
—
—
9.75
—
— 25.00
22-10-1997
9.00
—
—
—
—
—
26-06-1997
10.00
—
—
—
—
—
16-04-1997
11.00
—
—
—
—
—
—
—
10.00
—
—
4-01-1997
—
—
—
10.50
—
—
9-11-1996
—
—
—
11.00
—
—
26-10-1996
—
—
—
11.50
—
—
6-07-1996
—
—
—
12.00
—
—
11-05-1996
—
—
—
13.00
—
—
27-04-1996
—
—
—
13.50
—
—
9-12-1995
—
—
—
14.00
—
—
11-11-1995
—
—
—
14.50
29-10-1994
—
—
—
18-01-1997
—
—
— —
— 31.50
17-09-1994
—
—
—
—
—
33.75
20-08-1994
—
—
—
—
—
34.25
6-08-1994
—
—
—
15.00
—
—
9-07-1994
—
—
—
14.75
—
—
11-06-1994
—
—
—
14.50
16-10-1993
—
—
—
—
— —
— 34.75
18-09-1993
—
—
—
—
—
37.25
21-08-1993
—
—
—
—
—
37.50
15-05-1993
—
—
—
14.00
17-04-1993
—
—
—
14.50
6-03-1993
—
—
—
—
— — —
— — 37.75
6-02-1993
—
—
—
—
—
38.00
9-01-1993
—
—
—
—
—
38.25
9-10-1991
12.00
—
—
—
—
—
4-07-1991
11.00
—
—
—
—
—
22-09-1990
—
—
—
1-07-1989
—
—
—
—
—
30-07-1988
—
—
2-07-1988
—
—
2-01-1988
—
—
—
24-10-1987
—
—
—
25-04-1987
—
—
—
—
—
28-02-1987
—
—
—
9.50
—
38.50
15.00
—
—
—
11.00
—
—
—
10.50
—
— 10.00
— —
— 38.00 — 37.50 — (Contd.)
The Reserve Bank of India 6-07-1985
—
—
—
—
—
37.00
8-06-1985
—
—
—
—
—
36.50
1-09-1984
—
—
—
—
—
36.00
28-07-1984
—
—
—
—
—
35.50
4-02-1984
—
—
—
9.00
—
—
27-08-1983
—
—
—
8.50
—
—
29-07-1983
—
—
—
8.00
—
—
27-05-1983
—
—
—
7.50
—
—
11-06-1982
—
—
—
7.00
—
—
9-04-1982
—
—
—
7.25
—
—
29-01-1982
—
—
—
7.75
—
—
25-12-1981
—
—
—
7.50
—
—
27-11-1981
—
—
—
7.25
—
30-10-1981
—
—
—
—
—
35.00
25-09-1981
—
—
—
—
—
34.50
21-08-1981
—
—
—
7.00
—
—
31-07-1981
—
—
—
6.50
—
—
12-07-1981
10.00
6.23
—
—
—
—
—
1-12-1978
—
—
—
—
—
—
13-11-1976
—
—
—
6.00
—
—
4-09-1976
—
—
—
5.00
—
—
28-12-1974
—
—
—
4.00
—
—
14-12-1974
—
—
—
4.50
—
—
34.00
23-07-1974
9.00
—
—
—
—
1-07-1974
—
—
—
5.00
—
33.00
—
8-12-1973
—
—
—
—
—
32.00
22-09-1973
—
—
—
7.00
—
—
8-09-1973
—
—
—
6.00
—
—
29-06-1973
—
—
—
5.00
—
—
31-05-1973
7.00
—
—
—
—
—
17-11-1972
—
—
—
—
—
30.00
4-08-1972
—
—
—
—
—
29.00
9-01-1971
6.00
—
—
—
—
28-08-1970
—
—
—
—
—
— 28.00
24-04-1970
—
—
—
—
—
27.00
5-02-1970
—
—
—
—
—
26.00
2-03-1968
5.00
—
—
—
—
—
17-02-1965
6.00
—
—
—
—
—
26-09-1964
5.00
—
—
—
—
— (Contd.)
6.24
Financial Institutions and Markets
16-09-1964
—
—
—
—
—
—
25.00
3-01-1963
4.50
—
—
—
—
16-09-1962
—
—
—
3.00 % NDTL
of
—
—
11-11-1960
—
—
—
(a) 5% of DL, (b) 2% of TL
—
—
6-05-1960
—
—
—
(a) 5% of DL, (b) 2% of TL
—
—
6-03-1960
—
—
—
(a) 5% of DL, (b) 2% of TL
—
—
16-05-1957
4.00
—
—
—
—
—
15-11-1951
3.50
—
—
—
—
—
16-03-1949
—
—
—
—
—
28-11-1935
3.00
—
—
—
—
—
5-07-1935
3.50
—
—
—
—
(a) 5% of DL, (b) 2% of TL
20.00
Source: RBI, various publications.
It must be stated at this juncture that the relevance and the extent of use of techniques such as direct credit
institutions, and the shift from the direct to indirect techniques, the authorities are also giving less emphasis
and empirically earlier and have shown that it may be neither desirable nor possible to discard or deactivate
Table 6.3 Summary of changes in techniques of monetary control in India, 1935–2013 1935–1950 1951–1970 1971–1990 1991–1997 1. Bank rate (a) No. of times used (b) Range of variation (%) 2. CRR (a) No. of times used (b) Range of variation (%)
1998–2016
2
6
— 4
— 5
15
3–3.5
3.5–6.0
6.0–11.0
9.0–12.0
6.0–11.0
—
—
— —
— —
24 4.0–15.0
17 9.5–15.0
51 4.0–11.0 (Contd.)
13
Bhole, L.M., ‘Recent Changes in the Theory and Policy of Cash Reserve Ratio and Statutory Liquidity Ratio: A Critical Appraisal’, Vikalpa, October–December 1993.
6.25
The Reserve Bank of India —
5. OMOs 6. Repo operation and repo rate (a) No. of times repo rate used (b) Range of variation in RR (%) (d) Range of variation in RRR (%)
—
—
—
—
—
—
—
—
—
—
—
—
—
—
45
— — —
— — —
— — —
— — —
4.75–9.00 34 3.25–7.50
—
—
—
—
Notes: Denotes the active use of the instrument. — Denotes absence of the use of the instrument. The range Source: RBI, RCF and annual reports.
6.7 MARKET STABILISATION SCHEME (MSS)
due to the depletion in stock of government securities, the burden of liquidity
LO 4 Discuss Market Stabilisation Scheme (MSS) and challenges to Monetary Policy in India
T-bills and dated securities under market stabilisation scheme (MSS) where the proceeds of MSS were to be
towards interest, premium and discount are shown in the budget and other related documents as distinct
6.26
Financial Institutions and Markets
of new central bank bills of overlapping maturity could cause considerable confusion and possible market segmentation which could obfuscate the yield curve, reduce liquidity of the instruments and make operations
6.8 CHALLENGES TO MONETARY POLICY IN INDIA ●
The growing importance of assets and asset prices in a globally integrated economy complicates the
●
●
show that ignoring the structural or permanent elements of shocks may slow down appropriate monetary ●
●
●
●
6.9 REPORT OF THE EXPERT COMMITTEE TO REVISE AND STRENGTHEN THE MONETARY POLICY FRAMEWORK IN INDIA14
and conduct of monetary policy in a globalised and highly inter-connected 14
LO 5 Review the report of the expert committee to revise and strengthen the Monetary Policy Framework in India
Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework in India (Chairman: Urjit Patel, Deputy Governor, RBI), January, 2014.
The Reserve Bank of India
6.27
review the organisational structure, operating framework and instruments of monetary policy, particularly the multiple indicator approach and the liquidity management framework, with a view to ensuring compatibility and other impediments to monetary policy transmission, and recommend measures and institutional pre-
nominal anchor should be communicated without ambiguity, so as to ensure a monetary policy regime establishment and achievement of the nominal anchor, monetary policy conduct should be consistent
governor of the RBI will be the chairman of the MPC, the deputy governor in charge of monetary policy will be the vice chairman and the executive director in charge of monetary policy will be a the basis of demonstrated expertise and experience in monetary economics, macroeconomics, central
several variants are available in the literature and in country practice, the committee is of the view that
6.28
Financial Institutions and Markets
decide the extent to which it is positive, with due consideration to the state of the output gap (actual
or transitional phase, the weighted average call rate will remain the operating target, and the overnight
liquidity of the banking system using a mix of term repos, overnight repos, outright operations and the
overnight policy rate since it allows market participants to hold central bank liquidity for a relatively longer period, thereby enabling them to lend repo term money in the inter-bank market and develop
with (i) two-way outright open market operations through both auctions and trading on the NDSbetween the repo and reverse repo rate); and (iii) discretionary changes in the CRR that calibrate bank
The Reserve Bank of India
6.29
of surplus liquidity from the system but without the need for providing collateral in exchange, a (low) remunerated standing deposit facility may be introduced, with the discretion to set the interest rate since term repo market segments could help in establishing market-based benchmarks for a variety of scheme (MSS) and cash management bills (CMBs) may be phased out, consistent with government
sterilized intervention: (a) the RBI should build a sterilization reserve out of its existing and evolving to rapidly intervene at the short end; and (b) the RBI should introduce a remunerated standing deposit
trade-off in the short run, it is designed around the critical importance of price stability for sustainable
central banks could ensure price stability, households and companies can plan ahead, negotiating wages 1. The Monetary Policy Committee (MPC): The MPC is empowered and responsible to set up the
6.30
Financial Institutions and Markets
as under: ● ● ●
What is the condition for a failed monetary policy with respect to the set target?
6.10 MONETARY POLICY IN OTHER COUNTRIES
targets and operating procedures of monetary policy worldwide have witnessed considerable shifts in tune with the evolution of monetary theory, central
LO 6 Compare the monetary policy operations of some developed and developing countries
of intermediate targets is conditional on the channels of monetary policy transmission that operate in the
To promote Maximum
Objective
Overnight rate
Cash rate
Overnight market interest rate Consistent with Bank Rate
Intermediate/ Operating Target
markets
Key Policy Indicators
Yes
Yes
Yes
CRR
Yes
Yes
Yes
Yes
OMO
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
REPO Standing Others Facilities
Key Instruments of Discretionary Liquidity
Operating procedures of liquidity management in developed countries
Source: RBI, RCF, 2005-06.
Canada
Japan
UK
USA
Country
Table 6.4
More than one per
repos)
One per week
Frequency of Market Operations
The Reserve Bank of India
6.31
growth
a sound basis for
Objective
Weighted
rate
forex rates
Yes
Yes
Yes
Overnight interest rate
Yes
Yes
CRR
Yes
output.
Key Policy Indicators
Overnight rate
Bank reserves
Intermediate/ Operating Target
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
OMO REPO
Yes
Yes
Yes
Yes
Yes
Yes
Standing Facilities
Reverse swaps
overdrafts
Market
Others
Key Instruments of Discretionary Liquidity
Operating procedures of liquidity management in developing countries
Source: RBI, RCF, 2005-06.
Singapore
Korea
China
Country
Table 6.5
1 or 2 per week
Frequency of Market Operations
6.32 Financial Institutions and Markets
The Reserve Bank of India
6.33
central banks, however, in countries such as the UK, select overnight market interest rates as their operating
The operating target in the case of several EMEs also is the overnight rate—determined in the interbank being the monopolistic suppliers of primary liquidity, have endeavoured to smoothen the movements in the
The operating procedures of monetary policy and liquidity management have also changed in response to
et al
system over which monetary authorities had direct control was reduced, warranting indirect (price-oriented as opposed to quantity-oriented instruments) ways to control the non-monetary components of liquidity in the
a growing urge on the part of central banks to stimulate money market activity and improve monetary policy
conscious policy effort to reduce the tax on intermediation with a view to reducing the burden of institutions
among the wide array of monetary policy instruments, repos have almost become the main policy tool, which growth of the collateralised repo market has played an important role in enhancing the overall stability of the
6.34
Financial Institutions and Markets
has been accompanied by a greater transparency in the policy signals relating to desired interest rate levels,
6.11 AUTONOMY OF THE CENTRAL BANK Central bank independence generally relates to three areas, viz to the extent to which the government distances itself from appointment, term of
LO 7 Describe the autonomy of the Central Bank
access of government to central bank credits would naturally imply that monetary policy is subordinated
itself can choose the policy priorities of stabilising output or prices at any given point of time, thus setting et al
6.11.1
Advantages
Three different theories have been advanced in support of autonomy of central banks, viz arises when the best plan (currently made for some future period) is no longer optimal when that period
bank independence—while the United States is often seen as an example of conservative central bank, New
The Reserve Bank of India
6.35
Second, the political business cycle theory studies the interaction between economic policy decisions and
basic contentions of these economists are that unless there are constitutional or institutional constraints to politicians do not necessarily pursue public interest but are more concerned with their personal or political
6.11.2 Limitations
this context differ widely on the relative importance between growth vis-a-vis
6.11.3 Measures of Autonomy and Relationship with Economic Performance
measures may be a better proxy for actual independence in some countries where informal relations are
6.36
Financial Institutions and Markets
aggregated from a number of basic legal characteristics of central bank charters; index based on issues attempts made to construct measures of central bank independence using different criteria and examine correlations among them reveal that the factors that affect central bank independence are highly diverse and the importance of each of these factors may have weights that vary markedly across countries, time and
6.11.4 Autonomy of Reserve Bank of India
Reserve Bank vis-à-vis important milestones in the direction of providing safeguards to monetary policy from the consequences of emergencies, there are limits to the ways and means advances by the Reserve Bank to the government and
harmony between the government and the central bank with shared objectives, though the instrumentalities de jure, the Reserve Bank has not been accorded autonomy on par with recent trends in some of the industrialised as well as emerging economies; but, de facto
The Reserve Bank of India
6.37
The system of
Central Bank autonomy encompasses the legal status; freedom in respect of the conduct of monetary
statutory provisions, the constitution and the mettle of the governing board, the spirit and character of the
SUMMARY ◆
organisation that functions as a corporate body with special powers and obligations for serving the
◆
The objectives of the monetary policy of the RBI have been (a) price stability, (b) controlled expansion
its policy have been eclectic; ideas from different schools of thought have guided the formulation and
◆
◆
6.38 ◆
Financial Institutions and Markets
The repo rate and other interest rates are being emphasized now as the potential instruments of monetary
◆ ◆
◆
◆
◆
◆
◆
◆
been frequently changed over a wide range, and the amount of liquidity absorbed through it has been ◆
The operating procedure of monetary policy in other developed and developing countries comprises
◆
Under Market Stabilization Scheme, issue of T-Bills and dated securities are to be held by the government
◆
The RBI has still a long way to go before it can be called an autonomous central bank; the signing of
KEY TERMS Reserve Bank of India Repo Rate Bank Rate Monetary Policy
Cash Reserve Ratio
Reverse Repo Rate Open Market Operation
QUESTIONS
Public Debt Rediscounting Market Stabilization Scheme
The Reserve Bank of India
(a) Open market operation (b) Direct regulation of interest rates (c) Credit rationing (d) Credit authorization scheme
(b) Market Stabilisation Scheme
6.39
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
7
CHAPTER
Learning Objectives LO 1 LO 2 LO 3
Know in detail, various aspects of the functioning of the Securities and Exchange Board of India Understand Insurance Regulatory Development Authority Discuss in detail Pension Fund and Regulatory Development Authority
7.1 INTRODUCTION The purpose of this chapter is to discuss various aspects of the functioning of the Securities and Exchange Board of India (SEBI, Pension Fund Regulatory Development Authority (PFRDA) and Insurance Regulatory Development Authority (IRDA) which have emerged as important constituents of the system that now exists
7.2 SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI) The year 1991 witnessed a big push being given to liberalisation and reforms
part of the same reform process, the globalisation or internationalisation of the
on the authorities the need to have in place a vigilant regulatory body or an
LO 1 Know in detail, various aspects of the functioning of the Securities and Exchange Board of India
coordinated and inadequate and that there was a need for an autonomous, statutory, integrated organisation The SEBI was established on 12 April, 1988 through an administrative order, but it became a statutory and
7.2
Financial Institutions and Markets
the Securities Laws (Amendment) Ordinance of January, 1995 which was subsequently replaced by an Act
The philosophy underlying the creation of the SEBI is that multiple regulatory bodies for securities industry mean that the regulatory system gets divided, causing confusion among market participants as to who is
in which every aspect of securities market regulation is entrusted to a single highly visible and independent organisation, which is backed by a statute, and which is accountable to the Parliament and in which investors
7.2.1 Constitution and Organisation The SEBI is a body of eight members comprising the chairman, three full time members, one part time
public interest, or if, on account of grave emergency, it is unable to discharge its functions or duties, or if it
The work of the SEBI has been organised into various operational departments each of which is headed by an
and the scope of their activities are as follows: Market Intermediaries Regulation and Supervision Department (MIRSD) supervision, compliance monitoring, and inspections of all market intermediaries in respect of all segments of the markets, viz department also handles the work related to registration, supervision, compliance monitoring, inspections,
Market Regulation Department (MRD) relating to derivatives) of securities exchanges, their subsidiaries and market institutions such as clearing and Commodity Derivatives Market Regulation Department (CDMRD)
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
7.3
Corporation Finance Department (CFD) including initial and continuous listing requirements, (ii) corporate governance and accounting/auditing Investment Management Department (IMD) capital funds, foreign venture capital investors, collective investment schemes including plantation schemes, Integrated Surveillance Department (ISD) The Integrated Surveillance Department is responsible for monitoring market activity through market systems, maintaining, and operating an integrated market surveillance system including monitoring of all segments of the markets, (ii) developing methodologies for capturing information from media review, public complaints and tips, other agencies, exchanges, and direct solicitations; assignment of staff to handle functions; evolving methods of logging and cataloguing information; criteria for evaluating and distributing information; input into tracking; and other systems, (iii) recognizing potentially illegal activities and referrals to investigations, Investigations Department (IVD) The Investigations Department is responsible for (i) conducting investigations on potentially illegal market activities, (ii) providing referrals to the enforcement department, and (iii) assisting the enforcement department Enforcement of Department (EFD) Enforcement Department is responsible for proceedings related to regulatory action and obtaining redress for violations of securities laws and regulations against all market participants, issuers and individuals and other Legal Affairs Department (LAD) The Department of Legal Affairs would be responsible to provide legal counsel to the board and to its other Enquiries and Adjudication Department (EAD) and initiate adjudication brought by other departments against alleged violators who are within SEBI’s
7.4
Financial Institutions and Markets
Table 7.1 SEBI-registered market intermediaries Market intermediaries
1993
2000
2006
2011
2015
Stock exchanges (Cash market)
21
23
22
19
15
Stock exchanges (Derivatives market)
—
2
2
2
3
Stock exchanges (Currency derivatives)
—
—
—
4
3
Stock exchanges (Commodity derivatives)
—
—
—
—
—
Brokers (Cash segment) Corporate brokers (Cash segment)
5290
9192
9335
9235
5899
—
3316
3961
4563
3677
Sub-brokers (Cash segment)
—
4675
23479
83952
42409
Brokers (Derivatives)
—
—
1120
4195
5165
Foreign institutional investors
18
506
882
1722
1710
Custodians
—
15
11
19
19
Depositories
—
2
2
2
2
Depository participants
—
191
526
805
854
Merchant bankers
74
186
130
192
197
Bankers to an issue
—
68
60
55
60
Underwriters
—
42
57
3
2
Debenture trustees
—
38
32
29
32
Credit rating agencies
—
4
4
6
6
Venture capital funds
—
—
80
184
201
Foreign venture capital Investors
—
—
39
153
204
Registrars to an issue and share transfer agents
—
242
83
73
72
Portfolio managers
—
23
132
267
188
Mutual funds
28
38
38
51
47
Approved intermediaries (Stock lending schemes)
—
6
3
2
2
Source: SEBI, Handbook of Statistics.
7.2.2 Objectives and Regulatory Approach The overall objective of the SEBI, as enshrined in the preamble of the SEBI Act, 1992 is ‘to protect the interests of investors in securities and to promote the development of, and to regulate the securities market
Having regard to the emerging nature of the securities markets in India, the SEBI necessarily has the twin task
mechanism and encourage responsible and accountable autonomy on the part of all players in the market,
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
7.5
rights and interests through adequate, accurate and authentic information and disclosure of such information
7.2.3 Powers, Scope, and Functions The scope of operations of SEBI is very wide; it can frame or issue rules, regulations, directives, guidelines, norms in respect of both the primary and secondary markets, intermediaries operating in these markets and Major Functions of SEBI ●
To protect the interests of investors in securities and to promote the development of, and to regulate the
● ●
issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, ●
To register and regulate the working of the depositories, participants, custodians of securities, foreign
●
To register and regulate the working of venture capital funds and collective investment schemes,
● ● ● ● ● ●
●
● ●
To call for information from, undertaking inspection, conducting inquiries and audits of the stock
7.6
Financial Institutions and Markets
●
●
The SEBI can issue guidelines in respect of (a) information disclosure, operational transparency and
Powers of SEBI ●
The SEBI is empowered to register any agency or intermediary who may be associated with the securities market and none of them shall buy, sell or deal in securities except under and in accordance with the
●
●
The SEBI Act lays down the civil and criminal penalties for contravention of the Act; anyone who contravenes or attempts to contravene or abets contravention of the provisions of the Act or of any rules
●
●
conduct inquiries into the working of the stock exchanges which have to submit their annual reports to
●
●
●
The SEBI has also been empowered to demand explanations, to summon the attendance and call for documents from all categories of market intermediaries in order to enable it to investigate irregularities,
●
However, in the exercise of its powers and in performing its functions, the SEBI is bound by such directions
7.2.4 Pre-Issue Obligations Imposed by SEBI1 ●
1
The lead merchant banker shall exercise due diligence and satisfy himself about all the aspects of
http://www.sebi.gov.in/guide/sebidipguideaug09.pdf.
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
7.7
● ●
The lead merchant banker shall pay requisite fee in accordance with the regulation 24A of Securities and
●
The lead merchant banker shall ensure that facility of applications supported by blocked amount is
2 ●
In case a public or rights issue is managed by more than one merchant banker, the rights, obligations issue, the lead merchant banker responsible for underwriting arrangements shall invoke underwriting obligations and ensure that the underwriters pay the amount of devolvement and the same shall be incorporated in the inter se
●
or chartered accountant along with the draft offer documents: (i) all refund orders of the previous issues that were despatched to the allottees within the prescribed time and in the prescribed manner, and (iii) the ●
The issuer shall submit an undertaking to SEBI to the effect that transactions in securities by the ‘promoter’, the ‘promoter group’ and the immediate relatives of the ‘promoters’ during the period the case may be, and the date of closure of the issue shall be reported to the stock exchanges concerned
●
The issuer company shall submit to the board the list of the persons who constitute the promoters’ group securities are proposed to be listed, the permanent account number, bank account number and passport
●
A merchant banker shall not lead or manage the issue if he is a promoter or a director or an associate of lead or manage the issue if, the securities of the issuer company are listed or proposed to be listed on the
associate of the issuer company may be appointed as a merchant banker for the issue, if it is involved ●
2
It is being entered into between a lead merchant banker and the issuer company specifying their mutual rights, liabilities and obligations relating to the issue.
7.8
Financial Institutions and Markets
board are appointed in all public issues and rights issues and in case where the issuer company is a registered registrar to an issue, the issuer shall appoint an independent outside registrar to process its
●
Where the number of applications in a public issue is expected to be large, the issuer company in consultation with the lead merchant banker may associate one or more registrars registered with the board for the limited purpose of collecting the application forms at different centres and forward the same the Issue shall, be primarily and solely responsible for all the activities as assigned to them for the issue
●
The lead merchant bankers shall satisfy themselves about the ability of the underwriters to discharge their to the effect that in the opinion of the lead merchant banker, the underwriters’ assets are adequate to meet their underwriting obligations and obtain underwriters’ written consent before including their names as
●
In respect of every underwritten issue, the lead merchant banker(s) shall undertake a minimum underwriting obligation of 5 percent of the total underwriting commitment or ` The outstanding underwriting commitments of a merchant banker shall not exceed 20 times its net worth
●
of the draft offer document with the stock exchanges where the securities offered through the issue are ●
national daily with wide circulation, one Hindi national newspaper and a regional language newspaper
●
Every unlisted company obtaining grading for IPO shall disclose all the grades obtained, along with the rationale/description furnished by the credit rating agency for each of the grades obtained, in the prospectus, abridged prospectus, issue advertisements and at all other places where the issuer company
●
The lead merchant banker shall ensure that for public issues offer documents and other issue materials are dispatched to the various stock exchanges, brokers, underwriters, bankers to the issue, investors
●
In the case of rights issues, lead merchant banker shall ensure that the abridged letters of offer along with composite application form are dispatched to all shareholders at least 3 days before the date of opening
●
The lead manager shall ensure that the issuer company has entered into agreements with all the depositories
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
7.9
7.2.5 Post-Issue Obligations Imposed by SEBI3 ●
●
●
●
If the issue is proposed to be closed at the earliest closing date, the lead merchant banker shall satisfy
take care of the underwriters’ interests and to avoid any dispute with the underwriters in respect of their
undersubscribed issues, the lead merchant banker shall furnish information in respect of underwriters ●
under the said section has been obtained from all the stock exchanges where the securities was proposed ●
basis of allotment, number, value and percentage of all applications including applications supported by blocked amount, number, value and percentage of successful allottees for all applications including applications supported by blocked amount, date of completion of despatch of refund orders, date of of completion of various activities at least in an english national daily with wide circulation, one hindi
●
The basis of allotment shall be signed as correct by the executive director/managing director of the designated stock exchange and the public representative (where applicable) in addition to the lead
●
credit is completed and the allotment and listing documents are submitted to the stock exchanges within ●
3
The lead merchant bankers are liable to take all steps for completion of the necessary formalities for listing and commencement of trading at all stock exchanges where the securities are to be listed within 7
http://www.sebi.gov.in/guide/sebidipguideaug09.pdf.
7.10
Financial Institutions and Markets
7.2.6 Bonus Issue Guidelines of SEBI A listed company proposing to issue bonus shares shall comply with the following: ●
●
The shares so reserved may be issued at the time of conversion of such debentures on the same terms on
●
● ● ● ●
it has not defaulted in respect of the payment of statutory dues of the employees such as contribution to ●
A company which announces bonus issue after the approval of board of directors and does not require of Association, shall implement bonus issue within 15 days from the date of approval of the issue by the
●
A company which announces its bonus issue after the approval of the board of directors must implement the proposal within a period of 6 months from the date of such approval and shall not have the option
issue shall be implemented within 2 months from the date of the meeting of the board of directors ●
The Articles of Association of the company shall contain a provision for capitalisation of reserves and so on and if no provision is given, the company shall pass a resolution at its general body meeting making
●
share capital, a resolution shall be passed by the company at its general body meeting for increasing the
7.2.7 Measures Taken by SEBI
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
●
7.11
The issues of capital by companies no longer require any consent from any authority either for making
●
●
their projects are appraised by banks or FIs with minimum 10 percent participation in the equity capital ●
Allocation of shares to retail individual investors has been increased from 25 percent to 35 percent of the one who applies or bids for securities of or for a value not exceeding `2 lakh, as against the earlier limit of `
●
●
●
●
Under the listing agreement, a listed company is required to make continuous disclosures to the stock repetitive disclosures in case of rights issues and public issues by the listed companies which have a
●
In order to bring uniformity in the practice of making available abridged offer documents, it was decided to permit an issuer company making a rights issue, to despatch an abridged letter of offer, which shall
●
●
mobilisation, a company has been permitted to issue further shares, provided full disclosures as regards
7.12
Financial Institutions and Markets
●
●
●
To enable a minimum level of public shareholding, listed companies will now be required to maintain minimum level of public shareholding at 25 percent of the total shares issued for continued listing
(Regulation) Rules, 1957 and to companies that have 2 crore or more number of listed shares, and market capitalisation of ` SEBI framed guidelines relating to disclosure of grading of the initial public offer (IPO) by issuer opt for grading, then they are required to disclose the grades, including the unaccepted ones, in the
●
●
●
●
●
● ●
The capital adequacy norms of 3 percent for individual brokers and 6 percent for corporate brokers
●
●
Penal action can now be taken directly by the SEBI against any member of a stock exchange for violation
●
It has been made mandatory for the stock brokers to disclose the transaction price and brokerage
●
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
7.13
● ●
● ●
Insider trading has been prohibited and such trading has been made a criminal offence punishable in
●
In order to facilitate execution of large trades without impacting the market, the stock exchanges were
●
advised depositories that, in case of IPOs, the ISINs of securities should be activated only on the date of commencement of trading on the stock exchanges ●
impression for a trade order value of ` `5 lakh, a choice is given to the investors (natural persons) to provide either the permanent account number (PAN) decision, PAN has been made compulsory for all categories of investors for opening a demat account
●
executed on the stock exchanges would be necessarily settled through the clearing corporation/clearing
connectivity of companies provided by the depositories, stock exchanges were advised to shift the shares
●
of only at the end of the trading day and then apply it to the open positions for the subsequent trading day, ●
audit trail, PAN was made mandatory for all transactions in the cash market with effect from 1 January, ●
●
A large number of representations were received from investors relating to transfer of securities from
7.14 ●
Financial Institutions and Markets
According to the SEBI guidelines dated 12 December, 2003, every mutual fund scheme should have a minimum of 20 investors and holding of a single investor should not be more than 25 percent of the
●
●
Transaction Tax (STT), it was decided to allow mutual funds to share the unique client code of their ●
to this effect were not made in the offer document, all mutual funds were advised to send a written ●
companies listed on recognised stock exchanges overseas and rated debt securities was raised from USD
●
●
of a mutual fund which has investment objective to invest directly or indirectly in real estate property and ●
●
Implementation of T + 3 rolling settlement for all listed securities across the exchanges from 2 April,
● ●
Introduction of Electronic Data Information Filing and Retrieval (EDIFAR) System to facilitate
● ●
Introduction of rating corporate governance on the principles of wealth creation, wealth management
● ● ● ● ● ● ●
Posting all the orders passed by the Securities Appellate Tribunal (SAT) and the board on the SEBI
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA ●
7.15
Introducing the consultative process on policy formulation by putting all reports of committees and draft
● ● ●
● ●
Introduction of benchmarking of all the mutual funds schemes to facilitate the understanding of the
● ● ●
● ■ ■ ■ ■
■
●
Disclosures should be made as reasonably soon as possible but within a timeframe of 24 hours of the
●
●
of market capitalisation of the public shareholding of the issuer has been reduced from `3000 crore to `1000 crore in case of further public offers (FPOs) and to ` With the objective of restricting access to capital markets by such wilful defaulters4, the following proposals have been approved by the Board: ■
preference shares, if the issuer company or its promoter or its director is in the list of wilful
■
Any company or its promoter or its director categorised as wilful defaulter may not be allowed to categorised as wilful defaulter, and there is a takeover offer with respect to the listed company, it may be
4
inter alia, defaulted in meeting its payment obligations or not utilised the finance from the lender for the specific purposes for
7.16
Financial Institutions and Markets
●
include the provision that no fresh registration shall be granted to any entity if the entity or its promoters ●
T + 12 to T + 6 days, increasing the reach of retail investors and reducing the costs involved in a public ●
SEBI monitored the compliance of composition of boards of the listed entities to ensure that they had
●
●
Framework for setting up of new exchange or separate platform of existing stock exchange having
●
Stock exchanges are permitted to introduce option contracts on Sensex and Nifty with tenure up to 5
September/December, and (b) the exchange has in place the appropriate risk management framework for ●
●
●
It has been decided that above incremental limits, shall be allocated to the market participants through
●
It has been decided to permit stock exchanges to introduce derivative contracts (futures and options) on
●
●
In July 2012, SEBI decided to redress to complaints against stock exchanges and depositories through admin
● ●
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
7.17
●
●
●
Foreign instructional investors’ were permitted to offer government securities, corporate bonds, cash and
●
SEBI rationalized the debt limits by merging the categories of government debt old (USD 10 billion) and government debt long term (USD 15 billion) into a single category named ‘government debt’ and
●
●
SEBI created centralized database regarding corporate bonds which is available in demat form for public viz.
●
●
SEBI mandated that all the trades in securitised debt instruments (listed or unlisted) by mutual funds, FIIs/
●
platform provided in the debt segment of stock exchanges, viz ●
●
In consultation with RBI, SEBI revised the position limits for currency derivatives contracts and
●
●
With a view to increase participation, resident individual investors were allowed to open a trading Saral
7.2.8 Corporate Governance and SEBI The corporate governance institutions comprise both formal and informal rules (the latter notably include a country’s generally accepted business practices and ethical standards, though these are normally unwritten) institutions and actors are corporate law, securities laws, securities regulations, listing requirements, judicial
7.18
Financial Institutions and Markets
relationships can add to/impede future wealth creation by the corporation, (ii) governance processes must be, such that wealth created is evenly distributed across all classes of stakeholders, (iii) management quality must be such that it is able to adopt the above two to match the dynamics of the business environment, and (iv) all Exchange Board of India (SEBI) has been focussing on the following areas to improve corporate governance:
Recognising the rising concern of corporate governance issue, SEBI has taken various steps for improvement
the recommendations of this committee, a new clause 49 was incorporated in the stock exchange listing
But enforcement continues to be a problem because of limited trained staff and companies not being subjected
empowering investors on the lines of the United States class action, using information technology and
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
7.19
SEBI’s Role on Satyam and Sahara Scandals
those companies which are not following the corporate governance standards recommended by SEBI and
Case of Satyam According to SEBI, loopholes in the company’s accounting system and instructions from the company’s
debarred from markets for 14 years and asked them to return `1,849 crore worth of unlawful gains with
Case of Sahara
`10 lakh and ` the companies planned to raise `
take the approval of SEBI in doing so, in which case the company would have to make all the disclosures from the size and number of investors, another deliberate error was keeping the issue open ended; ideally, `17,250
7.20
Financial Institutions and Markets
`24,000 crores to SEBI, which will be
7.3 INSURANCE REGULATORY DEVELOPMENT AUTHORITY (IRDA) Insurance Regulatory and Development Authority (IRDA) is a statutory body set up for protecting the interests of the policyholders and regulating, the enactment of the Insurance Regulatory and Development Authority (IRDA) Act, 1999, Insurance Regulatory and Development Authority was formed as
LO 2 Understand Insurance Regulatory Development Authority
7.3.1 Structure and Statutory Functions of IRDA
than 25 members excluding the and development of the sector by protecting policyholders’ interests; registering and regulating insurance companies; licensing and establishing norms for insurance companies, regulating and overseeing premium policyholders’ funds and ensuring the maintenance of solvency margin by insurance companies; ensuring insurance coverage in rural areas and of vulnerable sections of society; promoting professional organisations are as follows:
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
7.21
●
●
registration Protection of the interests of the policyholders in matters concerning assigning of policy, nomination by policy holders, insurable interest, settlement of insurance claim, surrender value of policy and other terms and conditions of contracts of insurance
●
●
intermediaries and agents Specifying the code of conduct for surveyors and loss assessors
● ● ●
Promoting and regulating professional organisations connected with insurance and reinsurance business Levying fees and other charges for carrying out the purposes of the Act
●
audit of the insurers, intermediaries, insurance intermediaries and other organisations connected with the insurance business ●
●
● ● ●
under Section 64 U of the Insurance Act 1938 (4 of 1938) Specifying the form and manner in which books of accounts shall be maintained and statements of accounts shall be rendered by insurers and other insurance intermediaries Regulating investment of funds by insurance companies Regulating maintenance of margin of solvency Adjudication of disputes between insurers and intermediaries or insurance intermediaries
● ●
●
regulating professional organisations referred to in clause (f) Specifying the percentage of life insurance business and general insurance business to be undertaken by the insurers in the rural and social sector
7.3.2 Major Initiatives Taken by IRDA5 ●
Since 2002, the insurance industry has witnessed numerous changes such as introduction of new type
●
The framework of regulations to protect the interests of prospects and policyholders are contained in the be followed at the point of sale; disclosures to be made in life insurance and general insurance policy document, claim procedure in respect of life insurance and general insurance policy; and turn around
5
http://financialservices.gov.in/insurance, IRDA, Annual Reports, Various Issues.
7.22
Financial Institutions and Markets
●
companies in India in April 2002, after terrorism cover was withdrawn by international reinsurers post ●
Insurance Regulatory and Development Authority (IRDA) has issued guidelines to implement the The health insurance policy holder by virtue of the said guidelines can, at the time of renewal, switch (i) from one insurance company to another insurance company of his choice, or (ii) from one insurance
●
Authority has also relaxed the ceiling of investments in infrastructure to 20 percent in a ‘single’ investee
5 percent has been permitted in ‘debt’ alone with prior approval of the respective insurer’s investment ●
Further strengthening on the risk management structure, IRDA has issued guidelines on the scope for ‘internal and concurrent audit’ for investment operations of insurance companies to monitor investment
●
●
The stipulations on disclosures to be made by insurance companies have been strengthened by the to be made through (i) publication in newspapers, and (ii) hosting on the respective company websites, which are presently not publicly listed entities, at par with the listed entities in the corporate world in
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
7.23
●
is to facilitate analysis of the current block of business as on the valuation date to bring out clearly the risks, viz. ●
In order to facilitate customers to reach the insurers for their grievances, IRDAI has provided channels
●
guidelines further require that only regular premium products with minimum policy and payment terms
●
These guidelines specify that a policyholder should necessarily be a supplier of goods and services and
●
The guidelines provide for the structure, responsibilities and functions of the board of directors and the
7.24
Financial Institutions and Markets
auditors, disclosures, outsourcing, relationship with stakeholders, interaction with the supervisor, and
●
viz.,
●
In a press release on 4 September, 2014, IRDAI while cautioning public about spurious calls informed
●
Bima Bemisaal
●
of products, respectively, and features offered by the insurers and bringing in transparency in terms of ●
●
The regulations also require that every insurer should maintain the maximum possible retention
7.4 PENSION FUND AND REGULATORY DEVELOPMENT AUTHORITY (PFRDA) Pension reforms in most countries initially are driven by the budgetary ageing of the population and social change, including breakdown of traditional
LO 2 Discuss in detail Pension Fund and Regulatory Development Authority
(formal pension coverage being about 12 percent of the working population), while the ageing and social change are important considerations for introducing pension reforms in the
(PFRDA) has been established to establish and promote pension system for all the citizens through guided development and enabling framework for innovations in products, schemes and programmes across all
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
7.25
7.4.1 Structure and Statutory Functions of PFRDA
promote and ensure the orderly growth of the National Pension System (NPS) and pension schemes and follows: ● Regulation of intermediaries and National Pension System (NPS) ● Registration and regulation of pension schemes and NPS ● Approval of pension schemes, the terms and conditions thereof, and laying down norms for the management of corpus of the pension funds including investment guidelines under such scheme ● Reporting the exit of the subscription from NPS ●
Keeping Agency, custodian of securities, point of presence and redressal of subscriber’s grievances ● ● ●
●
Providing the professional organizations connected with the pension system Educating subscribers and the general public on issues relating to pension, retirement and related issues, and training of intermediaries Standardising dissemination of information about performance of pension funds and performance benchmarks
7.4.2 PFRDA and National Pension Scheme (NPS)6 ●
The National Pension Scheme was launched by PFRDA in the year 2003 and thereby extended to all
●
●
The passage of the Pension Fund Regulatory and Development Authority (PFRDA) Act, 2013 on 19
The PFRDA Act, 20137 has following features: ■ Establishing a statutory Pension Fund Regulatory and Development Authority (PFRDA) for (a) promoting old age income security by establishing, developing and regulating pension funds, and
6 7
The details about NPS have been explained in Chapter 10 of the book. PFRDA, Annual Report, 2013–14.
7.26
Financial Institutions and Markets ■
Empowering PFRDA for (a) regulating the National Pension System and other pension schemes not covered under any other Act; (b) registering and regulating pension funds, the central recordkeeping collection, management and distribution; (c) framing investment guidelines for pension funds; and
■
■ ●
PFRDA takes various initiatives from time to time in order to simplify and improve the operational issues in National Pension System (NPS) like new functionality development under NPS architecture,
■
Point of Presence (POPs) were previously allowed to upload the regular monthly contribution in the upload the contribution for subscribers who have shifted from one of their associated corporate to
■
■
The POPs can process the ‘Voluntary’ contributions made by any corporate subscriber even if they
■
The government subscribers (mandatorily covered under NPS) can also approach their associated
■
the option of registering grievance/complaints through call centre/interactive voice response system
Other Regulatory Institutions in India: SEBI, IRDA and PFRDA
7.27
SUMMARY ◆ ◆
◆
◆
It has wide powers to issue rules, regulations, and guidelines in respect of both the primary and secondary securities markets, a wide variety of intermediaries operating in these, markets, viz
◆
It is empowered to summon all categories of market intermediaries, to investigate their working, to
◆
The SEBI has issued a large number of regulations in respect of primary and secondary markets, market
◆
shows that the SEBI has failed to protect the small and individual investor, and to check the unfair, ◆
◆
◆ ◆ ◆
The SEBI has taken various steps to improve the corporate governance system to avoid corporate
◆
Insurance Regulatory and Development Authority (IRDA) is a statutory body set up for protecting the interests of the policyholders and regulating, promoting and ensuring orderly growth of the insurance
◆
◆
◆
◆
◆
Since 2002, IRDA has taken many initiatives in terms of regulatory measures, introduction of many
7.28
Financial Institutions and Markets
KEY TERMS Securities and Exchange Board of India Pension Fund Regulatory Development Authority Insurance Regulatory Development Authority
Lead merchant banker Insider trading Bonus issue
QUESTIONS the work of SEBI has been organised?
development of primary securities market?
sector?
Part 3 Banking Institutions
CHAPTERS 8. Commercial Banks 9. Co-operative Banks
Commercial Banks
8
CHAPTER Learning Objectives LO 1
Identify the basis for operation of commercial banks in India and services offered by them
LO 2 commercial banks are presented LO 3 LO 4 LO 5 it LO 6 LO 7 LO 8
in India Determine the trends in all liabilities and all assets of commercial banks in India Show how commercial banks perform in India and what has been their Capital
LO 9 LO 10
8.1 INTRODUCTION
8.4
8.2 THEORETICAL BASIS OF BANKING OPERATIONS LO 1 Identify the basis for operation of commercial banks in India and services offered by them
1. Management of Reserves: the form of ready cash which is known as cash reserves; and the ratio of cash reserves to deposits is
2. Creation of Credit:
8.5
Basis and Process of Credit Creation:
Process of Money Creation
` ` ` ` of ` `
`
` `
called the
1
or
or
For a complete discussion of the money creation process, see Samuelson, P A and Nordhaus, W D, Economics, Fifteenth Edition, McGraw-Hill, New York, 1995, pp. 488–95.
8.6
8.3 SPECIAL ROLE OF BANKS
2
set their conditions on events that are relatively easy to verify, viz.
viz.
2
For full discussion of issues involved, see Bhole, L M., ‘Indirect vs. Direct System of Business Finance: Theory and Evidence’, International Journal of Development Banking, July 1998.
8.7
8.4 MAJOR SERVICES PROVIDED BY COMMERCIAL BANKS Acceptance of deposits:
Lending money or advancing of loans:
Investment of funds: Remittance of funds:
8.8 Dealing in foreign exchange:
Overdraft Facility: Discounting of Bills of Exchange: (
Credit Cards:
Table 8.1 Credit card operation cycle S. No. 1
Credit purchases
A cardholder purchases goods/services and gives the credit card
2
Processing of credit card
Merchant establishment delivers goods after taking an authenticated credit card and noting the number and taking signatures
Raising of bill
The merchant establishment raises the bill for the purchase and sends it to the credit card-issuing bank for payment.
4
Making payment
The issuing bank pays the amount to the merchant establishment.
5
Bills to the cardholder
The issuing bank raises bill on the credit cardholder and sends it for payment.
6
Card payment
The credit cardholder makes the payment to the issuing bank.
3
Table 8.2 Credit card transaction process S. No. 1.
Authorisation
The cardholder pays for the purchase and the merchant submits the transaction to the type and the amount with the issuer (Card-issuing bank) and reserves that amount of the cardholder’s credit limit for the merchant. An authorisation will generate an approval (Contd.)
8.9 2.
Batching are typically submitted once per day at the end of the business day. If a transaction is
credit. 3.
Clearing and settlement
4.
Funding
5.
Charge Backs
acquirer for the transaction.
the fee the merchant pays the acquirer for processing the transactions. A chargeback is an event in which money in a merchant account is held due to a dispute relating to the transaction. Charge backs are typically initiated by cardholders. In the
the chargeback or contest it.
Figure 8.1
Mechanism of credit card operation
Automatic Teller Machines (ATMs) Services:
Debit cards:
8.10 Online banking:
:
Private banking:
Mobile Banking:
Public Provident Fund Account:
8.11
Go to the Secure Website of your Bank
Enter your Login Identity and Password
Perform Banking Operations Account Administration
Banking Transactions
Stop or check payments
Pay Bills
Order copy of Cheque
Order Foreign Currencies
Order a copy of Account Statement
Transfer funds
Changes Address, Update user information etc.
Automatic fund transfer
Verification Confirmation
Figure 8.2
Online banking process.
8.12
8.5 BANK FINANCIAL STATEMENTS LO 2 Know the two financial statements through which the financial data on commercial banks are presented
8.5.1 Balance Sheet of the Commercial Bank .
(A) Liabilities of Banks shareholders; from other banks and central bank and
8.13
(i) Types of Bank Deposits: Demand deposits can and
are also known as (B) Assets of Banks
.
(i) Investments:
(ii) Types of Loans and Advances:
8.14
(a) Cash credits and overdrafts
(b) Purchasing and discounting of bills
(c) Demand and Term Loans:
Demand loans by convention
3
3
RBI, Report of the Study Group to Frame Guidelines for Follow-up of Bank Credit, Bombay, 1975.
8.15
Approaches to Bank Lending: , and going concern
‘
’ in case of
8.16
Credit Plans:
Securities used in Bank Lending:
8.17
viz.
Margins:
Seasonal Character as a Determinant of Bank Credits:
8.18
Credit Information and Bank Lending:
8.19
8.5.2 Income Statement
Table 8.3 Major items of income statement of commercial bank (i) Interest income from loans (ii) Total interest expenses (interest on borrowings made by banks) (iii) Net interest income (i – ii) (iv) Non-interest income (v) Total operating income (iii + iv) (vi) Overhead expenses (vii) Provision for loans and leases (viii) Securities gains (losses) (ix) Pre-tax operating income [v – (vi + vii) + viii] (x) Tax (xi) Net operating income (xii) Net income (xi – any extraordinary items)
8.6 BANK PERFORMANCE MEASURES LO 3 Explain how the bank’s performances are measured
8.20
ROA: Net Income ¥ Total Assets ROE: Net Income ¥ Total Equity Capital Net Income Net Income Total Assets = ¥ Total Equity Capital Total Assets Total Equity ¥ NIM:
Total Interest Income – Total Interest Expenses ¥ Average Earning Assets Provision for Loan Losses Ratio: Provisions for Loan Losses ¥ Total Loans Loan Ratio: Net Loans ¥ Total Loans Temporary Investments Ratio: Government securities sold + Investment securities with maturities of 1 year or less + Due from banks ¥ Total Loans Volatility Liability Dependence Ratio: Total Volatile Liabilities – Temporary Investments ¥ Net Loans and Leases
8.21 Interest Sensitivity:
Interest Rate Sensitive Assets – Interest Rate Sensitive Liabilities ¥ Total Assets (` in crore)
Example: Performance Measures of State Bank of India Balance Sheet 2014–2015
2015–2016
Total share capital
747
776
Equity Share capital
747
776
Reserves and Surplus Net worth Deposits Borrowings Total Debt Other Liabilities and Provisions Total Liabilities Assets Cash and balances with RBI
Advances Investments Gross Block Net Block Capital work in Progress Other Assets Total Assets Contingent Liabilities Book value
Income Interest Earned Other Income Total income Expenditure Interest Expended (Contd.)
8.22 Employee cost
Depreciation Operating Expenses Provisions and contingencies Total Expenses
Total
Equity Dividend Corporate dividend tax
334
Per share data (Annualised) 17.55
Earnings Per share(`) Equity dividend (%)
172
Book Value(`) Appropriations Transfer to statutory reserves Proposed dividend/Transfer to govt Balance c/f to balance sheet Total
Sl. no.
2015–2016
2014–2015
1
Return on Assets ¥
¥
2
Cost to deposit ratio
Interest paid on deposit/ Total deposit
¥
¥
3
Return on Loans
Interest earned on loans/ Total Loans
¥
¥
4
Interest Income ratio
Interest income/Total asset
¥
¥
5
Net interest income ratio
Net interest income/Total assets
¥
¥
6
Expenditure ratio
Total expenditure/Total Asset Ratio
¥
¥
asset
¥
¥
7 ratio
8.23
8.7 NON-PERFORMING ASSETS (NPAS) AND CLASSIFICATION OF ASSETS Non-Performing Assets (NPAs):
‘
’
days’
viz. Standard Asset: Standard Asset is one which does not disclose any problems and which does not carry more Sub-Standard Asset:
Doubtful Asset:
Loss Asset:
4
(i)
`
` `
8.24
8.8 CAPITAL BASE OF THE BANKS
8.9 RETAIL BANKING LO 4 Illustrate retail banking
8.25
● ●
●
● ●
8.26
8.10 BANK COMPETITION
As far as the
is concerned, there was hardly any need for competition either with
`
8.27
8.11 INTERNATIONAL BANKING LO 5 Understand various types of international banking and the risks associated with it
8.11.1 Types of International Banks Correspondent Banks:
8.28
Foreign Branch of a Local Bank: Offshore Banking Centre:
8.11.2 Different types of risk in International Banking Country Risk:
Transfer Risk:
Credit Risk:
Currency Risk:
8.12 OTHER ISSUES IN COMMERCIAL BANKING IN INDIA 8.12.1 System of Cheque Clearances
5
LO 6 Describe other issues in commercial banking along with its structure and growth in India
The risk arises due to change in the economic, social, and political conditions of a foreign country, which adversely affect an institution’s financial interests.
8.29
8.12.2
8.12.3 Stockinvest Scheme
InterBank Participations
8.30
8.12.4 Consortium Approach or Multiple Banking Arrangements
`
for `
6
Another connotation of the concept of single window lending is that both the term loan and working capital loan for a given project are made available by the same financial institution.
8.31
8.12.5 Lead Bank Scheme, Service Area Approach and Action Plans
Lead Bank Scheme (LBS):
viz.
7
www.rbi.org.in/Scripts/NotificationUser.aspx?Id=9077&Mode=0.
8.32
Service Area Approach (SAA): In the context of vast expansion in the network of bank branches and in the
Action Plans (APs):
8
RBI, Master Circular, July 1, 2014.
8.33
8.12.6 Local Area Banks (LABNKs)
`
8.34
8.12.7 Commercial Banks and
`
8.35
8.13 STRUCTURE AND GROWTH OF COMMERCIAL BANKS IN INDIA
RBI
Scheduled Banks
Non-Scheduled Banks
State Co-operative Banks
Commercial Banks
Foreign
Indian
Public Sector Banks
SBI and its Associates
Central Cooperative Banks
Private Banks
Other Nationalized Banks
Figure 8.3
Regional Rural Banks
Structure of Indian banking system.
Commercial Banks
8.36 Table 8.4 Growth of number of banks in India 1969
2010
2011
2012
No. of commercial banks
2013
173
(a) Scheduled commercial banks
73
Of which: regional rural banks
–
(b) Non-scheduled commercial banks
16
165
165
4
4
4
13.4
12.3
2014
155
151
151
146
64
57
4
5
(in thousands) 1951–1969
1969–1996
Percentage)
1996–2014
1951–2014
7.47
5.44
Source: RBI, RTPBI, Various Issues.
Table 8.5 Growth of overall deposits and credits of commercial banks in India 1969 Deposits of scheduled commercial banks in India (billion `)
46.46
Credit of scheduled commercial banks in India (billion `)
36
Deposits of scheduled commercial banks `)
5.6
Credit of scheduled commercial banks per `)
4.4
2010
2011
2012
526.1 436.7
Per capita deposits of scheduled commercial banks (`) Per capita credit of scheduled commercial banks (`) Credit deposit ratio (%)
32574 77.5
72.2
2013
2014
657.7
674.7
511.5
523.5
55445
62252
43123
75.7
77.6
Investment deposit ratio (%) Cash deposit ratio (%) Deposits of scheduled commercial banks as percentage of national income (NNP at
6.7
6.1
5.6
15.5
Annual average (compound) rate of growth of all commercial banks in India ,1951 to 2014 (Percentage)
7.13 17.73 17.45 15.43 Source: RBI, RTPBI, various issues.
15.15
5.4
8.37
Table 8.6 Share of different types of banks in total bank deposits and credit (Percentage) Year
74.2
6.4
5.6
6.6
4.2
17.1
72.7 72.56 76.6
75.3
23.65
77.77
77.24
17.33
3.5 4.7
6.5
5.6
6.4
5.75
6.5
5.26
5.51 4.66 4.54
77.5
76.42
4.53
75.73
4.32
77.33 77.21
Source: RBI, Reports on Trends and Progress of Banking in India, various issues.
Table 8.7 Regional distribution of deposits and credits (percentage to total) Year 55.77
Rural Semi-urban
66.64 14.45 (Contd.)
8.38 16.23
Urban 54.13
Metropolitan
65.43
All India Source: RBI, Basic Statistical Returns of Commercial Banks in India, March 2014.
8.14 TRENDS IN ALL LIABILITIES OF COMMERCIAL BANKS IN INDIA
it has been observed that the shares of capital, deposits, other liabilities and
LO 7 Determine the trends in all liabilities and all assets of commercial banks in India
Table 8.8 Liabilities of commercial banks in India (percentage to total liabilities) Year
2.45
4.27
3.25
1.47
3.75 5.25
4.27 7.14
5.67 6.36
76.74 77.56
6.33 6.27 6.54
77.55
6.65
77.47
6.65 Source: RBI, Handbook of Statistics of Indian Economy.
8.14.1 Bank Deposits
6.37 5.27 5.31
4.77
8.39 Table 8.9
Growth and structure of bank deposits in India (percentage to total deposits)
Year 16.4
33.37
17.36 13.31
22.41
11.63
21.52
11.43 66.55 23.66
66.73
Annual average compound rate of growth
12.63 16.66
16.66 17.37
13.17
17.27
Source: RBI, Statistical Tables Relating to Banks in India, Various Issues.
Table 8.10 Maturity structure of term deposits of commercial banks Year 14.1
25.46
14.64
6.2
36.46
15.44
16.54
7.62 7.66
13.55
16.42
7.76
13.37
31.11
15.24
(Contd.)
8.40
26.32
16.53
17.66
7.52
17.14
7.62
15.44
Source: RBI, Statistical Tables Relating to Banks in India, Various Issues.
Table 8.11 Ownership pattern of different types of bank deposits (percentages) Financial 1994 Current
12.3
Saving
4.5
Term
5.1
Total
6.1
23.4
6.3 7.5
4.7
6.2
73.2
2005 Current Saving
22
11.3
6.6
7.2
Term
17.6
7.1
Total
14.6
5.3
52.2
2008 Current
16.3
Saving Term
15.3
Total
13.5
15.2
12.7
51.5
2009 Current
17.6
27.5
2.4
43.7
Saving Term
17.2
Total
14.5
11.7
3.7 2.7 (Contd.)
8.41 2010 Current
1.7
Saving Term
15.1
Total
13.5
14.2
2011 Current
1.7
Saving Term
15.1
Total
13.5
Current
16.2
14.2
2012 5.2
1.7
41.5
Saving Term Total
5.7 14.6
12.7
4.7
3.4 2.4
Source: RBI, Statistical Tables Relating to Banks in India, Various Issues. Data after 2012 is not available in this format.
Factors Affecting Composition of Bank Deposits in India
9
The two factors, (b) and (c) are inter-related. An increase in banking habit is caused, among other things, by the increased availability of banking facilities. 10 The reasoning here is that for economic units in the organised sector, current deposits are substitutable for currency which was being held earlier for transactions purposes; while in rural areas, people were using currency as a saving medium and availability of banking facilities would lead them to hold saving and time deposits.
8.42
in terms of the level of bank deposits rates
`
8.14.2 Bank Borrowings
8.43 Table 8.12 Components of total borrowings of commercial banks (percentage to total borrowings) Year 43.35 3.12
44.25
6.26
46.63
5.67 42.34 7.14
52.23
6.7
43.43
42.57
11.63
44.75
14.76
3.61
47.31
Source: RBI, Statistical Table Relating to Banks in India.
8.15 TRENDS IN ALL ASSETS OF COMMERCIAL BANKS IN INDIA
Table 8.13 Assets of commercial banks in India (percentage to total assets) Year
7.57 6.53
1.25
5.47
54.45 5.64
57.26
4.13
7.47
2.52
27.21
57.25
4.56
5.67
3.75
27.67
57.27
4.72
2.56 27.25 3.71 Source: RBI, Hand Book of Statistics on Indian Economy, Various Issues.
61.31 61.43
3.57
8.44
8.15.1 Investments
Table 8.14 Investment by scheduled commercial banks (percentage to total investments) Year Sec
1.16
11.61
1.27
1.72 4.54
1.34
6.55 1.72
7.25
2.12
1.21 1.44 75.31
1.72
77.75
1.53
76.42
1.75
Source: RBI, RTPBI, Various Issues.
8.45
8.15.2 Bank Credits
Table 8.15 Types of outstanding bank credit (percentage to total bank credit) Year -
1.13
Source: RBI, Statistical Table Relating to Banks, Various Issues.
8.46
Table 8.16 Sectoral distribution of outstanding bank credit (percentage to total bank credit) Year 3.61
37.23
22.56
2.32
34.51
22.73
12.25 1.72 — —
24.43
23.21
24.41
21.25
43.15 13.11
43.75 44.32
1.62 1.63
44.77 12.55
43.55
Source: RBI, Hand Book of Statistics on Indian Economy, Various Issues.
23.16
8.47 Table 8.17 Occupational distribution of outstanding bank credit in different areas (Percentage to total bank credit) Semi Urban 2006 Agriculture
2014
2006
Urban
2014
2006
2014
2006
32.2
Industry
2014
2006
2014
11.41
13.40
37.40
41.65
Transport
1.6
1.57
2.06
Professional and other services
2.4
5.41
7.49
23.33
16.19
4.86
4.52
4.80
4.62
6.28
8.07
4.68
2.01
Personal loans Whole sale trade Retail trade
5.3
Finance Others
4.3
3.7
Source: RBI, Basic Statistical Returns of Scheduled Commercial Banks in India.
Table 8.18 Outstanding credit to government and other sectors by scheduled commercial banks, 2010–2014 (amount in ` crore)
2010–2011
2011–2012
2012–2013
2013–2014
1. Public sector (16.3) 2. Co-operative sector
(1.2)
(1.3) (Contd.)
8.48 3. Private corporate sector
(41.4)
4. Household sector institutions
(35.3) (1.7)
(1.4)
(36.4)
(37.6)
(44.6)
(42.6)
(1.7)
(1.4)
institutions serving households 7. Non residents
452
1112
1114
6163
526
7154
Total
Source: RBI, Basic Statistical Returns of Scheduled Commercial Banks in India, Various Issues.
Table 8.19 Scheduled commercial banks’ credit to priority sectors Year —
—
—
—
—
—
—
—
—
—
—
—
-
-
36.7 33.27
11.43
35.22
34.42
34.42
13.11
32.51
33.13
12.74
11.62
1.16
31.62
12.11
11.55
12.76
13.33
32.55
Source: RBI, Hand Book of Statistics on Indian Economy, Various Issues.
8.15.3 Changes in Maturities of Bank Loans and Deposits
1.12
8.49
(percentages)
2003
2011
2012
2013
2014
25.27
26.27
25.24
2015
Deposits Upto 1 year Over 1–3 years Over 3–5 years
26 7.63
Over 5 years
16.57
17.11
Borrowings Upto 1 year
45.41
Over 1–3 years
12.47
12.21
Over 3–5 years
12.33
15.21
Over 5 years
54.52
27.17
Loans and Advances Upto 1 year Over 1–3 years
36.25
34.25
33.72
37.37
37.35
Over 3–5 years Over 5 years
17.35
16.46
Investments (at book value) Upto 1 year
15.71
Over 1–3 years Over 3–5 years
13.25
13.34
14.36
Over 5 years
53.15
2011
2012
52.51
2013
2014
2015
Deposits Upto 1 year Over 1–3 years
42.66 27.37
26.22 (Contd.)
8.50 Over 3–5 years
5.65
Over 5 years
15.66
17.55
Borrowings Upto 1 year
42.41
Over 1–3 years
16.17
43.75 22.44
Over 3–5 years Over 5 years
25.66
23.77
Loans and Advances Upto 1 year Over 1–3 years
35.16
33.41
36.44
31.66
35.75
Over 3–5 years
11.42
11.34
Over 5 years
14.54
16.45
11.65
12.37
Investments (at book value) Upto 1 year
42.62
44.52
Over 1–3 years
17.41
Over 3–5 years Over 5 years
2011
2012
2013
2014
2015
Deposits Upto 1 year Over 1–3 years
61.53
54.67
27.35
Over 3–5 years
7.33
Over 5 years Borrowings Upto 1 year Over 1–3 years
14.75
Over 3–5 years Over 5 years
6.71 2.72
4.41
2.67
5.43
3.31
63.15
63.73
3.54
Loans and Advances Upto 1 year
67.17
Over 1–3 years
15.47
17.35
12.52
12.41
5.16
3.54
Over 3–5 years
4.24
Over 5 years
6.74
5.64
Investments (at book value) Upto 1 year Over 1–3 years
14.21
Over 3–5 years Over 5 years Source: RBI, RTPBI, Various Issues.
2.54
11.37
5.21
12.67 2.13 5.63
8.51
8.16 NPAS AND CLASSIFICATIONS OF ASSETS OF INDIAN COMMERCIAL BANKS
Table 8.21 NPAs in different types of scheduled commercial banks
Year 11.4 3.3 2.4 2.5 3.1 3.2
1.4 1.4 1.7 2.4
6.2 1.2 1.1 1.1 1.3 1.7 2.1
2.5
1.3 (Contd.)
8.52 Year TA 12.4 3.6 2.2 2.4 3.3 3.6 4.4
5.3 2.1 1.3 1.4
5.1 1.7
6.7 1.3 1.1 1.2 1.5
2.4
2.7 2.4 2.3
2.6
1.3 1.6
2.1
3.1
1.2
1.6 1.3 1.1
1.1
5.2 3.1 1.3 1.3 1.2 1.1 1.2
7.1 2.7
3.2 1.4 1.5 1.6
2.4
3.3 1.4
Year
2.7 2.2
4.3 2.5 2.7
1.1 1.3
1.1 Notes: GNPA = gross non-performing assets, ADV = gross advances, TA = total assets Source: RBI, Handbook of Statistics of Indian Economy.
banks Year SA
SSA
DA
LA
4.1
7.1
1.6
1.2
3.3
SA
SSA
DA
4.3 1.2
LA 1.7
3.4
1.2 1.1 1.4
1.2
1.5
1.6
SSA
DA
1.33
Year SA
3.7
LA
SA
SSA
DA 2.1
2.5
1.3
1.12 1.46 1.17
Note: SA = Standard Assets, SSA= Sub Standard Assets, DA= Doubtful Assets and LA= Loss Assets Source: RBI, Handbook of Statistics of Indian Economy.
LA
8.53
8.17 COMMERCIAL BANK PERFORMANCES IN INDIA LO 8 Show how commercial banks perform in India and what has been their Capital Adequacy Ratio
Table 8.23 Earnings and expenses of commercial banks in India Year (`
1951
80.0
20.0
32.3
15.5
14 37.2
12.7
25.6
743
63.62
26.52
6522
64.33
25.62
62.47
27.22
62.75
24.15
12.43 13.45
11576
24.52
52.62
17.76
54.62
16.37
57.76
14.16
63.77
12.52
42727 (Contd.)
8.54 16.22
14.14 62.21 15.73
11.64 11.35 11.77 Source: RBI statistical tables relating to banks, RBI, Reports on Trends and Progress of banking India, Various issues.
Table 8.24 Performance indicators of commercial banks (percentages) Year
3.4
4.5
2.6
7.2
3.5
2.1
4.2
6.1
12.3
11.2
6.2
3.2
5.51
2.77
5.4
6.45
2.7
2.7
4.43 4.2
7.2
6.1
6.61
4.1
7.2
7.7
6.65
4.4 5.4
6.7 6.6
6.24
4.12
7.16 7.4
2.35 5
7.37 7.44
6.57
2.4 2.54
4.52
7.52
5.55
7.57
5.74
Notes: (1) Cost of Deposit = Interest Paid on Deposit/Deposits, (2) Return on Loans = Interest earned on loans/Total loans, (3) Return on Investment = Interest earned on Investment/Investments Source: RBI statistical tables relating to banks, RBI, Reports on Trends and Progress of banking India, Various issues.
8.55
Table 8. 25
Various performance ratios for different types of banks (Percentage)
Year
NIM
II
IE
All schedule commercial banks 1.12 1.13
3.12 15.44
2.62
14.31
2.54
1.1
3.1 7.37
4.51
7.44
4.16
14.6
5.17 5.35 2.7
5.26
Nationalised banks
2.32 2.26
7.55
2.74
7.62
2.55
2.74 4.44 5.61
12.34
5.74
7.76 Private sector banks 1.13
13.43
2.67
1.13 7.6 1.43
13.7
1.53
15.25
1.63
16.46
3.22
1.65
16.22
3.31
5.15
3.27
5.54
3.11
4.44
3.16
3.1
3.51 5.12 3.66 5.26
3.64
Foreign banks 4.33 13.75
7.65
4.74
4.33
4.62
7.34 1.75
6.15
2.16 (Contd.)
8.56 1.76
6.67
2.54
4.13
11.53 1.57
3.57
6.66
Source: RBI, Statistical Table Relating to Banks, Various Issues Notes: ROA = Return on Assets, ROE = Return on Equity, NIM = Net Interest Margin, II= Interest Income to Total Assets, IE = Interest Expenses to Total Assets, Spread = Interest Income – Interest Expenses
8.18 CAPITAL ADEQUACY RATIO OF COMMERCIAL BANKS IN INDIA
Table 8.26 Capital adequacy ratio of commercial banks in India Year
Foreign 12.23
12.14 12.16 13.77
12.31 13.47 14.45 15.33 14.62 14.26 13.71 Source: RBI, RTPBI, Various Issues.
12.25
17.67
8.57
8.19 GROWTH OF REGIONAL RURAL BANKS (RRBs) IN INDIA LO 9 Discuss the growth of Regional Rural Banks and Basel norms for banking supervision in India
(Amount in ` crore: Ratios are percentages)
Sl No
2001–2002
1
Total assets
2
Total liability
3
Aggregate deposit
4
Bank credit
2005–2006
5
Investments
6
Credit–deposit ratio
42.5
55.7
7
Investment–deposit ratio
15.7
57.7
2010–2011
2011–2012
33.25
32.31
1.3
1.4
2012–2013
6772
Credit + investment – deposit ratio
113.4 1.4
1.4 (Contd.)
11
8.58 1.1 11
Income ratio
12
Interest income ratio
13
Other income ratio
7.3
7.5 7.1
7.5
14
Expenditure ratio
6.61
6.6
7.2
15
Interest expended ratio
3.64
4
4.5
16
Operating expenses ratio
2.6
17
wage bill ratio
2.2
2.63
2.3
2.4
2.1
1.6
1.7
1.5
provisions and contingencies ratio Note: Ratio from 9 to 19 are percentages to total assets. Source: RBI, RTPBI, Various Issues.
8.20 BASEL NORMS FOR BANKING SUPERVISION
8.20.1 Basel I
Constituents of capital:
Risk weighting system:
8.59 The target standard ratio:
is the ratio of capital to
Transitional and implementation arrangements:
viz., operation risk and market risk
8.20.2 Basel II
Minimum Capital Requirements:
Supervisory Review Process:
Market Discipline:
8.60
8.20.3 Basel III
are as Better Capital Quality: Capital Conservation Buffer:
Countercyclical Buffer:
Minimum Common Equity and Tier 1 Capital Requirements:
Leverage Ratio:
Liquidity Ratios:
Systemically Important Financial Institutions (SIFI):
8.61 Table 8.28 Comparison of capital requirements under Basel II and Basel III
Minimum ratio of total capital to RWAs Minimum ratio of common equity to RWAs
2%
Tier I capital to RWAs
4%
Core Tier I capital to RWAs
2%
Capital conservation buffers to RWAs
None
Leverage ratio
None
Countercyclical buffer
None
Minimum liquidity coverage ratio
None
Minimum net stable funding ratio
Yes
None
Yes
None
Yes
` only consolation for Indian banks is the fact that historically they have maintained their core and overall
8.21
RISK MANAGEMENT IN BANKING LO 10 Summarise risk management in banking
8.21.1
Credit Risk Management
8.62
BASEL II on Credit Risk
viz.
Estimation of Credit Risk
Econometric Techniques:
Neural Network:
8.63 Optimisation Models: Rule-based or Expert Systems:
Hybrid Systems:
Credit Rating Framework
8.64
8.21.2 Market Risk Management
Interest Rate Risk Interest rate risk
Re-pricing Risk:
Yield Curve Risk:
Basis Risk:
8.65
Embedded Option Risk:
Re-investment Risk:
Measurement of Interest Rate Risk
Maturity Gap Analysis (MGA):
∂
∂{
8.66
Prosperity:
Recession:
Depression:
Recovery:
●
● ●
Duration Gap Analysis (DGA):
8.67
words, DA d ¥ DL where, DA liabilities and q denotes the ratio of liabilities to assets
∂p p
D¥∂
D
Ê -1ˆ ∂p ÁË p ˜¯ ∂y
C
-
where, D
Simulation Modelling:
¥C¥ ∂
∂D ∂y C
2
DL
8.68
Value at Risk (VaR):
i
¥
∂V ¥ ∂P ∂P
where, i,
i
P P
Interest Rate Risk ‘Stock Index Approach’:
DP
8.69 S
where,
L
b
l
M
L
M
l
8.21.3 Operational Risk
Sources of Operational Risk
Measurement of Operational Risk
(1) The Basic Indicator Approach
KBIA
[ Â (GI1º n ¥ a ]/ n
L
e
8.70 where, KBIA n a (2) The Standardised Approach
8.21.4 Liquidity Risk Management
Fundamental Approach:
8.71 Asset Management:
Liability Management:
Technical Approach:
Working Funds Approach:
Cash Flow Approach:
8.72
Reserve requirements: Liquidity ratio:
SUMMARY ◆
◆
◆
◆
8.73 ◆
◆
◆
◆
◆ ◆
◆
◆
◆
◆
◆
◆
◆
◆
viz.
8.74 ◆ ◆
◆
◆ ◆ ◆
◆
◆ ◆
◆
◆
◆
◆ ◆
◆
◆
KEY TERMS Deposit Credit
Demand Deposit
Credit Card Call Deposits Debit Card Standard Asset
8.75
Loss Asset
Standardised Approach
QUESTIONS
8.76
Co-operative Banks
9
CHAPTER Learning Objectives LO 1 LO 2
Know the evolution of co-operatives in India Identify the structure of co-operative banks in India
LO 3 LO 4
List the features of co-operative banks Discuss various government initiatives undertaken to strengthen the development of co-operative banks Explain the growth of co-operative banking in India Review major weaknesses of co-operative banks in India
LO 5 LO 6
9.1 INTRODUCTION
also has increased in recent years mainly due to the sharp increase in the number of primary co-operative
were initiated to create a new type of institution based on the principles of co-operative organisation and
9.2
Financial Institutions and Markets
9.2 EVOLUTION OF CO-OPERATIVES IN INDIA1
of establishing co-operatives of the type that worked successfully in Germany
LO 1 Know the evolution of co-operatives in India
integrated approach to co-operative credit and emphasized the need for viable credit co-operative societies by
1
Taken from the speech delivered by Dr. Deepali Pant Joshi, Executive Director, Reserve Bank of India at the National Meet of CEOs of State Co-operative Banks held at Mumbai on 21 March, 2014.
Co-operative Banks
9.3
the need for better business planning at the local level and for strategies to enable co-operatives to be self-
9.3 STRUCTURE OF CO-OPERATIVE BANKS IN INDIA LO 2 Identify the structure of co-operative banks in India
While the urban areas are served by the
Figure 9.1
Structure of co-operative banks in India.
9.4
Financial Institutions and Markets
have a three-tier structure comprising
District Central
level and State Co-operative Agriculture and Rural state level and the credit institutions have a unitary structure in some states with state level banks operating through their own
9.4 FEATURES OF CO-OPERATIVE BANKS LO 3 List the features of co-operative banks
and the degree of product differentiation in each main type of service is much less in the case of co-
viz.
2
See Government of India, Report of the Banking Commission, Delhi, 1972, p. 56.
Co-operative Banks
9.5
means that intra-sectoral competition is absent and intra-sectoral integration is high for co-operative
conditions: ` `
families for amount of `
9.6
Financial Institutions and Markets
the short-term agricultural loans are given at a concessional rate of interest whereas interest rates
9.5 GOVERNMENT INITIATIVES TO STRENGTHEN THE DEVELOPMENT OF CO-OPERATIVE BANKS Khusro Committee has enunciated well the philosophy of future
the system must look upon the lower tiers as mother institutions from
becomes cohesive and has an organic relationship between its different
LO 4 Discuss various government initiatives undertaken to strengthen the development of co-operative banks
Co-operative Banks
9.7
operative movement in decision making at banker’s forums and regional and national decision-making
which is said to have brought about considerable improvement in the performance of selected PACSs
`
9.8
Financial Institutions and Markets
viz
inter alia discussed the problems of the sector and highlighted the issue of dual regulatory mechanism which
in the draft Report: `
Co-operative Banks
9.9
to the institutional and legal reforms envisaged in the revival package or would enact the necessary viz.
have also initiated steps for bringing in necessary legal amendments to the respective Co-operative
9.10
Financial Institutions and Markets
conditions with the prior permission of the respective RCS granted in consultation with the
the entire issues of creating an appropriate legislative and supervisory framework for the purpose With a view to facilitate consolidation and emergence of strong entities and to provide an avenue for
Co-operative Banks
9.11
application for merger giving the proposed scheme will have to be submitted by the banks concerned
following circumstances:
3
https://rbi.org.in/Scripts/NotificationUser.aspx?Id=2631&Mode=0Guidelines for merger/amalgamation of Urban Co-operative Banks (UCBs)
9.12
Financial Institutions and Markets
framework for a long time on the grounds that there is an in-built accretion to capital every time a
institutions and every credit institution has to be a member of at least one Credit Information Company
from ` 4
`
The points XXIII to XXIX are taken from the speech delivered by Dr. Deepali Pant Joshi, Executive Director, Reserve Bank of India at the National Meet of CEOs of State Cooperative Banks held at Mumbai on 21 March, 2014.
Co-operative Banks
9.13
the percentage of SLR to be maintained by co-operative banks were brought in line with that of
viz CD ratio for initiating structured and discretionary action in respect of banks hitting such trigger
9.6 GROWTH OF CO-OPERATIVE BANKING IN INDIA
major initiatives taken by the commercial banks to open their branches in the
5
LO 5 Explain the growth of co-operative banking in India
The points XXIII to XXIX are taken from the Speech delivered by Shri R. Gandhi, Deputy Governor at Maharashtra Urban Co-operative Banks’ Conference 2015 at Nagpur on 24 October, 2015.
9.14
Financial Institutions and Markets
Table 9.1 Growth of co-operative banking in India Variable & Year
SCBs
CCBs/DCCBs
PACs
SLDBs/ SCARDBs
PLDBs/ PCARDBs
UCBs
1985–1986
29
352
95000
19
NA
1306
1994–1995
28
361
90000
20
731
1431
2001–2002
30
368
NA
20
768
1854
2005–2006
31
366
NA
20
696
1853
2007–2008
31
371
97224
20
697
1770
2011–2012
31
370
93413
20
697
1618
2012–2013
31
370
92432
20
697
1606
2013–2014
31
370
NA
20
NA
1589
1985–1986
616
1007
1128
473
NA
612
1994–1995
1635
2783
2584
938
372
3312
2001–2002
6323
14148
NA
2753
2502
13797
2005–2006
10545
23450
NA
3352
3380
13973
2007–2008
10549
26180
11038
2931
3596
19499
2011–2012
11200
24200
14500
4500
4900
34300
2012–2013
14500
35900
16000
6400
4800
38000
2013–2014
NA
NA
NA
NA
NA
NA
Number of Banks
Owned Funds (` Crore)
Total Deposits (` Crore) 1985–1986
21
38
4
NA
NA
NA
1994–1995
11547
18616
2520
112
NA
20101
2001–2002
35500
68090
NA
587
354
93069
2005–2006
45405
87532
NA
636
382
114060
2007–2008
56325
109597
25449
605
341
138496
2011–2012
86700
176800
50300
1100
500
238500
2012–2013
NA
NA
NA
NA
NA
276900
2013–2014
104730
236890
81900
1540
740
NA
Total Borrowings (` Crore) 1985–1986
923
2351
3927
NA
NA
214
1994–1995
5150
7921
6596
6087
2816
577
2001–2002
11550
18818
NA
14875
10292
NA
2005–2006
16989
24217
17075
13066
1781
2007–2008
22164
21096
47849
16662
12751
2292
2011–2012
42700
50500
88800
16000
13500
3600
2012–2013
NA
NA
NA
NA
NA
3100
2013–2014
61000
72690
95840
15750
14440
NA (Contd.)
9.15
Co-operative Banks Loans Outstanding (` Crore) 1985–1986
3852
5444
4321
2652
NA
3046
1994–1995
10492
18240
11404
5646
1699
14795
2001–2002
32111
59269
NA
14172
10010
62060
2005–2006
39684
79202
NA
17712
12740
71641
2007–2008
57445
93162
57643
2226
1822
90444
2011–2012
75600
144800
107300
4159
3341
157800
2012–2013
NA
NA
161900
3652
3718
181000
2013–2014
103120
203003
171420
4924
4372
NA
Notes: SCBs, State Co-operative Banks; CCBs, Central Co-operative Banks; DCCBs, District Central Co-operative Banks; PACS, Primary Agricultural Credit Societies; SCARDBs, State Co-operative Agriculture and Rural Development Banks; SLDBs, State Land Development Banks; PCARDBs, Primary Co-operative Agriculture and Rural Development Banks; PLDBs, Primary Land Development Banks; UCBs, Urban Co-operative Banks. Source: RBI, RTPBI, Various Issues.
Table 9.2 Ratio analysis of operations of co-operative banks, 1985–86 to 2013–14 (Percentage)
Variable & Year
SCBs
CCBs/DCCBs
PACs
SLDBs/ SCARDBs
PLDBs/ PCARDBs
UCBs
Borrowings to Deposits 1985–1986
72.27
47.67
686.53
NA
5.43
57.80
1994–1995
44.60
42.55
380.79
5434.82
2.87
60.77
2002–2003
32.26
24.88
NA
2011.76
1.56
NA
2005–2006
37.41
27.66
NA
2684.74
1.56
29.48
2007–2008
39.35
19.25
188.02
2754.05
3739.30
1.65
2011–2012
49.25
28.56
176.54
1454.55
2700.00
1.51
2012–2013
NA
NA
NA
NA
NA
1.12
2013–2014
58.25
30.69
117.02
1022.73
1951.35
NA (Contd.)
9.16
Financial Institutions and Markets
Loans Outstanding to Deposits 1985–1986
113.79
110.38
755.42
NA
77.32
150.57
1994–1995
90.86
97.98
452.54
5041.07
73.60
117.73
2002–2003
93.12
81.30
NA
2013
63.89
NA
2005–2006
87.40
90.48
2785.06
62.81
89.09
2007–2008
101.99
85.00
226.50
367.93
534.31
65.30
2011–2012
87.20
81.90
213.32
378.09
668.20
66.16
2012–2013
NA
NA
NA
NA
NA
65.37
2013–2014
98.46
85.70
209.30
319.74
590.81
NA
Notes and Source: Same as Table 9.1.
Table 9.3 State-wise distribution of UCBs in India (as on 31 March, 2003 and 31 March, 2007 State
As on 31 March, 2007 No. of Banks
Andhra Pradesh
%
As on 31 March, 2013 No. Of Banks
%
116
6.39
103
6.41
Assam
9
0.50
8
0.50
Bihar
3
0.16
3
0.19
Chhatisgarh
14
0.77
12
0.75
Delhi
15
0.82
15
0.93
Goa
6
0.33
6
0.37
284
15.66
234
14.57
Haryana
7
0.38
7
0.44
Himachal Pradesh
5
0.27
5
0.31
Jammu and Kashmir
4
0.22
4
0.25
Gujarat
Jharkhand
2
0.11
2
0.12
Karnataka
288
15.88
266
16.56
Kerala
60
3.30
60
3.74
Madhya Pradesh
60
3.30
51
3.18
Maharashtra
616
33.97
517
32.19
Manipur
3
0.16
3
0.19
Meghalaya
3
0.16
3
0.19
Mizoram
1
0.05
1
0.06
14
0.77
11
0.68
Pondicherry
1
0.05
1
0.06
Punjab
4
0.22
4
0.25
Rajasthan
39
2.15
39
2.43
Tamil Nadu
130
7.17
129
8.03
1
0.05
1
0.06
Orissa
Tripura
(Contd.)
9.17
Co-operative Banks Uttar Pradesh
70
3.86
Uttaranchal
7
0.38
5
0.31
West Bengal
50
2.75
46
2.86
1
0.05
1
0.06
1813
100
1606
100
Sikkim Total
69
4.30
Source: RBI, RTPBI, 2006-07 and 2013-14.
viz
Table 9.4 Performance of different types of co-operative banks in India (percentage to total assets)
Variable and Year
SCBs
CCBs/ DCCBs
9.62
10.14
SLDBs/ SCARDBs
PLDBs/ PCARDBs
UCBs
Interest Income 2001–2002
NA
NA
9.40
2005-–2006
6.95
7.46
NA
NA
4.53
2010–2011
6.37
6.92
7.01
6.35
7.66
2011–2012
6.56
8.39
6.80
6.11
8.60
2001–2002
0.52
0.60
NA
NA
1.31
2005–2006
0.43
0.69
NA
NA
0.68
2010–2011
0.30
0.47
0.46
2.38
0.58
2011–2012
0.34
0.50
0.48
2.29
0.65
2001–2002
7.33
7.14
NA
NA
7.19
2005–2006
4.78
4.59
NA
NA
2.92
2010–2011
5.22
4.36
4.56
5.16
4.80
2011–2012
5.34
5.28
4.76
4.96
5.47
NA
NA
NA
NA
4.40
Other Income
Interest Expenditure
Non-Interest Expenditure 2001–2002 2005–2006
NA
NA
NA
NA
1.31
2010–2011
NA
NA
NA
NA
1.99
2011–2012
NA
NA
NA
NA
2.11
2001–2002
0.73
1.70
NA
NA
NA
2005–2006
0.75
1.63
NA
NA
NA
Operating Expenses
(Contd.)
9.18
Financial Institutions and Markets
2010–2011
0.84
1.81
1.05
1.98
NA
2011–2012
0.88
2.17
1.36
1.91
NA
2001–2002
0.31
-0.03
NA
NA
-0.88
2005–2006
0.49
0.14
NA
NA
0.59
2010–2011
0.35
0.39
0.00
-0.79
0.80
2011–2012
0.34
0.54
-0.07
-0.76
0.92
Notes and Source: Same as Table 9.1.
Table 9.5 Non-performing assets of co-operative banks in India (Percentage)
Year
SCBs
CCBs/ DCCBs
PACs
SLDBs/ SCARDBs
PLDBs/ PCARDBs
1997–1998
12.5
17.8
35.3
18.6
16.5
11.7
2001–2002
13.4
17.9
32.4
18.5
30.2
21.9
2005–2006
16.8
19.7
30.4
32.7
35.6
18.9
2007–2008
12.8
20.5
35.7
34.5
53.7
15.5
2008–2009
12.0
18.0
44.8
30.1
39.0
13.0
2009–2010
8.8
13.0
41.4
45.1
51.9
10.1
2010–2011
8.5
11.2
25.2
32.3
40.6
8.4
2011–2012
7.0
10.2
26.8
33.1
36.7
7.0
2012–2013
6.1
9.7
NA
36.0
37.7
6.0
2013–2014
5.5
10.3
NA
31.6
38.0
5.7
2014–2015
4.9
9.5
NA
NA
NA
6.0
Notes and Source: Same as Table 9.1.
UCBs
Co-operative Banks
9.19
9.7 MAIN WEAKNESSES OF CO-OPERATIVE BANKS IN INDIA LO 6 Review major weaknesses of cooperative banks in India
9.20
Financial Institutions and Markets
SUMMARY ◆
◆
◆
the rural areas are largely served by two distinct sets of institutions extending short-term and long-term ◆
◆
◆
◆
◆
◆
◆
◆
Co-operative Banks
9.21
◆
◆
◆ ◆
KEY TERMS
Primary agricultural society State co-operative banks
State co-operative agriculture and rural development banks District central co-operative banks
QUESTIONS
Primary co-operative agriculture and rural development banks
Part 4 Non-Bank Financial Intermediaries and Statutory Financial Organisations
CHAPTERS 10. Small Savings, Provident Funds, and Pension Funds 11. Insurance Companies 12. Mutual Funds 13. Miscellaneous Non-Bank Financial Intermediaries 14. Non-Bank Statutory Financial Organisations
Small Savings, Provident Funds and Pension Funds
10
CHAPTER
Learning Objectives LO 1 LO 2 LO 3 LO 4
Know small savings in detail—types of instruments growth, composition and interest rates Understand provident fund, rates of return of provident fund accounts, and their investment pattern Review pension funds in India Discuss New Pension System or National Pension System (NPS): Architecture, features, investments, and challenges
10.1 INTRODUCTION In the previous two chapters, we have discussed the working of banking institutions. Before we turn to non-banking institutions, it is convenient and useful to familiarise ourselves with two very important,
Both small savings and provident funds supply budgetary resources to the government. In the recent years, the importance of pension funds has increased due to the introduction of New Pension System in India. followed by provident fund and pension fund.
10.2 IMPORTANCE AND CHARACTERISTICS OF SMALL SAVINGS savings organisations mobilise the largest volume of savings, followed by cooperative banks. In a country like India, where small savers predominate and where savers are dispersed over a vast area in innumerable villages, the work of
LO 1 Know small savings in detail—types of instruments growth, composition and interest rates
10.4
largest number of villages in India. Small savings are directly available to the central government as a part of its budgetary resources and they constitute the non-marketable debt of the government. Although the entire volume of small savings is technically available to the central government, in practice it has been shared with
savings media are as follows: (1) These assets represent medium-term and long-term investment opportunities. They are a good substitute, deposits, debentures, government securities, and units. (2) Many of them are in the form of re-investment plans. Therefore, they offer good opportunities to those investors who can forgo current income; they are also liquid. (4) POSB and there are no restrictions on the number of withdrawals. It is for this reason that the RBI now includes these deposits as one of the constituents of money supply in the economy. (5) As with unit-linked insurance plans, recurring deposits and cumulative time deposits provide insurance cover to the investor. A small saver before the maturity value of the account. His heir or nominee is entitled to get the full amount of the account as if the depositor had continued to make deposit till the end of the maturity period. (6) Finally, for those who
10.3 TYPES OF INSTRUMENTS IN THE SMALL SAVINGS MEDIA 10.3.1 joint accounts. The minimum investment is ` ` if an account is opened with `
` `
open and operate the account. Joint account can be opened by two or three adults. At least one transaction of converted into joint and vice versa. Minor after attaining maturity has to apply for conversion of the account in his name. Deposits and withdrawals can be done through any electronic mode in core banking solution can be issued to savings account holders (having prescribed minimum balance on the day of issue of card)
10.5
10.3.2
compounded). The minimum amount of `
`5 can be deposited
th
th
th
of day and last
is charged for each default. The default fee is 5 paisa for every `5. After four regular defaults, the account becomes discontinued and can be revived in 2 months, but if the same is not revived within this period, no the defaulted monthly deposit with default fee and then pay the current monthly deposit. There is rebate on vice versa. One
10.3.3
is `4.5 lakh in single account and `
`
majority has to apply for conversion of the account in his name. Interest can be drawn through auto credit
(Discount means deduction from the deposit). A bonus of 5 percent on principal amount is admissible on
10.3.4
periods. Minimum limit is `
account will be automatically renewed for the period for which the account was initially opened, e.g. 2 Years TD account will be automatically renewed for 2 years. Interest rate applicable on the day of maturity will be applied.
10.6
10.3.5
` ` per annum. Maturity period is 5 years. A depositor may operate more than one account in individual capacity
one year of the maturity by giving application in prescribed format. In such cases, account can be closed at if the interest amount is more than `
10.3.6
`
will not be discharged. Name of old holder shall be rounded and name of new holder shall be written on the
10.3.7
in denominations of `
`
10.7
10.3.8
` discontinued and can be revived with a penalty of `
basis, compounded annually. A minimum investment of ` `
Name of the scheme
Limits of investment
Maturity period (years)
`
Amount Deductions Rate of interest at end October under sec 80C outstanding 2016 (percent per of Income tax at end March 2016 (` Crore) Act annum) 4.0
`
No
61,567
` (` 15
`
57,603
` 70,635
`
`
7.3
No
7.70
No
` `
5
`
5
` `
(Contd.
10.8 `
112
`
5
`
14
7.70
No
` No
`1,50,000
10.4 GROWTH, COMPOSITION AND INTEREST RATES ON SMALL SAVINGS The growth in the volume of small savings and their distribution among different major schemes are presented the years. The monthly income and recurring deposits schemes have been attracting many investors. Small savings organisations, rather surprisingly, have not been able to induce investors to hold more time deposits savings have increased. Among the deposits, monthly income scheme has been the most popular scheme savings schemes in India during this period. The competition from commercial banks in rural areas appears
` Sr. Scheme no. 1.
1990– 1991
2000– 2001
2010– 2011
2011– 2012
2012– 2013
2013– 2014
2014– 2015
4253
157415
4205 2.
30101 1043
34070 151 4465
43017 140
61567 47
5.
57
4146
3. 4.
2015– 2016
31526 2340
42560
746
—
200557 —
—
24674 40714
—
—
—
—
—
—
—
—
—
42453 51757
70635 40315
74513 (Contd.
10.9 6.
—
—
—
—
3011
10321
4
0
554
1466
26763 117466
55071 7. 3135
4136
Receipts
Total
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
4 27 106754
8214
19129
16946
17142
11292
Outstanding 21358
194001
182736
171336
153888
7074
11.
12.
—
—
—
—
—
7221
—
—
—
—
41121
17599
29681
152936
117466
186469
202060
239048
301170
Outstanding 38106
55071
284397
270586
604112
615947
620235
640174
Receipts
57603
Source: RBI, Bulletins, Various Issues (December).
Table 10.3 Interest rates on small savings (Percentage
Schemes
1969–1970
*
3.5 4.5
1973– 1974
1978– 1979
1988– 1989
2002–2003
2006– 2007
2013– 2014
2015– 2016
5.0
5.5
5.5
3.5
3.50
4.00
4.0
6.25
6.75
—
—
—
—
—
Time Deposits* 5.50 — 6.25 #
NSCs
6.25
6.25
7.0
10.0
6.5
6.25
7.1 7.3
10.5
7.25
6.50
6.75
10.0
10.5
11.0
7.5
7.25
—
—
10.5
11.0
12.5
7.50
5.0
6.0
6.5
—
—
7.5
5.0
6.0
6.0
—
—
7.25
10.25
10.25
—
—
10.75
—
—
—
12.0
12.5
7.3
*
—
@ *
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
10.5
—
—
—
—
—
—
—
—
—
—
—
01.12.2011 (Contd.
10.10 *
$
—
—
—
13.43
10.3
7.5
—
—
—
—
—
—
11.0
7.5
7.0
—
—
12.0
—
—
—
—
—
—
—
—
—
—
—
—
7.70 — 7.70
@@
##
Notes: * denotes percent per annum, # denotes compounded quarterly, @ denotes bonus of 10 percent of the deposited amount at the time of repayment of maturity. @@ denotes payable quarterly, ## denotes compounded annually.
important is that, unlike in the earlier period, interest rates on small savings changed simultaneously with
intermediaries. However, changes in these rates were made an integral part of changes in the interest rates structure in the economy. The level of interest rates on small savings, and changes in them which have
10.5 PROVIDENT FUNDS This is a way of saving mostly by people who earn their income in salaries. However, recently, with the starting of the Public Provident Fund Scheme, it is possible for non-salaried earners also to save in this form. Saving in PFs is a contractual obligation, and the main motive behind saving in this form this form small amount on a regular basis to provide for old age or for the
LO 2 Understand provident fund, rates of return of provident fund accounts, and their investment pattern
The popular operational provident fund accounts available in India are (i) General Provident Fund (GPF),
(CPF), (ii) All India Services Provident Fund, (iii) State Railway Provident Fund, and (iv) Armed Forces
10.11 Personal Provident Fund and so on. The following section discusses about the detailed features of most
10.5.1
1
All temporary government servants after a continuous service of one year, all re-employed pensioners (other than those eligible for admission to the Contributory Provident Fund) and all permanent government servants nomination, in the prescribed form, conferring on one or more persons the right to receive the amount that may stand to his credit in the fund in the event of his death, before that amount becomes payable or having become payable has not been paid.
of interest on GPF accumulations at present is 12 percent compounded annually. The rules are provided for The purposes for which customers can withdraw their general provident fund amount are as follows: (i) purchase of consumer durables, (ii) education, (iii) illness, (iv) purchase of land for housing, (v) buying
10.5.2 The CPF rules are applicable to every non-pensionable servant of the government belonging to any of the a nomination in the prescribed form conferring on one or more persons the right to receive the amount that may stand to his credit in the fund in the event of his death, before that amount has become payable or having become payable has not been paid. A subscriber shall subscribe monthly to the fund when on duty or foreign service but not during a period
2
1
http://persmin.nic.in/Pension_Rules.asp On the death of a subscriber, the person entitled to receive the amount standing to the credit of the subscriber shall be paid an additional amount equal to the average balance in the account during the 3 years immediately preceding the death of the subscriber subject to certain conditions provided in the relevant rule. The additional amount payable under that rule shall not exceed `60,000. To get this benefit, the subscriber should have put in at least 5 years of service at the time of his/her death. 2
10.12
scheme (pension scheme). The last such option was allowed based on the recommendations of fourth CPC. As a number of options have already been allowed as and when substantial improvement were made in
government to consider any further change in options.
10.5.3
brought under it. This scheme is provided for provident fund system on contributory basis by the employers Fund account with interest in lump sum on retirement or leaving the job. This scheme is applicable for all ` must contribute to the employee provident fund. PF contribution is voluntary for those who earn more than `
The UAN does not change with the change of job. This portable number helps the employee to transfer the PF balance while changing the job. The PF member ID changes with every job, which is given by the employer. An employee is allowed to make a nomination conferring on one or more persons the right to receive the or share payable to each of the nominees in the nomination. Advances can be withdrawn from PF account
10.5.4
can also take advantage of it. The account holder should deposit a minimum of ` `1.5 lakh per annum. Any resident of India is eligible for this account. Only one PPF account can be opened and maintained not eligible for a PPF account. It is a 15 years scheme and the account matures only after 15 years. Partial
the nominee will be given the amount from the fund. Interest rates of the PF accounts are announced by the
10.13 central government periodically, usually annually. Interest earned is compounded yearly. The current rate of advantages are as follows: ●
●
investment goals. With interest rates compounded annually, effective returns tend to be more attractive vis-a-vis bank FDs.
●
a retirement corpus. ● ●
Being government-backed, there is low risk of default.
●
of which should have wide reach. Accounts can be opened online as well.
10.6 RATES OF RETURN OF PROVIDENT FUND ACCOUNTS
Table 10.4 Interest Rates of GPF, EPF and PPF Year
GPF
PPF
EPF
2000–2001
11
11
11
2001–2002 2002–2003 2003–2004 2010–2011 2011–2012 2012–2013 2013–2014 2014–2015 2015–2016 Source: Employee Provident Fund Organization, India.
10.7 INVESTMENT PATTERN OF PF FUNDS in the PF are mostly invested in the government securities, debt instruments and term deposits in the banks.
10.14 This implies that money available in the PF funds is invested in the regular income generating instruments as
Table 10.5 Investment pattern of provident funds since 1st April, 2015 Sl. No.
Instruments
Limit
1
45– 55%
2
35– 45%
3
Up to 5%
4
5– 15%
5
5– 15%
6
Up to 5%
Source: http://pib.nic.in/newsite/PrintRelease.aspx?relid=116214
(`
Sl. No. Categories of Investments
Holding at Face Value
% age Holding
1.
25.77%
2.
20.55%
3
3.61%
4. @
5.
36.15%
Total
379458.51
100.00%
@ (including Private Sector Bonds/Securities). Source: EPFO, Annual Report 2014–2015.
10.8 GROWTH OF PFS IN INDIA The members of the employees provident fund organisation have increased gradually and their contribution
` Items
2006– 2007
2007– 2008
444.04
2008– 2009
2009– 2010
2010– 2011
2011– 2012
2012– 2013
2013– 2014
2014– 2015
470.72
Contributions of members 24667.21 14767.47 16124.01
24251.5 (Contd.
10.15 250.65
423.22
566.4
620.13
Investments 15212.15 614.55
1016.13
1433.25
1620.16
Source: EPFO Annual Report Various issues.
Several factors have contributed to the growth of provident funds in India: (a) the adoption of statutory measures to make provident fund compulsory for industrial and other establishments; (b) the increase in
the minimum rates of contribution by the employees and employers; (g) the changes in the pay structure, like raising the basic pay of employees; and (h) the increase in the level of money income in the economy.
10.9 PENSION FUNDS
fund (PNF). Pension Funds (PNFs) have grown rapidly to become the primary
LO 3 Review pension funds in India
many countries. A Pension Plan (PP) is an arrangement to provide income to participants in the plan when they retire. PPs are generally sponsored by private employers, government as an employer and labour unions. Some pension plans are said to be insured, that is, in such cases the sponsor pays premiums to a life insurance
after year, it is called an UPP. There may also be Individual Retirement Pension Plans (IRPPs).
10.10 CLASSIFICATIONS OF PENSION PLANS Pension Plan (DCPP) or Money Purchase Pension Plan (MPPP), (c) Pay-as-you-go Pension Plan (PAYGPP). Pay-As-You-Go Pension Plan (PAYGPP): pensions are paid through PAYGPP, under which the current employees pay a percentage of their income to provide for the old, and this, along with the contribution of the state, goes as a pension that sustains the older generation.
10.16
salary and the period of service. Most of the pension plans offered by public sector enterprises and the government as employer in India are of DBPP variety. This type ensures a predictable amount of pension to the employees for all the years after their retirement and it is guaranteed by the State. DBPPs involve
determined contribution each year, and these funds are invested over the period of time till the retirement of employee. Whatever the value of these investments at the time of retirement, the employee will get a certain amount which he would use to purchase an annuity. From the point of view of the employer, DCPP is also
10.11 MANAGEMENT OF PENSION FUNDS Some sponsors of pension plans manage their pension funds themselves, but most of the sponsors appoint a trustee to do so on their behalf. This trustee is usually a trust department of a commercial bank, or an insurance company or a mutual fund. The trustee-manager invests contributions provided by the sponsor
large sponsors may divide the management of their PNFs among several trustee-managers. There are certain advantages in managing PNFs by outside trustees: (a) Transaction costs are lower. The trustee has greater
steady and predictable. The amount of contributions to the pension plan by the participants (employees) and
part of their resources in pooled funds that is insurance companies and mutual funds. Many employers (companies) encourage their employees to invest a considerable part of their retirement savings in the stock of companies in which they are employed. But this is not desirable because it goes viz. UK),
investments of accumulated funds. Similarly, the investments of PNFs should be such as to match the cash assets, which are weakly related. In many developed countries, the PNFs have become the biggest institutional players in the securities markets. The PNFs are generally managed professionally and they generate good returns. Many countries have encouraged active participation of the private sector companies in pension funds
10.17
savings for infrastructure projects. It is found that in those countries, PNFs broadly invest their resources
manage the resources of PNFs which happen to be huge in amount. The insurance companies, mutual funds, bank trust departments are found to be competing furiously in this regard. The sheer size of PNFs has made them an important factor in the markets for long-term securities. The PNFs in US held only one percent of
have been in the forefront of globalisation. The developed countries are engaged in reforming their pension systems at present. Some of the features of these reforms have been: ● To privatise their pension systems and to replace PAYGPPs with privately managed DCPPs. ● To involve private sector institutions in managing investments and in undertaking administrative functions relating to pensions. ● To emphasise regulation, capital market reform, business transparency and so on with a view to assign higher responsibility to provident and pension fund administrators.
10.12 PENSION SYSTEM IN INDIA
The dependency ratio4 has increased in India. The dependency ratio has two components, the young
pressures that demographics pose for pension systems. It measures how many people there are of working age relative to the number of retirement age. The increasing dependency ratio brings more economic pressure on working population. As the ratio increases there may be an increased burden on the productive part of the population to maintain the means of livelihood of the economically dependent part of the population. This
3
PFRDA, Annual Report, 2013–14. Dependency ratio is defined as the number of persons in age group 0–14 years plus number of persons in age group 60 years or more as a proportion of 100 number of persons in age group of 15–59 years. 4
10.18 organized sector and a vast majority of the workforce in the unorganized sector has remained outside the
Scheme (OPS), and (iv) Indira Gandhi National Old Age Pension Scheme. Central and state government employees receive pension under these at the time of retirement. They are paid out of current revenues of respective central and state governments
`
The public sector enterprises have similar type of pension arrangements like civil servants. These systems are now changing and most of them have become contributory. Some private sector enterprises also provide pensions but the mode of payment of pensions varies from enterprise to enterprise. The enterprises sometimes manage the fund themselves and sometimes jointly with pension annuities providing companies such as the Life Insurance Corporation of India Ltd. It is a welfare programme being administered by the Ministry of Rural Development. This programme is being implemented in rural areas citizens, especially those belonging to the below poverty line (BPL) and also the families in the same category
` provides ` discretion.
10.13 DEVELOPMENTS IN INDIAN PENSION SECTOR attaining the age of superannuation varying between 52 and 65 years. But for others, which constitutes constraint for the entire household. For those in the lowest segments of the population, particularly in the unorganized sector, this absence of old age income security can easily push them back into the poverty trap. objective to achieve a better balance in the pension regime by rationalizing the future pension liabilities of
up a new pension system based on Individual Retirement Accounts (IRAs) which can be opened anywhere in India with modest contributions through the working career of the workers.
10.19
contributions from employees and the central government on matching basis and the second tier (optional), Chairman, Insurance Regulatory and Development Authority (IRDA) submitted its report on pension reforms in an unorganized sector. The report suggested a pension scheme which would be voluntary in nature to be contributed by the members of the unorganised sector and capable of absorbing all others who want to participate as members of the scheme. An individual would save and accumulate assets through his entire working life. Upon retirement, the individual would be able to use his pension assets to buy annuities
The major recommendations of OASIS committee are as follows: ● ●
● ●
percent thereafter. That the setting up of private pension funds should be allowed. That a regulatory authority (pension authority) for pension funds needs to be set up.
●
●
●
corporate debt. That the guidelines should be issued to pension funds to ensure superior returns and better risk management. That pension funds should be allowed to invest in secondary markets for various securities.
●
encourage them to earn higher rate of return on investments during the period of accumulation of funds. ●
managed by professional funds managers. ● ●
●
That pension fund managers should offer schemes of three categories: safe income, balanced income and growth. The OASIS has also suggested the creation of Individual Retirement Pension Accounts (IRPA), which will have the following features: 1. Individuals would make voluntary contributions into individual retirement accounts throughout
transactions of IRPA can be done through these POPs anywhere in India. portability.
10.20 4. Record keeping in respect of IRPAs will be centralised and there will be a central depository. years. (I) Central depository will transfer block of funds to pension funds managers.
10.14 NEW PENSION SYSTEM OR NATIONAL PENSION SYSTEM The Government of India introduced the New Pension System (NPS) from
popularly known as national pension system. The Pension Fund Regulatory Development Authority (PFRDA) is the regulator of this NPS. The detailed
LO 4 Discuss New Pension System or National Pension System (NPS): Architecture, features, investments, and challenges
The NPS architecture involves a set of intermediaries, called Points of Presence (PoP) and aggregators, which are authorized to open NPS accounts and receive contributions; the pension funds, which are registered with PFRDA and are authorized to manage the pension corpus of the subscribers; Trustee Bank which facilitates fund transfer between the POPs and aggregators at the front end and pension funds and annuity service providers at the back end and the Central Record keeping Agency (CRA), which maintains the record and is responsible for keeping the data of individual subscribers and also acts as an interface between the different intermediaries in the NPS system. The main functions and responsibilities of the CRA shall include: (i) Record keeping, administration and customer service functions for all subscribers of the NPS. (ii) Issue Permanent Retirement Account Number (PRAN) to each subscriber, maintaining a database of all interface between PFRDA and other NPS intermediaries such as pension funds, annuity service providers, trustee bank and so on. bidding, National Securities Depository Limited (NSDL) to function as the CRA in respect of government employees. Similarly, three public sector entities namely, the Life Insurance Corporation of India, The State pension funds. be provided to all the citizens at various locations across India. These processes are carried out through the services under NPS through its network of branches called POP Service Providers (POP-SP). Currently, there
10.21
PFRDA
NPS Trust PrAO/DTA/POP/ CHO/NL-OO
Fund Flow Trustee Bank
Central Recordkeeping Agency
PAO/DTO/POPSP/ CBO/NL-AO
NAV
Custodian
Pension Funds
Information Flow
Online Subscribers Annuity Service Providers
Funds Flow
Figure 10.1 Source: PFRDA, Annual Report, 2013–2014.
pension fund for receiving contributions, accumulating them and making payments to the subscriber in the
authority for providing custodial and depository participant services for the pension schemes regulated by the
pension funds due to the negligence on its part or on the part of its approved agents. The custodian is not permitted to assign, transfer, hypothecate, pledge, lend, use or otherwise dispose off any assets or property of
provide custodial services for securities in physical form and depository participant services for securities in demat mode.
10.14.2 Features of NPS ●
retirement investment product.
10.22 ●
join NPS either as individuals or as an employee-employer group(s) (corporates) subject to submission age, you will not be permitted to make further contributions to the NPS accounts. An NRI can open an
● ●
The new pension system will be voluntary. The system would, however, be mandatory for new recruits
●
●
The State Government can choose to join this new pension scheme. Investment in NPS is independent of your contribution to any provident fund. NPS account can be operated from anywhere in the country irrespective of individual employment and
●
NPS account can be opened through the Point of Presence (POP) which will assist the subscriber in
●
and any other relevant information in this regard. NPS offers two types of accounts to its subscribers, namely tier I and tier II. While tier I account is mandatory for opening of an NPS account, opening of tier II account is optional and to be decided by
●
●
●
opening a tier II account. After opening the account, every individual subscriber is issued a Permanent Retirement Account can be re-printed with additional charges. A subscriber has to contribute a minimum annual contribution of ` year and if not contributed the account will be frozen. In order to unfreeze the account, the customer has to pay the total of minimum contributions for the period of freeze, the minimum contribution for the year in which the account is reactivated and a penalty of `
●
●
matched by the central government or the employer. The contributions and returns thereon would be deposited in a non-withdrawable pension account.
●
●
●
option of the subscriber. At present, subscriber has option to select any one of the following eight pension funds: (i) ICICI Prudential Pension Fund, (ii) LIC Pension Fund, (iii) Kotak Mahindra Pension Fund, (iv) Reliance Capital Pension Fund, (v) SBI Pension Fund, (vi) UTI Retirement Solutions Pension Fund, (vii) HDFC Pension Management Company (viii) DSP Blackrock Pension Fund Managers. Since registration of PFMs is an on-going process, this list will be updated from time to time. There is a default PFM provision under NPS and SBI Pension Funds Private Limited acts as the default pension fund manager. You may select different PFMs and investment options for your NPS tier I and tier II accounts.
●
would decide on the asset classes in which the contributed funds are to be invested and their percentages
10.23
fund—This is the default option under NPS and wherein the management of investment of funds is done
●
Subscribers can shift from one sector to another like private to government or vice versa. Hence a private citizen can move to central government, state government and so on with the same account. Also, subscriber can shift within sector like from one POP to another POP and from one POP-SP to another POP-SP. Likewise an employee who leaves the employment to become a self-employed can continue with his individual contributions. If he enters re-employment, he may continue to contribute and his employer may also contribute and so on. ●
●
them and from anywhere in India. You can appoint up to three nominees for your NPS tier-I and NPS tier-II account. In such a case, you are
●
` limit of ` ●
CCD (1) with in the overall ceiling of ` ●
●
percent of the pension wealth to purchase an annuity from the IRDA regulated life insurer. Indian life insurance companies which are licensed by Insurance Regulatory and Development Authority (IRDA) are empanelled by PFRDA to act as annuity service provider to provide annuity services to the subscribers of NPS. Currently, the following are the ASPs empanelled by PFRDA. (1). Life Insurance (4). Bajaj Allianz Life Insurance Co. Ltd. (5). Star Union Dai-ichi Life Insurance Co. Ltd. (6). Reliance
●
percent of the accumulated pension wealth of the subscriber needs to be utilized for purchase of an annuity providing for the monthly pension of the subscriber and the balance is paid as a lump sum payment to the subscriber. ●
monthly pension.
10.24
10.15 INVESTMENT OF NPS FUNDS NPS will also provide various investment options and choices to individuals to switch over from one investment option to another or from one fund manager to another subject, of course, to certain regulatory restrictions. For managing the contributions of government employees, three Pension Funds (PFs) were registered with PFRDA which are: (i) LIC Pension Fund Ltd., (ii) SBI Pension Funds Private Ltd., and (iii) For managing the contributions of non-government employees, eight Pension Funds (PFs) were registered PFs are (i) SBI Pension Funds Pvt. Ltd., (ii) UTI Retirement Solutions Ltd., (iii) LIC Pension Fund Ltd., (iv) Kotak Mahindra Pension Fund Ltd., (v) Reliance Capital Pension Fund Ltd., (vi) ICICI Prudential Pension Funds Management Co. Ltd., (vii) HDFC Pension Management Co. Ltd., and (viii) DSP Black Rock Pension Fund Managers Pvt. Ltd. The investment management fee charged by the PFs is with the upper
as follows: (i) CG Scheme (ii) SG Scheme (tier I and tier II) (iv) NPS lite. schemes for both tier-I and tier-II accounts. It is evident from the tables, the investments in the government
S. No. Category
Investment guidelines
Source: PFRDA, Annual Report 2013–2014.
10.25 Table 10.9 Investment Guidelines for Private Sector NPS
Assets class
Investment guidelines
E C
G
Source: PFRDA, Annual Report 2013–2014.
10.16 CHALLENGES TO NPS This system needs to be tackled effectively to spread wide enough to cover the unorganised sector, agriculture
any pension or old age security scheme, is the immediate priority of those concerned with pension reform
is in transition from old age support systems, based on the family, to a new reality, where for the generation heavily in the latter direction. It is, therefore, essential that policymakers correctly anticipate the course of the
old age and the capacity of the state and the labour market to face the challenges is likely to become even more limited than is the case now. Recognising the fact that pension reforms are an urgent social priority, policymakers in India are working hard to evolve pension systems, which are not only capable of meeting the present challenges but are able to adapt and re-structure overtime to meet unforeseen developments in future.
10.26
risk during the accumulations phase when contributions and returns on investment buildup in the fund. The pension subscribers. The draft regulation has addressed this issue by providing prudential investment rules and ensuring that pension fund managers diversify their portfolios. Also, these regulations aim to promote Traditionally, coverage in India has been obtained by mandating participation and contributions coupled
retirement planning, also pose a challenge to achieving optimum coverage of NPS. Creating awareness about
available to them. This goes against the basic philosophy of encouraging long-term contractual savings, which provide long-term funds for investment.
10.17 FEATURES OF NPS-SWAVALAMBAN5 ●
disadvantaged sections of the society. ●
●
●
●
the NPS. Under the scheme, government will contribute `
` ` The scheme is for those citizens of India who are not part of any statutory pension or provident fund swavalamban of state governments, anganwadi workers and so on.
●
●
5
swavalamban
http://financialservices.gov.in/pensionreforms/swavalambanscheme.asp
10.27
` pension wealth does not yield an amount of ` annuitised would be increased so that the pension amount becomes ` entire pension wealth would be subject to annuitisation. This minimum pension ceiling may be revised from time to time.
10.18 FEATURES OF ATAL PENSION YOJANA6 ●
The Government of India has introduced a pension scheme called the Atal Pension Yojana (APY), with
●
social security system for all Indians, especially the poor, the under-privileged and the workers in the unorganised sector. APY is being administered by the Pension Fund Regulatory and Development Authority (PFRDA) under the overall administrative and institutional architecture of the National Pension System (NPS). APY is open to all citizens of India who have a savings bank account. The minimum age of joining APY
●
`
●
`
●
●
●
government. However, if higher investment returns are received on the contributions of subscribers of APY, higher pension would be paid to the subscribers. A subscriber joining the scheme of ` contribute ` ` a subscriber joining the scheme of ` contribute ` `1454 per month. APY applications may be submitted to any of the following enrolment agencies: (i) All banks, including all nationalised banks, private banks, banking companies, regional rural banks, co-operative banks and so on either directly or through the following enablers: (a) All points of presence (service providers) and aggregators, which are governed under the institutional architecture of NPS and are appointed as such by banking aggregators, Micro Finance Institutions (MFIs) and so on are appointed as enablers by banks. asDepartment of Posts under CBS Platform.
●
6
Ministry of Finance, Department of Financial Services, Notification, 16th October, 2015, New Delhi.
10.28
●
government from time to time. ●
subscriber, as the case may be. In case a subscriber, who has availed government co-contribution under made by him to APY, along with the net actual interest earned on his contributions (after deducting the account maintenance charges), whereas, the government co-contribution and the interest earned on the government co-contribution shall not be returned to such subscribers.
10.19
GROWTH OF NPS
The assets under management in various schemes have increased in absolute terms throughout the period. The share of government sector largely dominates the private sector. But, the trend shows that the share of share of central government employees has been highest followed by the state government. The share of the
2010–2011 Schemes
2011–2012
Actual Share (` Cr) to total
Actual (` Cr)
Share to total
31.30
0.36
71.00
0.47
0.27
56.10
0.37
3.10
0.04
140.50
0.00
0.00
0.00
0.00
1.05
352.20
2.32
32.60
0.56
2012–2013 Actual (` Cr)
Share to Total
2013–2014 Actual (` Cr)
2014–2015
Share to total
Actual (` Cr)
Share to Total
0.56
506.24
0.63
1.46
1.75
1605.72
2.32
3.76
4105.12
2015–2016 Actual (` Cr)
0.61
1.05
257.60 436.10
Share to total
1.00
1.17 2107.55 5.75
CG
7266.40
1713.70
5.74
3736.20
11256.00 74.23 17313.00 14.31
3555.10
23.45
7.76
12476.50 10.55
50.25 36736.77 45.44 36.26 20211.40
45.01 73133.03
100.00 15163.30 100.00 Source: NPS Trust, Annual Reports, Various Issues.
100.00
100.00
100.00
100.00
10.29
Subscriber class
Total private
2013–2014
2014–2015
2015–2016
Actual (` Cr)
Percent
Percent
365.30
0.76
0.73
2627.60
5.46
7.02
Actual (` Cr)
1.74
1605.70
3832.20
7.97
7874.50
24177.10
50.26
Actual (` Cr)
Percent 1.07
9.74
2107.55
1.77
13176.80
11.09
45.44
40.51
41.77 44272.30 Grand total
105633.30
48104.55
100.00
80855.14
100.00
118810.12
100.00
Source: NPS Trust, Annual Reports, Various Issues.
Table 10.12 Performance of pension fund managers PFM
AUM (in ` Mn) 31-Mar-15
31-Mar-16
314071
Increase in AUM Amount
Percent
146,117
46.52 44.65
240101
Total
115,017 7011
3321
1075
1727
652
770
1112
343
531
3762
3231
808552
1188102
379550
44.5
46.94
Source: NPS Trust, Annual Reports, Various Issues.
Table 10.13 Funds of Central Government and State Government employees performance:
Financial year return (%) Scheme
2010– 2011
2011– 2012
2012– 2013
2013– 2014
Trailing Return (%) 2014– 2015
2015– 2016
1-Yr
12.06 SBI
12.75
6.47
6.47
2-Yr
3-Yr
12.23
10.11
12.74
Since inception
10.2 (Contd.
10.30 5.52
12.26
10.77
5.04
6.24
6.62
6.62
13.02
6.30
6.30
12.36
12.75
SBI 6.04
13.22
12.21 12.44
13.01 11.34
6.24
4.70
10.22
Source: NPS Trust, Annual Reports, Various Issues.
I and II (Percentage)
SCHEME E—TIER I Year
ICICI Kotak Reliance
2010–2011 2011–2012
SBI
UTI
10.77 –7.75 –10.23
2012–2013
11.52
2013–2014
7.75
7.42
20.2
2014–2015 2015–2016
DSP HDFC
–7.26
–7.16
–6.72
IDFC SENSEX CNX Nifty
—
—
—
—
—
—
—
—
—
—
—
—
—
27.51
—
— –7.37
LIC
—
—
–7.47
11.14 –10.5 7.31 26.56
—
SCHEME E—TIER II Year
ICICI
2010–2011
10.12
2011–2012
–10.41
2012–2013 2013–2014
Kotak Reliance SBI 11.66
5.37 –10.37
–7.51
11.33 21.14
20.67
20.37
—7.22
–7.13
2014–2015 2015–2016
—6.67
UTI
DSP HDFC LIC
IDFC SENSEX CNX Nifty
10.16
—
—
—
7.05
–10.74
—
—
—
7.63
—
—
—
—
20.51
—
—
—
—
31.04
—
22.77
21.46
—
–6.54
—
–7.17
11.14 –10.5 7.31 26.56
—
SCHEME C—TIER I Year
ICICI Kotak Reliance
2010–2011 2011–2012
11.43
2012–2013
14.22
15.01
2013–2014
6.22
5.77
2014–2015
15.72
15.22
15.04
SBI
UTI
DSP HDFC
LIC
12.66
—
—
—
11.07
—
—
—
—
—
—
14.27
13.41
5.24
6.14
15.7
2015–2016
IDFC SENSEX CNX Nifty 6.26 —
—
—
—
—
—
15.2
15.43
—
—
11.14 –10.5 7.31 26.56
—
SCHEME C—TIER II Year
ICICI Kotak Reliance
2010–2011
10.74
2011–2012
12.27
2012–2013
13.6
7.2 13.15
12
SBI
UTI
DSP HDFC
LIC
IDFC SENSEX CNX Nifty
14.46
7.62
—
—
—
6.02
10.73
11.4
—
—
—
10.02
—
—
—
—
11.14 –10.5 7.31 (Contd.
10.31 2013–2014
6.10
5.76
6.04
2014–2015
4.15
5.75
—
15.62
15.3
—
2015–2016
—
—
—
12.37
—
—
26.56
—
SCHEME G—TIER I ICICI Kotak Reliance 2010–2011
7.71
2011–2012
6.07
2012–2013 2013–2014
1.51
2014–2015
20.75
2015–2016
SBI
UTI
DSP HDFC
LIC
IDFC SENSEX CNX Nifty
7.65
12.25
12.52
—
—
—
6.14
5.63
5.46
3.75
—
—
—
13.61
13.74
13.57
—
—
—
—
0.23
—
—
—
—
20.73
—
20.24 7.54
7.22
7.16
7.16
—
11.14 –10.5 7.31
— 6.77
6.50
26.56
—
SCHEME G—TIER II ICICI Kotak Reliance 2010–2011
6.43
6.40
2011–2012
6.36
5.37
2012–2013
14.36
2013–2014
1.12
2014–2015
20.70
2015–16
7.05
UTI
DSP HDFC
16.44 5.76
20.44 7.66
SBI 5.31
LIC
IDFC SENSEX CNX nifty
—
—
—
6.00
—
—
—
7.22
13.47
13.52
—
—
—
—
0.51
—
—
—
—
20.57
20.27
—
7.37
11.14 –10.5 7.31
—
—
6.75
26.56
—
Source: NPS Trust, Annual Reports, Various Issues.
Financial year return (%) Scheme
2011– 2012
2012– 2013
2013– 2014
Trailing Return (%) 2014– 2015
— 10.1 SBI
13.02 4.11
2015– 2016
1-Yr
2-Yr
3-Yr 10.06
6.37
6.37
12.57
5.72
5.72
12.33
6.30
6.30
12.72
Since inception 10.57 10.61
Source: NPS Trust, Annual Reports, Various Issues.
All the PFMs continued to witness good growth in assets under management. All the PFMs maintained their relative ranking in terms of size of AUM with SBI PF having the largest corpus. HDFC Pension Management
scheme CG, scheme SG, scheme NPS lite and scheme corporate CG have outperformed the CRISIL—AMFI
10.32
(Scheme C—tier I and Scheme C—tier II) of all PFMs have delivered superior returns to CRISIL - AMFI
SUMMARY ◆
◆
◆
Small savings are directly available to the central and state governments as a part of their budgetary resources and they constitute the non-marketable debt of the government. Small savings organisations are instrumental in draining resources from the rural to the urban areas.
◆
instruments represent medium-term and long-term investment opportunities, and are a good substitute for bank deposits, debentures, units and marketable government securities. ◆
◆
Saving in PFs is a contractual obligation, and the main motive behind saving in this form is not to make
◆
The popular operational provident fund accounts available in India are (i) General Provident Fund (GPF),
◆
◆
The funds in the PF are mostly invested in the government securities, debt instruments and term deposits in the banks.
◆
◆
◆
Contribution Pension Plan (DCPP) or Money Purchase Pension Plan (MPPP), (c) Pay-as-you-go Pension Plan (PAYGPP). ◆
(OPS), and (iv) Indira Gandhi National Old Age Pension Scheme. ◆
◆
all the citizens of India since 1st The NPS architecture involves a set of intermediaries, called Points of Presence (PoP) and aggregators; the pension funds; Trustee Bank and the Central Recordkeeping Agency (CRA).
10.33 ◆
retirement investment product. ◆
◆
◆
◆
can join NPS. The new pension system will be voluntary. The system would, however, be mandatory for new recruits NPS offers two types of accounts to its subscribers, namely, tier I and tier II. While tier I account is mandatory for opening of an NPS account, opening of tier II account is optional and to be decided by opening a tier II account. There are different schemes under which the investments are made in NPS. All these schemes are
and (iv) NPS lite.
KEY TERMS Small Savings Scheme Sukanya Samridhi Account
General Provident Fund Public Provident Fund Contributory Provident Fund New Pension System
QUESTIONS savings. 2. Analyse the trends in growth in the volume of small savings among different schemes in India. the period of liberalisation? 4. Discuss the various provident funds schemes in India and how all these schemes work. 5. Discuss the architecture and features of New Pension System in India. 6. What are the major challenges to the New Pension System?
Insurance Companies
11
CHAPTER Learning Objectives LO 1 LO 2 LO 3 LO 4 LO 5 LO 6
11.1
Know insurance principles and types Recall the nature of life insurance policies and non-life insurance policies Understand risk management and its process in insurance company Explain Insurer Solvency and Risk-Based Capital Review insurance industry in India and the Policy Developments Growth of life insurance and non-life insurance
INTRODUCTION
The insurance industry has both economic and social purpose and relevance. It provides social security and promotes individual welfare. The insurance business in India has grown by many folds after the entry of private insurance companies in 2000–2001. Up to that time the sector was largely dominated by the Government. The insurance industry of India consists of 53 insurance companies of which 24 are in life insurance business and 29 are non-life insurers. Among the life insurers, Life Insurance Corporation (LIC) is the sole public sector company. Apart from that, among the non-life insurers there are six public sector insurers. In addition to these, there is sole national reinsurer, namely, General Insurance Corporation of India. Other stakeholders in Indian Insurance market include agents (individual and corporate), brokers, surveyors and third party administrators servicing health insurance claims. This chapter is devoted to describing the working of all types of insurance companies operating in India.
11.2
MEANING AND CONCEPTS
Insurance which mitigates it in exchange for a monetary compensation popularly known as insurance premium. The actual premium of insurance companies comprises
LO 1 Know insurance principles and types
11.2
Financial Institutions and Markets
the pure premium and administrative as well as marketing cost. The pure premium is the present value of the expected cost of an insurance claim. Since there is a lag between payment of premiums and payment of claims, there is generation of investible funds known as insurance reserves. Insurance involves not only risk transfer but also pooling and risk reduction. Pooling is the sharing of total losses among a group. Pooling within a large group facilitates risk reduction, which is a decrease in the total amount of uncertainty present in a particular situation. Insurance allows individuals, business and other entities to protect themselves against Insurance policy is the contract between the insured (policy holder) and the insurer (insurance company). Sum assured is the amount that is promised by the insurance company in the case of a claim either by maturity or by loss to the insured subject matter. Surrender value is the amount that the insurer pays if the insured discontinues the policy to the insurer. Life of the policy is the time period wherein the insurance policy is in vogue. Moral hazard refers to the obligations with respect to their performance of the contract. For example, when the insured burns down increase making it a moral hazard.
11.3
PRINCIPLES OF INSURANCE
11.3.1
Principle of Utmost Good Faith
Both insurer and insured should enter into the contract in good faith. The insured should voluntarily disclose all the facts related to the subject matter of the contract. The insurer should also provide all the details regarding the insurance contract. Any material facts that are not disclosed to the other party having a direct or indirect relationship to the contract will make it null and void. For example, a smoker took a health insurance policy and at the time of taking the policy, he did not disclose this fact. After that if he/she suffers from lung cancer, the insurance company may not pay anything as he/she did not reveal the true fact to the company.
11.3.2
Principle of Insurable Interest
All insurance contracts should have an insurable interest by the policy holder. Insured must have the insurable interest on the subject matter, that is, the policy holder should be able to establish a monetary relationship between him/her and the subject matter of the insurance. Any loss of subject matter should directly lead to monetary loss to the policy holder. For example, in the case of life insurance of a person the spouse and dependents should have insurable interest in the life of the person. In the case of general insurance like motor insurance, insured must be the owner both at the time of entering into the insurance contract and at the time of accident.
11.3.3
Principle of Indemnity
Indemnity refers to the assurance given by one to put the person who buys insurance, in the event of loss, in the same position that he/she occupied immediately before the happening of the event for which indemnity is sought for. According to the indemnity principle, the insured may not collect more money than the actual loss
Insurance Companies
11.3
the insurance contract. This principle serves to control moral hazard problem. This principle does not apply for the life insurance contracts.
11.3.4 Principle of Subrogation This principle refers to the right of the insurer to stand in the place of insured after the settlement of a claim and it gives the insurer right to recover from an alternative source, which is involved in this case. In other
11.3.5 Principle of Warranties Warranties are the conditions that are written by the insured in the insurance contract that state the truth by
and (ii) implied warranties. Express warranties are stated in the contract and the implied warranties are not found in the contract but are assumed by parties to the contract. For example, a shipper purchases insurance under the implied condition that the ship is seaworthy, the voyage is legal, so on. A warranty also may be
11.3.6 Principle of Cause Proxima Cause proxima means nearest cause. Proximate cause refers to the immediate cause that resulted in the loss. short circuit. An insurer is liable for any loss proximately caused by a peril insured against. It is important to identify the proximate cause of the loss that occurred so that it can be known whether the insured can collect the policy amount or not.
11.3.7 Principle of Contribution if somebody has taken a property insurance from company A and company B, then in the case of any accident the insured can take the claim from one company only.
11.3.8 Principle of Loss Minimisation This principle states that the insured must take all the necessary steps to minimise the loss to insured properties.
11.4
11.4
Financial Institutions and Markets
TYPES OF INSURANCE
They offer protection to the investors, provide means for accumulating savings and channelise funds to the government and other sectors. They are contractual saving agencies that receive, mostly without fail,
Furthermore, their liabilities in most cases are long-term liabilities, for many life policies are held for 30 or
their investments. As a combined result of all these factors, the investments of insurance companies have been largely in government bonds, mortgages, state and local (municipal) government claims and corporate bonds. Broadly, insurance is offered either as life insurance or general insurance. Life insurance covers insurance of life and covers risks related to the death of a person for whom insurance is bought. The objectives of life insurance companies are as follows: (i) To spread life insurance and provide linked saving schemes. (iii) To invest the funds to serve the best interests of both the policyholders and the nation. (iv) To conduct business with maximum economy, remembering always that the money belongs to the policyholders. (v) To act as trustees of the policyholders and protect their individual and collective interests. (vi) To innovate and adapt to meet the changing life insurance needs of the community. (vii) To involve all promote amongst all agents and employees of the Corporation a sense of pride and job satisfaction through dedicated service to achieve the corporate objective. Its vision is to become ‘a trans-nationally competitive
General insurance encompasses all those kinds of insurance contracts that cover non-life subjects. Health on the peril against which the insurance is sought. These include motor insurance, marine insurance, property insurance, liability insurance, commercial or business insurance, housing loan insurance,1 and so on. The and certain, but in the case of the latter, the claim is uncertain, that is, the amount of claim is variable and it is ascertainable only sometime after the event.
11.5 NATURE OF LIFE INSURANCE POLICIES a few basic types of such policies, viz. term insurance, whole life insurance, endowment policies, annuity contracts, individual insurance, group insurance,
1
LO 2 Recall the nature of life insurance policies and non-life insurance policies
A loan insurance plan covers the balance to be paid in the case of the loanee’s death as per the loan schedule decided at the time of taking the policy.
Insurance Companies
11.5
term investments, which cover risk rather than provide return. However, in order to serve different purposes, these basic types can be and have been combined in many ways to devise a large number of plans. Life maturity or at death is the sum assured of the policy when it was taken out. In the former case, bonuses out of extra earnings from various investments are added to the assured sum periodically during its currency
income. The value of a policy is the present value of a lump sum or a future stream of income less the value of future premiums. It is possible to withdraw from the obligation to contribute further premiums and of
policy. The life assurance policies and pension funds are popular because they act as life cover or protection many tax advantages. Life policies become, in many cases, vehicles for linking up such actions as house purchase, provision of school fees, purchase of unit trust units and avoidance of tax. In many cases now, the provision of life cover becomes a subordinate motive, while the other motives are more important even when taking up a life insurance policy. The funds collected through the sale of life plans are invested in a variety of income-producing assets. The life fund is built up out of the excess of premiums and investment income over claims and expenses on revenue and capital accounts. The life fund is valued from time to time, the valuation being based on the method of
rate. A life fund is in surplus if the valuation of fund is greater than the present value of future liabilities. This surplus is available partly for distribution to policyholders and partly for adding to reserves. Only surplus to policyholders: in the form of cash, as a reduction in premium and as an addition to the value of policy. If the surplus is distributed in the form of addition to the value of policy, it is known as reversionary bonus. The bonus may be declared as a simple reversionary bonus, calculated on the original sum assured, or a compound reversionary bonus, calculated on the original sum assured plus any bonuses already declared. The surplus can be of two types: (a) revenue surplus discussed above, that is an excess of future income over future outgoings, and (b) capital surplus that arises when the value of the fund is balanced by the values of the various assets of the life fund as recorded in the balance sheet.
11.6
NATURE OF NON-LIFE INSURANCE POLICIES
are. The essence of general insurance is the collective pooling of risks arising from fortuitous occurrences. For insurance, to be worthwhile, the premium must be small in relation to the potential loss. The policies in
11.6
Financial Institutions and Markets
general branch rarely run for a period longer than 1 year, and with some types (e.g. holiday insurance) the period is even much shorter. There is no guarantee of renewal of policy on the same terms or on any terms. The short-term contracts do not create large funds of invested assets as in the case of life insurance. The general insurance companies do not collect savings, yet they do accumulate pools of funds from premium and investment income out of which they meet claims under their policies. Since their liabilities are normally
and their investment pattern has to take care of this need. The general insurance companies are also known as hail, automobile, ocean and inland marine, aviation, theft, loss, damage liability and so on.
11.7 RISK MANAGEMENT IN INSURANCE COMPANIES Risk management in an insurance company plays a vital role in the area of measuring, assessing the risk and developing strategies to manage it. Strategies include transferring the risk to another party, avoiding risks reducing the
LO 3 Understand risk management and its process in insurance company
a particular risk. An insurer always makes an effort to know the business activities of the insured minutely. Traditional risk management practices, like purchasing insurance to cover losses, remain the foundation of any risk management function. But
management; (ii) operational risks that include human resources risks, business partner risks, data integrity risks and technology risks; and (iii) market place risks that include reputational risks, regulatory risk, tax risks and product strategy risks.
investment and policy contract design and customer satisfaction strategies also need to be developed to meet ALM objectives. In terms of ALM risk exposures, asset risk involves the risk of loss in investments— whether bonds, stocks, real estate, and so on. A source of asset risk involves default rates from debt issuers larger than expectations in ALM and pricing models. Credit risk can also arise from defaults on accounts receivable from distributors, and so on. Operational risk
of operational risk, which are broken down into four categories: people, processes, systems and external factors. The committee originally proposed the level of capital for operational risk to be 20 percent of the
Insurance Companies
11.7
sophistication and risk sensitivity. There are three types of effects due to this category of risks, viz. announcement effect, contagion effect and following three ways. First, if the announcement is fully anticipated, there will be no change in the stock price. Second, if the announcement conveys negative and unexpected information, the stock price will be adversely affected. Third, if the announcement conveys positive and unexpected information, the stock price will go up. The last situation may be unusual, but it is possible. If there is substantial information leakage before the announcement day, the estimated loss amount will be incorporated into the stock price before amount, this news will be considered positive and will lead to upward adjustment to the stock price. In an
the announcement is said to be non-informative. Under the latter two situations, the announcement is said to be informative. of event studies have documented the contagion effect around a variety of corporate events in many industries announcements, earning restatement announcements and asset write-down announcements. Lang and Stulz point out that announcement for bankruptcy needs not only convey negative information. The announcement can potentially increase the value of rival companies by redistributing wealth from the announcing company. competitive and contagion intra-industry effects can occur. The competitive effect, which indicates that the
effect dominates in highly concentrated industries.
11.8 RISK MANAGEMENT PROCESS IN INSURANCE COMPANY The process of risk management from an insurance perspective follows a logical approach as below: It broadly involves an in-depth understanding of the industry, the areas/markets it serves, its activities, range of products, legal, social and economic environment in which it operates and other identifying the risk factors and evaluating the potential loss that might take place.
help the underwriter to apply judgment to the risk by securing material information and by determining if
11.8
Financial Institutions and Markets
actual conditions are better or worse than average, whether there are more or fewer hazards than average and
avoidance is non-performance of an activity that could carry risk. A risk of potential damage to a control room in a petrochemical complex can be avoided by making the control room blast proof, potential damage retention involves acceptance of loss. All risks that are not avoided or not transferred are retained by default. This includes risks that are so large or catastrophic that they either cannot be insured against or the premiums would be infeasible. War is an example since most property and risks are not insured against war, so the loss attributed by war is retained by the insured. Risk transfer means causing another party to accept the risk, typically by contract or by hedging. Insurance is one type of risk transfer that uses contracts. Risk transfer takes place when the activity that creates the risk is transferred. It is an important task of risk management which involves methods that reduce the severity This method may cause a greater loss by water damage and therefore may not be suitable. Therefore, there can be minimised if it becomes a liability. Risk is a relative measure and from insurer
Loss Expectancy. These need minor repairs, replacement and minimum business inconvenience. Below this low probability is the objective of risk-based continuous improvement. The total risk is reduced and they are most productive. From an assessment point of view, the companies or plants moving in this direction are
The threshold, which is Probable Maximum Loss (PML), relates to the value of possible major accidents or which is one of the prudent parts of risk management exercise. The cost imprecations are fundamental to
11.9 INSURER SOLVENCY reserves against future liabilities towards the policyholders. In estimating this reserve, the insurer makes assumptions into the future for parameters such as mortality, morbidity, expense, interest rate, and so on. These assumptions are
LO 4 Explain Insurer Solvency and RiskBased Capital
Insurance Companies
11.9
other experience. Sub-regulation (b) of Regulation 5 of IRDA Regulations (Assets, Liabilities and Solvency
expected level. The purpose of MAD is to build a buffer for misestimation of the best estimate or adverse
Solvency margin is the amount by which the assets of an insurer exceeds its liabilities and will form part of
company so that each business will stand on its own and not subsidise the other. For life insurance business, the minimum solvency will normally be related to the policy reserve as disclosed by an actuarial valuation of the liabilities. For general insurance business, it is related to the higher of a percentage of net premium or net
11.9.1 Solvency I The key principle upon which the solvency I directives are based is that every insurer must maintain an
and its ability to meet its obligations to policyholders. Basic objectives of Solvency I are as follows: ● To update the thresholds contained in the initial version of the insurance directives to take account of indexation and to update amounts that have been devalued since the insurance directives were brought into force originally; ● To provide a mechanism to ensure that solvency limits are reviewed annually by reference to the European Index of Consumer Prices; and ●
occurred and to empower them to reduce the credit given to reinsurances in certain circumstances.
11.10
Financial Institutions and Markets
It should be noted that, in common with the insurance directives, the solvency I directives operate to set out minimum standards for solvency margins. The starting point for determining the actual solvency margin for both general insurer and life insurer is determining the value of its excess assets after deducting all of its liabilities, all valued in accordance with the applicable asset/liabilities valuation regulations. Excess assets generally comprise the paid-up share capital (including non-cumulative preference share capital) of the forward) that do not correspond to its underwriting liabilities. Under the solvency I directives, the limits to which these reserves may be counted have been tightened. The amount allowed may be up to 50 percent of
For non-life companies, the insurance directives are amended by the Solvency I directives and provide that
further adjustment is then made to take account of reinsurance recoveries, which is achieved by multiplying that can be allowed for this reinsurance adjustment is 50 percent. The second calculation is based on claims and is derived from the average claim experience in the previous exposure in certain classes of business (namely storms, hail, frost or credit default), an average of the claims
again up to a maximum of 50 percent. amount of the aggregate premium or claims taken at the outset must be increased by 50 percent in both calculations, although the insurer may apply to use statistical methods to allocate this over the past 3 years when the reinsurance adjustment is made. It should also be noted that the member state responsible for the
30 percent of net incurred claims whichever is higher. The reduction for reinsurance is subject to a maximum which varies from 0.5 to 0.9 depending on the class of business. This formula is similar to the provision applicable under European Union legislation during the early 1990s and is in fact drawn from the same.
which individual companies are exposed. To that extent, it may be felt that the provisions need a relook. Risk-
Insurance Companies
11.11
11.9.2 Solvency II Although Solvency I directives went some way to modernising the prudential supervision of insurers, the amendments were essentially limited to updating rules that had remained substantially unchanged since
differences in the prudential supervision regimes that have developed across the European Community (EC).
Rather than developing the prudential supervision process by simply building further on the existing rules, the outcome of Solvency II is likely to introduce more far-reaching changes. These are likely to include a move to a more risk-based approach to regulation which will encourage insurers to improve the measurement to allow the insurance market to develop, for example, through further involvement with the derivative following are key areas for consideration under Solvency II: viz. underwriting risk, asset risk, credit risk and operation risk. (ii) Assessment of how these risks interact and overlap with each other and modelling how these are to be managed by the insurer and regulators on a consistent basis with a view to using the models for decision-making purposes.
determining claims, sensitivity analysis and details of the development of the claims run-off; (iv) Introduction of a more consistent approach to asset valuation across member states, again applying a more risk-based approach to account for volatility and resilience. (v) Integration and harmonisation of the approach to the treatment of reinsurance in the solvency calculation;
of insurance undertakings analogous to the approach taken by the Basel Committee for banking. This might be structured as follows: ● Pillar 1: Financial resources and the valuation of assets and liabilities, including assessment of liabilities at a group level. ● Pillar 2: Supervisory review—assessment of the strength and effectiveness of risk management systems and internal controls. ● Pillar 3: Market discipline—obligations for insurers to make disclosures to allow policyholders to
11.12
Financial Institutions and Markets
11.9.3 Solvency Ratio margin. The numerator of the ratio denotes the items such as: (a) capital/funds, (b) various reserves that real estate and stocks. The above characteristics call on the insurers to follow certain basic principles of returns must exceed cost of liabilities. There should also be a risk buffer for sudden change in investment refers to the risks like: (i) underwriting risks: risk of miscalculating premiums and miscalculate technical provisions. (ii) Risks on the expected interest rates: It is considered to be an important factor contributing to the insolvency of an insurance company. (iii) Risks related to asset management: growth risk arising out of In order to maintain healthy asset liability ratio, life insurers all over the world follow one or more of the following assets-liability management methods: scenarios.
Immunisation: Duration of the liability portfolio is estimated and matched with an asset portfolio of identical durations.
11.10
RISK-BASED CAPITAL
Under the risk-based capital regime, the following risks are to be duly recognised.
11.10.1 Current Risks ●
●
● ● ● ● ●
risk. Deviation risk: price and wage levels, cancellation probability, legislation, and falling interest rates. Evaluation risk: Reinsurance risk: Operation expenses risk: Major losses risk (only non-life): The risk due to the size and number of major losses. Accumulation or catastrophe risk:
11.10.2 ● ●
Special Risks
Growth risk: Excessive growth, uncoordinated growth. Liquidation risk:
Insurance Companies ● ●
● ● ● ●
11.13
Depreciation risk: Investments losing their value due to credit, non-payment and market risks. Liquidity risk: manner. The risk that the assets are poorly matched to the liabilities. Interest rate risk: Risk of changing interest rates, including reinvestment risk. Evaluation risk: The risk that an investment has been evaluated at too high a value. Participation risk: Risk due to the undertakings holding shares in other weak undertakings.
●
11.10.3 ●
●
●
●
Non-Technical Risk
Incompetence or criminal intentions of the management. Untrained staff of the undertaking is also a risk. : Risk that economic capital of the undertaking is strained. Risk of the loss of receivables due from insurance intermediaries: Risk that external third parties do not meet their obligations. General business risks: Risk of change in general legal conditions, e.g. tax laws and regulations.
11.11 INSURANCE INDUSTRY IN INDIA The institutions providing insurance services have been an important part of working of insurance organisations in India in the following three phases:
LO 5 Review insurance industry in India and the Policy Developments
Phase-I Life insurance
1818–1956 (about 138 years)
Many private sector companies only highly competitive
General insurance
1850–1972
Many private sector companies only highly competitive
Life insurance
1956–2000 (about 44 years)
Nationalisation, public sector and state monopoly; only one company
General insurance
1972–2000 (about 28 years)
Nationalisation, public sector and state monopoly; only one company with its four subsidiaries
After 2000
Opened to the entry of private domestic and foreign companies; mixed sector of public and private sector units; oligopoly of public sector companies.
Phase-II
Phase-III Life insurance and general insurance
namely, Oriental Life Insurance Company was established in Calcutta. The general insurance service has
11.14
Financial Institutions and Markets
grown in terms of the number of companies providing those services, the volume of premium, investible 245 life and 107 general insurance companies), and all of them were in the private sector. Both the general and life insurance industries were truly competitive. The insurance business was regulated through the
were nationalised, and a new single entity namely, Life Insurance Corporation (LIC) was established by
viz.
into monopolistic and oligopolistic state or public sector insurance industry in India. After 2000, the private companies are allowed to do insurance business in India.
Insurance companies
Life insurance companies
Public
Non-life insurance companies
Private
Public
Private
Specialised
Standalone health private
Reinsurance
Figure 11.1
11.11.1 Life Insurers in India insurance companies are operating in India. The names of the private insurers are as follows: (1) Aegon Life Insurance Co. Ltd., (2) Aviva Life Insurance Co. India Ltd., (3) Bajaj Allianz Life Insurance Co. Ltd.,
Insurance Companies
11.15
Tokio Life Insurance Co. Ltd., (9) Exide Life Insurance Co. Ltd., (10) Future Generali India Life Insurance Co. Ltd., (11) HDFC Standard Life Insurance Co. Ltd., (12) ICICI Prudential Life Insurance Co. Ltd., (13) IDBI Federal Life Insurance Co. Ltd., (14) India First Life Insurance Co. Ltd., (15) Kotak Mahindra Old
Insurance Co. Ltd., (21) Shriram Life Insurance Co. Ltd., (22) Star Union Dai-ichi Life Insurance Co. Ltd., and (23) TATA AIA Life Insurance Co. Ltd. A large number of insurance policies have been introduced and popularised by the life insurance companies. A study of the provisions of these plans, the essential differences between them and the principles underlying those plans are interesting and essential from the point of view of management of insurance companies. However, since the focus of our discussion is elsewhere, we do not intend to describe these policies here. Like insurance companies in other countries, the LIC also offers various schemes, policies and plans to the investors. There are individual insurance, group insurance, group gratuity, group superannuation, nonmedical insurance, salary saving insurance, annuities and many other schemes.
11.11.2 Non-Life Insurers in India
travel insurance segments. They are Star Health and Allied Insurance Company Ltd., Apollo Munich Health Insurance Company Ltd., Max Bupa Health Insurance Company Ltd., Religare Health Insurance Company Ltd. and Cigna TTK Health Insurance Company Ltd. There are two more specialised insurers belonging to public sector, namely, Export Credit Guarantee Corporation of India for Credit Insurance and Agriculture Insurance Company Ltd. for crop insurance. GIC is the national reinsurer, providing reinsurance to the direct
(4) United India Insurance Co. Ltd. The private sector insurers are: (1) Bajaj Allianz General Insurance Co. Ltd., (2) Bharti AXA General Insurance Co. Ltd., (3) Cholamandalam MS General Insurance Co. Ltd., (4)
Ltd., (9) Liberty Videocon General Insurance Co. Ltd., (10) Magma HDI General Insurance Co. Ltd., (11) Raheja QBE General Insurance Co. Ltd., (12) Reliance General Insurance Co. Ltd., (13) Royal Sundaram General Insurance Co. Ltd., (14) SBI General Insurance Co. Ltd., (15) Shriram General Insurance Co. Ltd., Kotak Mahindra General Insurance Co. Ltd.
11.16
11.12
Financial Institutions and Markets
POLICY DEVELOPMENTS
inter alia, made the following recommendations: ●
pricing, acturial valuation, investments, personnel policies, systems development and so on; the zonal ● ●
● ●
●
●
● ●
●
● ●
● ●
● ●
The government stake in the insurance companies should be reduced to 50 percent. The GIC should cease to be a holding company. The Government should take over the holdings of GIC and its subsidiaries so that they can act as independent corporations. GIC should function exclusively as a reinsurance company. All insurance companies should be given greater freedom to operate. Private insurance companies with a minimum paid-up capital of `100 crore should be allowed to enter
The insurance companies should not be allowed to deal in both life and general insurance through a single entity. Foreign companies may be allowed to enter the industry selectively and in collaboration with domestic companies. Postal life insurance should be allowed to operate in the rural market. The insurance regulatory body be set up, and the Controller of Insurance should be separated from
The capital of the LIC should be raised from the present `5 to 200 crore, 50 percent of which should be held by the government and the remainder should be held by the public at large including the LIC employees for whom a suitable proportion be reserved. Mandatory investments of LIC in government securities should be reduced from 75 percent to 50 percent. The capital of the GIC be raised from the present `107.5 to 200 crore, its holding distribution being similar to that of the LIC. GIC and its subsidiaries should not hold more than 5 percent of capital in any company. The capital of each of the GIC subsidiaries is `40 crore at present and it is held by the GIC. The `100 crore, whose holding distribution should be similar to that of the LIC and GIC. LIC should pay interest on delays in payment beyond 30 days. LIC and GIC should operate as board-run enterprises. The institution of Ombudsman should be set up by the general insurance industry.
The insurance sector in India has gone through the process of reforms following these recommendations. The Insurance Regulatory and Development Authority (IRDA) Bill was passed by the Indian Parliament in
Insurance Companies
11.17
December 1999. The IRDA became a statutory body in April 2000 and has been framing regulations and registering the private sector insurance companies. The insurance sector was opened up to the private sector in August 2000. In the insurance sector, the major policy initiatives included are as follows: ●
●
policyholders, differentiated rates consistent with the level of risks borne as well as overall improvement in risk management. In October 2004, the RBI permitted Regional Rural Banks (RRBs) to take on insurance business as a
●
Obligations towards the rural and social sectors. The IRDA Regulations, 2002, had laid down the
●
IRDA had done away with the tariffs on the rates of general insurance products from 1 January, 2007. IRDA has advised all insurance companies to furnish details of the initiatives taken to promote microinsurance as a viable business opportunity, with particular reference to understanding the constraints faced by them. With a view to synergising the efforts of all state governments which are promoting the
●
of micro-insurance through their various agencies. While permitting foreign participation in the ventures set up by the private sector, the government
●
`50 crore and a sum which is based on a formula given in the said regulations. In the case of general insurers, the
net premiums and net incurred claims being actual but a percentage, determined by the regulations, not exceeding 50 percent. IRDA has set a working solvency margin ratio (the ratio of actual solvency margin ●
●
●
The Insurance Laws (Amendment) Bill 2015 provides for imprisonment of up to 10 years for selling policies without registration with the regulator IRDA. Under the new provisions, the Life Insurance Council and the General Insurance Council would act as self-regulating bodies for the insurance sector. It also allows insurers to raise capital through new instruments and do away with the restrictions on divestment of stake by Indian promoters of the joint venture. `100 crore.
●
`200 crore.
11.18 ●
●
●
●
● ●
●
●
Financial Institutions and Markets
The Insurance Amendment Act also permits foreign reinsurance companies to establish branches in India, provided the net worth of the foreign company is at least `5000 crore. The Bill provides for general insurance companies to raise funds from the capital markets with the capital. The Bill proposes to allow foreign insurers to operate in SEZs without regulatory control but allows the government in its discretion to allow any of the provisions of the Insurance Act to be applicable to such insurers. The Bill also proposes, amongst others, to provide greater protection to the insured by imposing penalties to those insurers who fail to meet their obligations with respect to underwriting third party motor insurance or other insurance policies in rural sectors and allows for the partial assignment of
The General Insurance Corporation is the sole national reinsurer in the country. Foreign investment has been allowed through automatic route for up to 49 percent subject to the Service tax on single premium annuity policies has been reduced from 3.5 percent to 1.4 percent of the premium paid in certain cases. Government insurance companies have been allowed to be listed on the exchanges.
●
System regulated by Pension Fund Regulatory and Development Authority (PFRDA) being exempted, ●
The Insurance Regulatory and Development Authority (IRDA) of India has formed two committees to explore and suggest ways to promote e-commerce in the sector in order to increase insurance penetration
●
IRDA has formulated a draft regulation, IRDAI (Obligations of Insures to Rural and Social Sectors) Regulations, 2015, in pursuance of the amendments brought about under section 32B of the Insurance Laws (Amendment) Act, 2015. These regulations impose obligations on insurers towards providing insurance cover to the rural and economically weaker sections of the population. The Government of India has launched two insurance schemes as announced in Union Budget 2015– Pradhan Mantri Suraksha Bima Yojana (PMSBY), which is a Personal Accident Insurance Scheme. The second is Pradhan Mantri Jeevan Jyoti Bima Yojana (PMJJBY), which is the
●
be easily availed through various government agencies and private sector outlets. ● ●
The GOI has also launched its new Social Security initiative—Aam Admi Bima Yojana (Common disability coverage to an estimated 15 million rural and landless households. Under this programmes, the State and the Union governments are expected to bear the premium of `200 for every policy holder who is insured to the extent of `50,000 in the case of natural death and `75,000 in the case of an accident.
●
Insurance Companies ●
11.19
Certain percentage of the sum assured on each policy by an insurance company is to be reinsured with
●
●
●
Private life insurance companies cannot enter into reinsurance with their promoter company or its associates, though the LIC can continue to reinsure its policies with GIC.
●
allowed to raise capital, keeping in view the need for expansion of the business in the rural and social sectors, meeting the solvency margin for this purpose and achieving enhanced competitiveness subject ●
●
`100 crore, thereby paving the way for promotion of health insurance as a separate vertical. Appeals against the orders of IRDAI are to be preferred to SAT as the amended Law provides for any insurer or insurance intermediary aggrieved by any order made by IRDAI to prefer an appeal to the Securities Appellate Tribunal (SAT). The Insurance Regulatory and Development Authority of India (IRDAI) plans to issue redesigned initial
●
through the IPO route. Insurance companies have to furnish details of expenses in the format, that is form 17D prescribed by the
●
●
to the management teams and penalise companies failing to adhere to guidelines. The service tax charged by insurance companies has increased to 12 percent from the existing 10 percent. The rate on life insurance policies where entire premium is not towards risk covered increased to 3 funds are exempt from such tax. On the other hand, the 2012 Budget mandated that the sum assured be
●
all insurance. With Health insurance portability being introduced, insured persons are likely to get credits for the envisaged that this initiative will compel the insurance industry to act towards standardisation of costs
●
●
product innovations to survive competition. The IRDA has dismantled the third-party liability pool in motor insurance and replaced it with the declined risk pool. While it is likely to have widespread implications on the size and loss ratio of the pool, the move is expected to drive the industry towards risk-based pricing. IRDA dismantled the existing India Motor-Third Party Insurance Premium (IMTPIP) with effect from March 2012, and has setup the framework for a declined risk pool for commercial vehicles.
11.20 ●
Financial Institutions and Markets
IRDA issued guidelines for health insurance portability with effect from October 2011 mandating all insurers to allow credit gained by the insured for existing conditions, e.g., waiting period and sum assured, in the event of switching between insurers/plans, provided the existing policy has been maintained without a break.
●
the regulator for seeking approval. Additional approvals from RBI, SEBI and FIPB are also mandated at a processing fee of 0.001 percent of gross written premium in preceding year. The proposed change will increase administrative costs and may cause delays. ●
● ●
reduce part-time agents thus improve customer service. Even in case the policy is surrendered, 2/3 of accumulated funds will be used to purchase an annuity. Training of tele-callers has been made mandatory.
11.13 INSURANCE PENETRATION AND DENSITY country. While insurance penetration is measured as the percentage of insurance premium to GDP, insurance density is calculated as the ratio of premium to population (per capita premium). insurance penetration from 2.71 percent in 2001 to 5.20 percent in 2009. Since then, the level of penetration was declining. However, there was a slight increase in 2015 reaching 3.44 percent compared to 3.3 percent in 2014. A similar trend is also observed in the level of insurance density, which reached the maximum of was USD 54.7. The insurance density of life insurance business had gone up from USD 9.1 in 2001 to the peak at USD 55.7 in 2010. During 2015, the level of life insurance density was USD 43.2. Similarly, the life declining trend. However, there was a slight increase in 2015 reaching 2.72 percent in 2015 when compared
USD 11.5 in 2015 (Table 11.1). Table 11.1 Insurance penetration and density in India Year
Life insurance
Non-life insurance
Total industry
Density (US dollar)
Penetration (percent)
Density (US Dollar)
Penetration (percent)
Density (US dollar)
Penetration (percent)
2001
9.1
2.15
2.4
0.56
11.5
2.71
2005
18.3
2.53
4.4
0.61
22.7
3.14
2010
55.7
4.40
8.7
0.71
64.4
5.10
2011
49.0
3.40
10.0
0.70
59.0
4.10 (Contd.)
Insurance Companies
11.21
2012
42.7
3.17
10.5
0.78
53.2
3.96
2013
41.0
3.10
11.0
0.80
52.0
3.90
2014
44.0
2.60
11.0
0.70
55.0
3.30
2015
43.2
2.72
11.5
0.72
54.7
3.44
Source: IRDA, Annual Reports Various Issues.
In the year 2015, the total insurance penetration has been highest in South Africa followed by South Korea, Japan and United Kingdom. In terms of life insurance, it is highest in South Africa followed by Japan, United Kingdom and South Korea. For non-life insurance, it is highest in the United States followed by South Korea and Germany. The total insurance density is the highest in the United Kingdom followed by the United States. For life insurance, it is highest in the United Kingdom followed by Japan and in the case of non-life insurance, it is highest in United States followed by Germany (Table 11.2). Table 11.2 Insurance penetration and density of select countries in the year 2015 Country
Insurance penetration
Insurance density
Life
Non-life
Total
Life
Non-life
Total
Australia
3.5
2.2
5.7
1830
1128
2958
Brazil
2.1
1.8
3.9
178
154
332
France
6.2
3.1
9.3
2263
1129
3392
Germany
2.9
3.4
6.3
1181
1381
2562
12.0
2.7
14.7
688
155
843
UK
7.5
2.4
9.9
3392
1067
4459
USA
3.1
4.2
7.3
1719
2377
4096
India
2.7
0.7
3.4
43
12
55
Japan
8.3
2.6
10.9
2717
837
3554
China
2.0
1.6
3.6
153
128
281
South Korea
7.3
4.1
11.4
1940
1094
3034
World
3.5
2.8
6.3
346
276
622
South Africa
Source: IRDA, Annual Reports Various Issues.
11.14 GROWTH OF LIFE INSURANCE
both the cases, the share of LIC, the public sector company has been very high in comparison with the private sector companies. The share of LIC has been
LO 6 Growth of life insurance and non-life insurance
percent (Table 11.3). The increasing in the share of the private sector after 2000–2001 is due to the opening of the insurance sector to the private companies in that year. Out of the total investments made by the life
11.22
Financial Institutions and Markets
Table 11.3 Total life insurance premium (all values are in ` crore and values in the bracket are percentage to total premium) First year premium Year
LIC
Total premium
Private
LIC
Private
2000–2001
9700.98 (99.93)
6.45 (0.07)
34892.02 (99.98)
6.45 (0.02)
2005–2006
28515.87 (73.52)
10269.6 (26.48)
90972.22 (85.78)
15083.54 (14.22)
2009–2010
71521.9 (65.08)
38372.01 (34.92)
186077.3 (70.10)
79369.94 (29.90)
2010–2011
87012.35 (68.84)
39385.84 (31.16)
203473.4 (69.77)
88165.24 (30.23)
2011–2012
81862.25 (71.83)
32103.78 (28.17)
202889.3 (70.68)
84182.83 (29.32)
2012–2013
76611.5 (71.36)
30749.58 (28.64)
208803.6 (72.70)
78398.91 (27.30)
2013–2014
90808.79 (75.47)
29516.43 (24.53)
236942.3 (75.39)
77359.36 (24.61)
2014–2015
78507.72 (69.27)
34821.81 (30.73)
239667.7 (73.05)
88434.35 (26.95)
2015–2016
97891.51 (70.50)
40970.8 (29.50)
266444.2 (72.61)
100499 (27.39)
Source: IRDA, Annual Reports Various Issues.
Table 11.4 Total investments by life insurers. Year
Public (LIC) (In ` Crore)
Private
Total
(In ` Crore) Total
(In ` Crore) Total
Total
2004–2005
418289
97.63
10162
2.37
428451
100
2009–2010
985028
81.73
220127
18.27
1205155
100
2010–2011
1148589
80.31
281528
19.69
1430117
100
2011–2012
1269070
80.26
312188
19.74
1581258
100
2012–2013
1402991
80.41
341902
19.59
1744893
100
2013–2014
1574296
80.43
383169
19.57
1957465
100
2014–2015
1786312
79.48
461210
20.52
2247522
100
2015–2016
2009119
80.30
492949
19.70
2502068
100
Source: IRDA, Annual Reports Various Issues.
Table 11.5 shows that the traditional instruments are the preferred investment alternatives over the ULIPs percent and among all the traditional investments the share of central government securities has been the
Insurance Companies
11.23
Table 11.5 Investments of life insurance: investment wise (percentage to total investments) Traditional
ULIP
Approved State and infra- investGovt. ment and other structure approved sec
Year
Central Govt. Sec
2010–2011
29.43
12.15
6.24
2011–2012
29.60
13.57
6.15
Other investments
Total
Approved
Other investments
Total
21.33
2.95
72.09
26.00
1.90
27.91
24.35
2.93
76.60
21.90
1.49
23.40
2012–2013
29.35
15.24
6.81
26.15
2.81
80.37
18.64
0.99
19.63
2013–2014
30.89
17.06
7.92
25.70
1.49
83.06
16.47
0.47
16.94
2014–2015
32.17
19.16
7.76
23.61
1.17
83.86
15.68
0.46
16.14
2015–2016
33.21
21.11
7.44
23.31
1.32
86.39
13.15
0.46
13.61
Source: IRDA, Annual Reports Various Issues.
also dominates over the private companies and among all types of funds, life funds are more preferred for
Table 11.6
Investments of life insurance: fund wise (percentage to total investments) Public (LIC)
Year
Life fund
Premium
Private
Unit trust fund
Total
Life
Premium
Unit trust fund
Total
fund 2010–2011
55.81
12.11
12.37
80.31
2.99
0.07
0.15
19.68
2011–2012
57.84
13.45
8.961
80.25
3.79
0.10
0.14
19.74
2012–2013
59.46
14.38
6.55
80.40
4.71
0.13
0.13
19.59
2013–2014
60.33
15.26
4.82
80.42
5.47
0.16
0.12
19.57
2014–2015
60.50
15.29
3.67
79.47
6.02
0.16
0.12
20.52
2015–2016
61.03
16.49
2.77
80.29
6.81
0.19
0.10
19.70
Source: IRDA, Annual Reports Various Issues.
The share of total income of LIC is also higher than the private sector companies throughout the period, and for both LIC and private companies, the share of premium income has been the highest (Table 11.7). For LIC, of operating expenses has increased continuously. For private companies, throughout the period the operating
11.24
Financial Institutions and Markets
Table 11.7 Income of life insurance companies (percentage to total income) Year
Public (LIC) Premium income
Private
Income from investments
Total
Premium income
Income from investments
Total
2008–2009
57.19
15.56
72.76
23.45
3.79
27.24
2009–2010
44.23
26.72
70.95
18.87
10.18
29.05
2010–2011
49.23
23.22
72.45
21.33
6.22
27.55
2011–2012
53.43
22.53
75.96
22.17
1.87
24.04
2012–2013
46.56
26.20
72.76
17.48
9.75
27.24
2013–2014
48.74
29.41
78.15
15.91
5.94
21.85
2014–2015
41.69
29.24
70.93
15.38
13.68
29.07
2015–2016
49.53
29.36
78.89
18.68
2.43
21.11
Source: IRDA, Annual Reports Various Issues.
Table 11.8 Expenses of life insurance companies (percentage to total expenses) Year
Public (LIC) Commission expenses
expenses
2008–2009
24.31
21.92
2009–2010
25.82
2010–2011
26.03
2011–2012 2012–2013
Private Total
Commission expenses
expenses
Total
46.23
13.24
40.53
53.77
26.06
51.88
12.88
35.24
48.12
33.12
59.15
9.72
31.13
40.85
29.18
30.95
60.12
9.25
30.63
39.88
29.11
32.88
61.99
8.80
29.21
38.01
2013–2014
29.99
36.28
66.27
7.30
26.43
33.73
2014–2015
26.84
39.77
66.61
7.71
25.68
33.39
2015–2016
26.25
38.43
64.68
8.07
27.25
35.32
Source: IRDA, Annual Reports Various Issues.
private companies. The average solvency ratio of the private companies is also higher than LIC throughout the period. Table 11.9 Equity share capital and average solvency ratio of life insurers Year
Equity capital (percent) Public (LIC)
Private
Public (LIC)
Private
2008–2009
0.03
99.97
1.54
3.04
2009–2010
0.02
99.98
1.54
2.96 (Contd.)
Insurance Companies 2010–2011 2011–2012 2012–2013 2013–2014 2014–2015
0.02 0.40 0.39 0.39 0.38
99.98 99.60 99.61 99.61 99.62
1.54 1.54 1.58 1.54 1.52
3.28 3.88 3.6 3.65 3.76
2015–2016
0.37
99.63
1.55
3.52
11.25
Source: IRDA, Annual Reports Various Issues.
11.15
GROWTH OF NON-LIFE INSURANCE
The share of public sector companies has been more than the private companies in terms of the gross direct premium and it has been observed that the share of private companies has been increasing throughout the period. The share of standalone private health insurance companies and specialised companies does not follow any particular trend (Table 11.10). The contribution of motor insurance is maximum to the total gross direct premium followed by health insurance across the years (Table 11.11). Table 11.10
Total gross direct premium of non-life insurer (Percentage)
Year
Public
Private
Standalone health private
2000–2001 2005–2006
Specialised insurers
99.93
0.07
0.00
0.00
71.09
23.86
0.00
5.04
2008–2009
56.93
36.71
1.66
4.70
2009–2010
55.67
35.63
2.74
5.95
2010–2011
54.79
36.14
3.19
5.88
2011–2012
53.93
37.30
2.77
5.99
2012–2013
52.06
39.25
2.42
6.26
2013–2014
51.27
40.05
2.81
5.88
2014–2015
51.65
40.26
3.38
4.71
2015–2016
50.98
39.96
4.18
4.87
Source: IRDA, Annual Reports Various Issues.
throughout the period, but the share of private sector insurance companies has been increasing continuously (Table 11.12). Like life insurance companies, the non-life insurance companies also mostly investing in the traditional instruments and government securities are the most preferred investment alternatives (Table 11.13).
11.26
Financial Institutions and Markets
Table 11.11
Gross direct premium of non-life insurer (segment wise) (percentage to total).
Fire
Marine
Pub- Prilic vate
Pub- Prilic vate
Public
Private
Public
Private
Standalone health insurance
Public
Private
Specialised insurers
Public
Private
2008– 7.18 3.97 2009
4.34 2.11
23.73
20.21
12.73
7.33
0.00
11.43
6.98
0.00
59.41
40.59
2009– 7.44 3.74 2010
4.49 1.77
22.22
21.25
14.39
6.73
0.00
11.09
6.89
0.00
59.63
40.37
2010– 7.25 3.45 2011
4.23 1.68
21.00
21.68
16.24
7.12
0.00
10.36
6.99
0.00
59.07
40.93
2011– 6.77 3.50 2012
3.80 1.64
22.25
23.59
15.41
6.86
0.00
9.57
6.61
0.00
57.80
42.20
2012– 6.69 3.88 2013
3.33 1.48
22.05
25.01
15.23
6.96
0.00
8.31
7.06
0.00
55.61
44.39
2013– 6.32 4.15 2014
2.96 1.51
22.37
25.54
15.44
6.74
0.00
7.58
7.40
0.00
54.67
45.33
2014– 5.64 3.87 2015
2.23 1.34
20.75
23.39
16.10
7.16
3.47
5.52
5.69
4.84
50.25
41.44
2015– 5.07 3.99 2016
1.80 1.30
20.46
23.43
17.12
7.06
4.31
5.03
5.41
5.02
49.48
41.19
Year
Motor
Health
Others
Total
Source: IRDA, Annual Reports Various Issues.
Table 11.12 Total investments by non-life insurers Year
Public
Private
(In ` Crore)
Total
(In ` Crore) total
(In ` Crore) total
total
2004–2005
34856
93.17
2555
6.83
37411
100
2009–2010
51687
77.87
14685
22.13
66372
100
2010–2011
61235
74.21
21285
25.79
82520
100
2011–2012
71104
71.63
28165
28.37
99269
100
2012–2013
83644
68.01
39348
31.99
122992
100
2013–2014
93785
67.08
46025
32.92
139810
100
2014–2015
103561
64.44
57153
35.56
160714
100
2015–2016
122560
65.15
65565
34.85
188125
100
Source: IRDA, Annual Reports Various Issues.
11.27
Insurance Companies
Table 11.13 Total Investments of non-life insurance: investment wise (all values in percentage to total) Traditional Year
ment securities
ULIP
other approved securities
loans to state
Infrastructure
Approved
Other investments
2008–2009
24.78
10.32
7.21
15.25
35.71
6.74
2009–2010
24.16
10.5
7.22
15.63
36.55
5.94
2010–2011
24.07
9.93
8.45
14.8
38.50
4.25
2011–2012
24.42
9.41
8.26
15.31
38.85
3.78
2012–2013
24.93
10.56
8.35
15.45
35.93
4.78
2013–2014
25.66
10.25
9.11
17.56
35.24
2.19
2014–2015
26.7
10.65
9.23
16.97
33.43
3.01
2015–2016
26.57
11.78
10.37
16.98
31.00
3.30
Source: IRDA, Annual Reports Various Issues.
Premium income is the major source of income and operating expense is the major source of expenditure for both public and private sector insurance companies in India (Tables 11.14 and 11.15). Like life insurance and other insurance companies. The average solvency ratio of the specialised insurers is higher than other
Table 11.14
Income of non-life insurance companies (percentage to total income)
Year
Public
Private
Premium income
Income from investments
Total
Premium income
Income from investments
Total
2008–2009
49.75
13.24
62.99
34.00
3.01
37.01
2009–2010
48.79
15.00
63.80
33.04
3.17
36.20
2010–2011
48.41
15.09
63.50
33.54
2.96
36.50
2011–2012
48.99
11.90
60.89
35.77
3.34
39.11
2012–2013
46.96
11.55
58.51
37.48
4.01
41.49
2013–2014
45.96
11.19
57.14
38.11
4.74
42.86
2014–2015
42.01
10.59
52.60
34.64
4.71
39.35
2015–2016
41.30
10.52
51.82
34.38
4.93
39.30
Panel-B
Standalone private health insurers
Specialised insures
2008–2009
—
—
—
—
—
—
2009–2010
—
—
—
—
—
—
2010–2011
—
—
—
—
—
— (Contd.)
11.28
Financial Institutions and Markets
2011–2012
—
—
—
—
—
—
2012–2013
—
—
—
—
—
—
2013–2014
—
—
—
—
—
—
2014–2015
2.91
0.18
3.08
4.05
0.92
4.97
2015–2016
3.60
0.21
3.81
4.19
0.87
5.07
Source: IRDA, Annual Reports Various Issues.
Table 11.15
Expenses of non-life insurance companies (percentage to total expenses)
Year
Public Commission expenses
2008–2009
17.19
Private Total
expenses 44.73
61.93
Commission expenses
expenses
Total
7.03
31.05
38.07
2009–2010
16.76
48.30
65.06
6.21
28.73
34.94
2010–2011
14.53
50.00
64.53
6.08
29.39
35.47
2011–2012
15.56
45.22
60.77
7.44
31.79
39.23
2012–2013
14.27
45.77
60.03
8.63
31.34
39.97
2013–2014
14.54
44.53
59.07
8.88
32.05
40.93
2014–2015
12.22
43.99
56.20
6.93
29.61
36.54
2015–2016
11.51
43.16
54.67
6.83
31.06
37.89
Panel-B
Standalone private health insurers
Specialised insures
2008–2009
—
—
—
—
—
—
2009–2010
—
—
—
—
—
—
2010–2011
—
—
—
—
—
—
2011–2012
—
—
—
—
—
—
2012–2013
—
—
—
—
—
—
2013–2014
—
—
—
—
—
—
2014–2015
1.23
4.82
6.04
0.13
1.08
1.22
2015–2016
1.57
4.81
6.39
0.10
0.95
1.05
Source: IRDA, Annual Reports Various Issues.
Table 11.16 Equity share capital of non-life insurers (in percentage) Year
Public
Private
Standalone health private
Specialised insures
Reinsurers
2008–2009
17.84
82.16
—
—
—
2009–2010
14.82
85.18
—
—
—
2010–2011
8.20
58.99
9.99
16.40
6.41
2011–2012
7.03
62.11
11.31
14.06
5.49
2012–2013
6.30
62.70
13.90
12.59
4.51 (Contd.)
Insurance Companies 2013–2014
5.86
60.80
16.44
12.69
4.20
2014–2015
5.65
60.61
17.84
12.17
3.74
2015–2016
5.16
60.83
18.70
11.90
3.41
11.29
Source: IRDA, Annual Reports Various Issues.
Table 11.17 Average solvency ratio of non-life insurers Year
Public
Private
Standalone Health Private
Specialised Insures
Reinsurers
2008–2009
2.49
2.02
6.05
—
3.67
2009–2010
2.53
2.79
4.33
—
3.71
2010–2011
2.11
2.49
1.81
6.38
3.35
2011–2012
1.87
2.36
1.72
6.64
1.59
2012–2013
2.00
2.75
2.06
6.05
2.39
2013–2014
2.07
2.01
1.85
6.81
2.73
2014–2015
2.00
2.19
2.07
4.89
3.04
2015–2016
1.76
1.94
2.61
6.52
3.48
Source: IRDA, Annual Reports Various Issues.
SUMMARY ◆
◆
compensation popularly known as insurance premium. There are eight principles of insurance, principle of utmost good faith, principle of insurable interest, principle of indemnity, principle of subrogation, principle of warranties, principle of cause proxima, principle of contribution and principle of loss minimisation.
◆
◆
premiums. They offer protection to the investors, provide means for accumulating savings and channelise funds to the government and other sectors. Broadly, there are two types of insurance companies, that is, life insurance companies and non-life insurance companies. At present, both life and general insurance business is carried out by both the public and private sector companies, but the business is dominated by the public sector organisations. The objective of Asset-Liability Management (ALM) in an insurance company is to measure and manage
◆
Solvency margin is the amount by which the assets of an insurer exceed its liabilities, and will form part
◆
◆
11.30
Financial Institutions and Markets
◆
solvency margin. ◆
private life insurance companies are operating in India. ◆ ◆
◆
IRDA has formulated a draft regulation, IRDAI (Obligations of Insures to Rural and Social Sectors) Regulations, 2015, in pursuance of the amendments brought about under section 32B of the Insurance Laws (Amendment) Act, 2015. These regulations impose obligations on insurers towards providing insurance cover to the rural and economically weaker sections of the population. The Government of India has launched two insurance schemes as announced in Union Budget 2015– Pradhan Mantri Suraksha Bima Yojana (PMSBY), which is a Personal Accident Insurance Scheme. The second is Pradhan Mantri Jeevan Jyoti Bima Yojana (PMJJBY), which is the
◆
in a country. While insurance penetration is measured as the percentage of insurance premium to GDP, insurance density is calculated as the ratio of premium to population (per capita premium). ◆
◆
◆ ◆
The traditional instruments are the preferred investment alternatives over the ULIPs throughout the period for the insurance companies. The average solvency ratio of the private companies is also higher than LIC throughout the period. The contribution of motor insurance is maximum to the total gross direct premium followed by health insurance across the years.
◆
◆
throughout the period, but the share of private sector insurance companies has been increasing continuously. The average solvency ratio of the specialised insurers is higher than other types of companies throughout the period.
KEY TERMS Insurance Insurance Premium Insurance Policy Principles of Insurance Indemnity Life Insurance
Reinsurance Asset-Liability Management Solvency I Solvency II Solvency Margin Solvency Ratio Risk Assessment
Risk Treatment Risk-Based Capital Insurance Penetration Insurance Density Standalone Private Health Insurers Specialised Insures
Insurance Companies
11.31
QUESTIONS 1. What is the objective of insurance? Explain the principles of insurance. 2. Explain the nature and objective of life and non-life insurance companies. 3. Highlight the risk management process of an insurance company. 4. What is solvency? Analyse the features of Solvency I and Solvency II. 5. Write a brief note on the various policy measures taken for the development of insurance industry in India. ID of various countries. 7. Analyse the trends in the growth of the life and non-life insurance companies during the period of liberalisation in India.
Mutual Funds
12
CHAPTER Learning Objectives LO 1 LO 2
Know Mutual Funds: advantages, disadvantages, economic growth and operation Identify key concepts related to mutual fund
LO 3 LO 4 LO 5 LO 6
Explain the determinants of mutual fund performance and the three ratios used for evaluating the performance of mutual funds Discuss Hedge Fund which is an alternative to mutual fund
12.1 INTRODUCTION
Investment trusts
unit trust is a
12.2
Financial Institutions and Markets
Mutual savings banks
different mutual funds and their schemes individually for lack of space, it presents primarily an aggregative
12.2 WHAT IS A MUTUAL FUND? Mutual Fund
investors in the MF are given the share in its total funds which is proportionate
LO 1 Know Mutual Funds: advantages, disadvantages, economic growth and operation
Mutual Funds
12.3
12.2.1 Advantages and Disadvantages of Mutual fund Investments1
2
Financial institutions such as unit trusts and Mutual
as follows: ●
1 2 3
Jones, C P, Investments: Analysis and Management, Second Edition, John Wiley & Sons, New York, 1988, pp. 539–563. Henning, C N, and others, Financial Markets and the Economy, Prentice-Hall, New Jersey, 1978, pp. 145–49.
12.4
Financial Institutions and Markets
●
●
●
●
●
●
●
and dividend reinvestment plans, one can systematically invest or withdraw funds according to his ●
Many mutual funds cater the need of investors and allow them to switch from one fund to another they can switch from growth to income funds and vice versa
●
or disadvantages: ●
●
●
Mutual Funds
12.5
●
12.3 MUTUAL FUNDS AND ECONOMIC GROWTH The Economist
12.4 ORGANISATION OF A MUTUAL FUND
Trustees
Sponsors
Asset Management Company
Mutual Fund
Custodian
Transfer Agents
Source:
Figure 12.1
Organisation of mutual fund.
12.6
Financial Institutions and Markets
12.5 KEY CONCEPTS RELATED TO MUTUAL FUND4 Entry Load
LO 2 Identify key concepts related to mutual fund
Exit Load It is the amount of money that the investor needs to pay to the mutual fund companies when
Sale Price Systematic Investment Pan
Systematic Encashment Plan
Switch
Monthly Income Plans
Net Asset Value (NAV)
4
http://www.sebi.gov.in/faq/mf_faq.html
Mutual Funds
t
12.7
t t
where
t t
12.6
TYPES OF SCHEMES5 LO 3 Understand the classification of mutual funds on the basis of operations, investment objectives and others
Open-ended Fund (OEF)
5
https://www.amfiindia.com/
12.8
Financial Institutions and Markets
Classification of Mutual Funds
Classification by Operation
Open ended fund
Classification by Investment Objectives
Others
Growth Fund
Index Fund
Balanced Fund
Tax Saving Fund
Income Fund
Exchange Traded Fund
Money Market Fund
Gold ETF
Gilt Funds
Fund of Fund (FoF)
Floating Rate Fund
Quantitative Fund
Treasury Management Funds
Assured Return Scheme
High Yield Debt Funds
Capital Protection Oriented
Fixed Maturity Plan
Arbitrage Fund
Monthly Income Plan
Load/Unload Fund
Sector Funds
Life style Fund
Close-ended fund
Interval fund
Figure 12.2
Close-ended Fund (CEF)
Mutual Funds
Interval Fund
Growth Fund
Income Fund
12.9
12.10
Financial Institutions and Markets
Balanced Fund
Money Market Mutual Funds
Gilt Funds
Floating Rate Funds
Treasury Management Funds
High Yield Debt Funds
Mutual Funds
Fixed Maturity Plans (FMPs)
Monthly Income Plan
Sector Funds
12.6.3 Other Funds
Index Funds
12.11
12.12
Financial Institutions and Markets
Tax Saving Funds
Exchange-Traded Funds (ETFs)
`
Mutual Funds
Gold ETFs
Fund of Fund
Quantitative Fund
Assured Return Schemes Capital Protection-Oriented Funds
Arbitrage funds
12.13
12.14
Financial Institutions and Markets
Load Fund
Life Style fund
12.7 DETERMINANTS OF MUTUAL FUND PERFORMANCE Factors affecting expected returns include asset allocation and systematic
12.8 MUTUAL FUND PERFORMANCE EVALUATION6
6
www.nseindia.com
LO 4 Explain the determinants of mutual fund performance and the three ratios used for evaluating the performance of mutual funds
Mutual Funds
12.15
Sharpe Ratio
E ( Rmf ) - R f smf Here, E Rmf
Rf
smf is the
standard deviation of returns in the denominator as its proxy of total that returns on
Example
Treynor Ratio
calculated as E ( Rmf ) - R f bm Here, E Rmf
Rf
bm is
12.16
Financial Institutions and Markets
Jensen Ratio
a bm a Ri Rm Rf bm a
Ri Rf
bm Rm
Rf
Example
¥ example, we got a positive alpha that shows that the mutual fund manager earned more than enough return
12.9 STRUCTURE AND SIZE OF THE MUTUAL FUND INDUSTRY IN INDIA
Types of schemes
Numbers Numbers Numbers Numbers Numbers (2002–2003) (2006–2007) (2012–2013) (2014–2015) (2015–2016)
a. Income/debt-oriented schemes (i) Liquid/Money Market (ii) Gilt (iii) Non-assured return debt schemes (iv) Assured return debt schemes (v) Infrastructure development
202 32 31 118 21 —
450 55 28 367 — —
857 55 42 760 — —
1346 52 45 1245 — 4
1831 53 41 1730 — 7
b. Growth/equity-oriented schemes (i) ELSS (ii) Others
168 47 121
267 40 227
347 50 297
434 55 379
473 60 413
36
38
32
25
28
c. Balanced schemes
(Contd.)
12.17
Mutual Funds d. Exchange-traded fund (i) Gold ETF (ii) Other ETF
—
—
37 14 23 21
31
30
406
755
1294
1884
2420
e. Fund of fund investing overseas Grand total
48 14 34
58 13 45
Source: SEBI annual report 2002–2003, 2006–2007, 2013–2014/2014–2015 and 2015–2016.
(Amount in ` crore) Scheme/MF
Gross mobilisation
Repurchase and redemptions
2002–2003 2006–2007 2015–2016
Net mobilisation
2002–2003
2006–2007
2015–2016
2002–2003
2006–2007 2015–2016
Private sector MFs Open–ended (OE)
283632 (97.33)
1482588 (76.48)
11092349 (80.58)
271675 (87.49)
1462528 (79.29)
10995460 (80.66)
11957 (285.03)
20060 (21.34)
96889 (42.98)
Close–ended (CE)
463 (0.16)
117286 (6.05)
33927 (0.25)
351 (0.11)
58308 (3.16)
39,423 (0.29)
112 (2.67)
58978 (62.75)
–5,496 (–2.44)
284095 (97.48)
1599874 (82.53)
11126276 (80.83)
272026 (87.61)
1520836 (82.45)
11034883 (80.95)
12069 (287.70)
79038 (84.10)
91393 (40.54)
Open–ended (OE)
7327.15 (2.51)
317570 (16.38)
2629048 (19.10)
30377 (9.78)
313730 (17.01)
2591330 (19.01)
229 (5.46)
3840 (4.09)
91394 (40.54)
Close–ended (CE)
3.85 (0.01)
21050 (1.09)
10230 (0.07)
8106 (2.61)
9942 (0.54)
5162 (0.04)
–8103 (–193.1)
11107 (11.82)
42651 (18.92)
Total
7331 (2.52)
338620 (17.47)
2639278 (19.17)
38483 (12.39)
323672 (17.55)
2596492 (19.05)
–7874 (–187.7)
14947 (15.90)
134045 (59.46)
Open–ended (OE)
290959.2 (99.84)
1800158 (92.86)
13721397 (99.68)
302052 (97.28)
1776258 (96.30)
13586790 (99.67)
12186 (290.49)
23900 (25.43)
188283 (83.52)
Close–ended (CE)
466.85 (0.16)
138336 (7.14)
44157 (0.32)
8457 (2.72)
68250 (3.70)
44585 (0.33)
–7991 (–190.5)
70085 (74.57)
37155 (16.48)
Grandt
314706 (100)
1938494 (100)
7267885 (100)
310509 (100)
1844509 (100)
7191346 (100)
4199 (100)
93985 (100)
76539 (100)
Total
Public sector MFs
Total MFs
Notes: Figures in brackets are percentage to grand totals; UTI is added to Public sector mutual funds. Source: SEBI annual report 2002–2003, 2006–2007, and 2015–2016.
314706.2 (100.00)
—
—
394.42 (0.13)
1938494 (100.00)
—
— — —
4473 (0.23)
2003
2002– 2007
2006– 2016
2015– 2003
2002–
—
—
—
—
2021.93 (0.10)
4596.26 (0.23) 678.9 (14.77) 3917.36 (85.23)
—
—
—
—
2762 (0.15)
66145 (3.59) 216 (0.33) 65929 (99.67)
64067 (68.17) 4985 (7.78) –964 (–1.50) 60046 (93.72) —
2007
2006–
691.10 (0.01)
12145 (0.09) 931 (7.67) 11214 (92.33)
8744 (0.06)
—
—
—
—
–1627.5 (–38.80)
2003
2002– 2007
2006– 2016
2015–
–417.56 (–0.31)
7821 (5.83) –903 (–11.55) 8724 (111.55)
19742 (14.71)
74027 (55.17) 6415 (8.67) 67612 (91.33)
—
—
—
—
14071.86 (12.87)
14316.26 (13.10) 1258.34 (8.79) 13057.92 (91.21)
—
—
—
—
9110 (2.79)
1967 (0.16)
22409 (1.82) 6346 (28.32) 16063 (71.68)
39146 (3.18)
123598 386403 (37.88) (31.34) 10212 41696 (8.26) (10.79) 113386 344707 (91.74) (89.21)
33007.5 80911.25 193585 782,900 (24.60) (74.03) (59.33) (63.50) 17108 13734.25 72006 199,404 (51.83) (16.97) (37.20) (25.47) 759 3910.21 2257 16,306 (2.30) (4.83) (1.17) (2.08) 14738 63266.79 119322 565460 (44.65) (78.19) (61.64) (72.23) 402.5 — — 1730 (1.22) 0.22
2016
2015–
Assets as on 31st March
Cumulative position of Net
93984 134179.9 109299.4 326293 1232825 (100.00) (100.00) (100.00) (100.00) (100.00)
—
—
—
—
1711 (1.82)
91249 43.32 28206 (0.67) (1.03) (30.01) 3566 –657.33 4453 (3.91) (–1517.38) (15.79) 87683 700.65 23753 (96.09) (1617.38) (84.21)
13794043 2020710 1844508 13631373 4194.4 (100.00) (100.00) (100.00) (100.00) (100.00)
274 (Neg.)
19966.25 (0.14) 28.25 (0.14) 19938 (99.86)
28487 (0.21)
193763 (1.40) 9981 (5.15) 155295 (80.15)
13551553 2014091 1775601 13518544 5778.58 (98.24) (99.67) (96.26) (99.17) (137.77) 13010039 1900242 1621805 12992930 5004.97 (96.00) (94.35) (91.34) (96.11) (86.61) 13158 5892.15 2816 12,399 –690.47 (0.10) (0.29) (0.16) (0.09) (–11.95) 527953 107957.28 150980 513215 1464.08 (3.90) (5.36) (8.50) (3.80) (25.34) 403 — — — — (0.00)
2016
2015–
Repurchase/Redemption
22.7 17.08 70.2
8.7
—
—
—
—
40.73
—
—
—
—
21.58
13.9
–18.3
99.3
–4.6
58.3
48.5
12.8
–5.7 –17
5.6
–28.8 54.99 22.1
12
— — —
–8.33 24.27
9.6 97.95 3.3
–6.1 –28.01 11.6
12.8
2015
54.98
2006
2005– 2014–
19
2002
2001–
% Variation over
Note: Figures in brackets are percentage to grand totals. Source: SEBI Annual Report 2002–2003, p.82, 2006–2007, p.63, 2015–2016, p.109.
Grand total (A + B + C + D + E)
F
(ii) Other ETFs
Fund of funds investing overseas
—
Exchange–traded fund (i) Gold ETF
D
E
—
Balanced schemes
C
94352 (4.87) 4669 (4.95) 89683 (95.05)
Growth/equity– oriented schemes (i) ELSS (ii) Others
B
4639.59 (1.47) 21.58 (0.47) 4618.01 (99.53)
Income/debt– 309672.2 1839669 oriented schemes (98.40) (94.90) (i) Liquid/Money 195047.14 1626790 Market (62.99) (88.43) (ii) Gilt 5201.67 1853 (iii) Debt (other than (1.68) (0.10) assured returns) 109423.37 211026 (iv) Infrastructure (35.34) (11.47) development — —
2007
2003
A
2006–
2002–
Gross fund mobilised
12.18 Financial Institutions and Markets
Mutual Funds
12.19
`
Year
Equity (` in crore) Gross purchase Gross sales
Debt (` in crore)
Net purchase/sales
Gross purchase Gross sales
Net purchase/sales
2000–2001
17375.78
20142.76
–2766.98
13512.17
8488.68
900.43
2001–2002
12098.11
15893.99
–3795.88
33583.64
22624.42
10959.22
2002–2003
14520.89
16587.59
–2066.7
46663.83
34059.41
12604.42
2003–2004
30654.14
28906.97
1747.17
54076.73
32775.75
21300.98
2004–2005
45045
44597
448
62186
45199
16987
2005–2006
100436
86134
14302
109805
73004
36801
2006–2007
135948
126886
9062
153733
101190
52543
2007–2008
217578
201274
16306
298605
224816
73790
2008–2009
144069
137085
6984
327744
245942
81803
2009–2010
195662
206173
–10512
624314
443728
180588
2010–2011
154919
174893
–19975
764142
515290
248854
2011–2012
132137
133494
–1358
1116760
781940
334820
2012–2013
113758
136507
–22749
1523393
1049934
473460
2013–2014
112131
133356
–21224
1538087
994842
543247
2014–2015
231405
190687
40722
1717155
1130138
1320825
2015–2016
281334
215898
66144
1497676
1121386
1336577
Source: SEBI Annual Report, Various Issues.
12.20
Countries
Financial Institutions and Markets
World
Brazil
United States
France
Germany
Italy
United Kingdom
China
India
Japan
Total Net Assets of Mutual Fund (US $ Million) 2001
11871028
148,189
6,974,913
713,378
213,662
359,879
316,702
N/A
15,284
343,907
2005
17771027
302,927
8,904,824 1,362,671
296,787
450,514
547,103
N/A
40,546
470,044
2008
20,631,003
479,321 10,151,925 1,591,082 1,130,972
288,354
504,681
276,303
62,805
575,327
2009
25,088,939
783,970
11,889,750 1,805,641 1,342,275
297,839
729,141
381,207 130,284
660,666
2010
27,374,359
980,448 12,825,352 1,617,176 1,389,306
248,838
854,413
364,985 111,421
785,504
2011
26,578,593 1,008,928 12,680,481 1,382,068 1,356,446
191,479
816,537
339,038
87,519
745,383
2012
30,213,561 1,070,998 14,393,789 1,473,085 1,587,390
189,937
985,517
437,449 114,489
738,488
2013
34,462,543 1,018,641 16,725,436 1,531,500 1,824,429
223,403 1,166,834
460,332 107,895 1,157,972
2014
37,072,351
989,542 17,849,645 1,940,490 1,847,268
217,363 1,501,308
708,884 136,834 1,171,974
2015
37,190,528
743,530 17,752,399 1,832,073 1,799,754
207,867 1,578,360 1,263,130 168,186 1,328,634
Number of Mutual Funds 2001
53,371
2097
8305
7603
1077
1059
1749
N/A
297
2867
2005
56,868
2685
7975
7758
1076
1035
1680
N/A
445
2640
2008
76,519
4169
8768
8301
5633
977
2371
429
551
3333
2009
75,293
4744
8463
7982
5967
880
2266
547
590
3656
2010
77,836
5618
8478
7791
5923
823
2204
660
658
3905
2011
81,429
6513
8722
7744
5813
822
1941
831
680
4196
2012
82,410
7468
8784
7392
5868
733
1922
1065
692
4384
2013
88,747
8072
9009
7154
5905
777
1910
1415
699
7818
2014
98,832
8560
9339
11273
5509
687
2597
1763
768
8761
2015
100,494
8783
9710
11122
5604
713
2573
2558
804
9804
Net Sales of Mutual Fund (US $ Million) 2001
904,012
N/A
623,152
91,737
19,144
–18,555
18,183
N/A
3114
–9627
2005
970,736
5293
382,400
76,441
10,557
–19,215
21,773
N/A
4914
77,458
2008
540,820
–32,653
817,413
–68,351
–1,601 –108,494
–3,506
35,721
2754
5430
2009
483,428
47,317
121,744
6164
58,262
–11,437
43,241
–35,612
43,029
32,571
2010
505,846
58,316
–6766
–110,856
99,321
–30,507
68,417
–15,115 –35,950
68,847
2011
345,087
49,995
197,553
–125,565
55,803
–41,845
13,696
27,179
532
33,028
(Contd.)
Mutual Funds
12.21
2012
1,223,059
56,099
575,621
–30,528
94,210
–14,247
30,567
90,505
15,832
21,526
2013
1,292,283
34,713
546,161
–99,007
110,189
16,796
26,794
–3842
2724
129,992
2014
1,794,520
1,886
559,986
–26,455
120,364
38,415
40,023
167,834
7895
97,243
2015
1,950,142
13,531
353,136
24,178
149,783
11,339
9534
470,457
33,195
233,405
Note: N/A indicates the value of that variable is not available. Source: Investment Company Institute, European Fund and Asset Management Association and other National Fund Associations.
Year
Debt fund Hybrid fund performance performance Index Index
NIFTY SENSEX NSE 500 Saving Fixed 50 bank deposit rate rate
Equity fund performance Index
Money market fund performance Index
–42.99
9.45
10.58
–39.44
2002
6.86
7.88
17.72
8.75
–1.62
2003
–4.54
6.79
11.20
2.91
–13.40
2004
119.71
4.94
8.86
44.69
81.14
2005
30.28
4.61
1.00
12.67
14.89
2006
77.83
5.44
4.21
32.62
2007
7.11
6.99
5.48
8.09
2001
–24.88
–27.93
–42.99
4.00
9.75
–3.75
2.83
4.00
9.38
–12.12
–9.56
3.96
8.13
83.38
107.81
3.50
5.88
16.14
21.64
3.50
5.13
67.15
73.73
64.16
3.50
5.25
12.31
15.89
8.07
3.50
5.75
2008
22.07
8.04
8.46
13.83
23.89
19.68
21.64
3.50
7.00
2009
–37.28
8.62
10.88
–15.62
–36.19
–37.94
–40.02
3.50
7.50
2010
93.15
4.64
6.63
53.09
73.76
80.54
87.95
3.50
8.05
2011
10.06
6.24
5.32
8.93
11.14
10.94
7.26
3.50
6.13
2012
–4.36
8.90
8.78
4.54
–9.23
–10.50
–8.75
3.96
8.25
2013
5.66
9.00
10.32
7.07
7.31
8.23
5.13
4.00
9.04
2014
20.95
9.35
5.58
13.16
17.98
18.85
17.72
4.00
8.63
2015
43.78
9.04
12.47
31.05
26.65
24.89
33.56
4.00
8.08
Source: CRISIL-AMFI Mutual Fund Performance Indices, 2017.
12.10
HEDGE FUND7
Hedge funds are a special type of investment vehicles, as an alternative to mutual funds, which pools funds from investors and invest in various investment avenues
7
http://economictimes.indiatimes.com/definition/hedge-fund
LO 5 Discuss Hedge Fund which is an alternative to mutual fund
12.22
Financial Institutions and Markets
12.10.1 Characteristics of Hedge Fund ●
●
is ` Hedge fund investment universe contains all categories of investments such as land, real estate, stocks, derivatives
● ●
12.10.2 Hedge Fund Strategies ●
Equity Market Neutral:
●
Convertible Arbitrage:
●
Fixed-Income Arbitrage: positions and short positions in different securities to hedge against the directional market movements to
●
Distressed Securities:
Mutual Funds
12.23
●
Merger Arbitrage: current market prices of corporate securities and their value upon successful completion of a takeover,
●
Global Macro:
●
Fund of Funds:
●
●
●
●
●
●
12.24
Financial Institutions and Markets
It is postulated and evident that assets with good fundamentals are considered stocks gives rise to phenomenal returns amongst other asset classes provided
investment plan which takes care of the risk due to adverse selection of assets
●
●
●
●
SUMMARY ◆
LO 6 Illustrate the benefits of Systematic Investment Plan (SIP) three broad categories under which the schemes floated by mutual funds are classified
Mutual Funds ◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
KEY TERMS Mutual Fund
12.25
12.26
Financial Institutions and Markets
Money Market Mutual Fund Index Fund Interval Fund Growth Fund Income Fund
Hedge Fund Quantitative Fund
QUESTIONS
Miscellaneous NonBank Financial Intermediaries
13
CHAPTER
Learning Objectives LO 1 LO 2
Recognise the difference between NBFCs and banks Identify the NBFCs registered with RBI and their new regulatory framework
LO 3 LO 4 LO 5
Know more about other NBFCs which are not regulated by the RBI Understand Credit Rating objectives and the major rating agencies in India Explain the credit rating process
13.1 INTRODUCTION
13.2 NATURE OF NBFC AND HOW IT IS DIFFERENT FROM THE BANK A Non-Banking Financial Company (NBFC) is a company registered under acquisition of shares/stocks/bonds/debentures/securities issued by government
LO 1 Recognise the difference between NBFCs and banks
13.2
Financial Institutions and Markets
whose principal business (other than securities) or providing any services and sale/purchase/construction of immovable property. A non-banking institution which is a company and has principal business of receiving deposits under any
Non-Banking Financial Company (
playing a positive role in accessing certain depositor segments and catering to specialised credit requirements
Ltd. NBFCs from their shareholders. Regulated deposit means a deposit which is subject to certain ceilings
Exempted deposits signify those types of deposits/borrowings that are outside the scope of the regulatory
appearing in the audited balance sheet of the company as reduced by the amount of accumulated balance of The differences between NBFC and bank are as follows: (i) NBFC cannot accept demand deposits; (ii) NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on itself;
of ` from the requirement of registration with RBI viz 1
Financial activity as a principal business is when a company’s financial assets constitute more than 50 percent of the total assets and income from financial assets constitute more than 50 percent of the gross income. A company which fulfils both these criteria will be registered as NBFC by RBI. The term ‘principal business’ is not defined by the Reserve Bank of India Act. The Reserve Bank has defined it so as to ensure that only companies pre-dominantly engaged in financial activity get registered with it and are regulated and supervised by it. Hence, if there are companies engaged in agricultural operations, industrial activity, purchase and sale of goods, providing services or purchase, sale or construction of immovable property as their principal business and are doing some financial business in a small way, they will not be regulated by the Reserve Bank. Interestingly, this test is popularly known as 50-50 test and is applied to determine whether or not a company is into financial business.
Miscellaneous Non-Bank Financial Intermediaries
13.3
13.3 NBFCS REGISTERED WITH RBI2
viz.
LO 2 Identify the NBFCs registered with RBI and their new regulatory framework
types of NBFCs are as follows:
13.3.1 Asset Finance Company (AFC) Asset Finance Company
services are the part of Asset Finance Companies. Hire-purchase credit are advanced to be fractionally liquidated through a contractual obligation. The goods whose purchases are
ownership is immediately transferred to the buyer. We shall also use these two terms interchangeably. Another term which is used in this context is ‘consumer credit’. It is a concept with limited scope in comparison with
2 3
https://www.rbi.org.in/Scripts/FAQView.aspx?Id = 92 NBFCs whose asset size is of `500 crore or more as per last audited balance sheet are considered as systemically important NBFCs.
13.4
Financial Institutions and Markets
may discount or purchase instalment receivables on an outright basis. This is rendered possible because
cash is made directly available to the buyer who repays it in the form of instalments over a given period;
productive goods and services rather than for purely consumer goods. A large part of instalment credit in India is given for the purchase of commercial vehicles. The borrowers in this market are transport operators
and so on.
the quality of services rendered by them could be improved through consolidation. The sources of funds
sales or purchases of goods by way of instalment credit directly to buyers and sellers; it has not been possible
the hirers. Lease Finance
Miscellaneous Non-Bank Financial Intermediaries
13.5
series of payments to the lessor for the use of an asset. It may be cancelled only if the lessor is reimbursed for
a guarantee from the lessee to the lender.
manufacturers to retain control of the market and customers. The growth of leasing or leasing industry means an increase in the number of lessors and an increase in the volume of lease business. The lessors may be
framework and tax policy of the government.
manufacturing companies. The prospective entry of banks into this business is one of the major developments from the point of view of the growth of leasing business in India. The number of subsidiaries set up by banks
13.3.2 Investment Company (IC) business the acquisition of securities. ICs are numerically the most important part of NBFCs. Their
rates of interest on deposits accepted by them. But the higher interest rate is not the only reason why people choose them for keeping their deposits; the other reason is the possibility of borrowing funds in amounts not
13.6
Financial Institutions and Markets
loan business in spite of higher interest rates because these loans are often unsecured and the procedures are
similar to the unorganised money market. The question that arises is whether these institutions pose any competition for the commercial banks. There
had pointed out that a part of their funds represents activation of currency balances. The loan business of these institutions is supplementary/complementary to that of banks. They give loans to borrowers and for to the problem of regulating and controlling these institutions for two reasons. (a) Their managements have
country.
13.3.3 Systemically Important Core Investment Company (CIC-ND-SI) following conditions:
(b) Its investment in the equity shares (including instruments compulsorily convertible into equity shares
sale for the purpose of dilution or disinvestment;
to and investments in debt issuances of group companies or guarantees issued on behalf of group companies; ` (f) It accepts public funds.
13.3.4 Loan Company (LC)
but does not include an Asset Finance Company. Loan companies constitute the major part of the NBFCs
Miscellaneous Non-Bank Financial Intermediaries
13.7
be recalled that these schemes are very much like those introduced by banks for the same purpose. Although
personal credit standing of the borrowers. The rate of interest charged on these loans is equivalent to the rates
hundis.
13.3.5 Infrastructure Finance Company (IFC) of `
13.3.6 Infrastructure Debt Fund: Non-Banking Financial Company (IDF-NBFC) Infrastructure Debt Fund:
4
Owned Fund means aggregate of the paid-up equity capital, preference shares which are compulsorily convertible into equity, free reserves, balance in share premium account and capital reserves representing surplus arising out of sale proceeds of asset, excluding reserves created by revaluation of asset, after deducting therefrom accumulated balance of loss, deferred revenue expenditure and other intangible assets. ‘Net Owned Fund’ is the amount as arrived at above, minus the amount of investments of such company in shares of its subsidiaries, companies in the same group and all other NBFCs and the book value of debentures, bonds, outstanding loans and advances including hire purchase and lease finance made to and deposits with subsidiaries and companies in the same group, to the extent it exceeds 10 percent of the owned fund.
13.8
Financial Institutions and Markets
13.3.7 Non-Banking Financial Company-Micro Finance Institution (NBFC-MFI)
criteria: ` (b) Loan amount does not exceed `
` `
(c) Total indebtedness of the borrower does not exceed ` ` without penalty; (e) Loan to be extended without collateral;
13.3.8 Non-Banking Financial Company–Factors (NBFC-Factors)
Business transactions both at the retail and wholesale levels take place partly on the basis of cash and partly services; the sellers allow the buyers some time before they make payments for goods received. The sellers extend credit (known as trade credit) to the buyers during this interval of time (known as net credit period) between receipt of goods and payment of cash. The dues which arise during this process of credit sales are buyers. The sellers may extend credit without demanding any legal evidence to the liability of the buyers (open account trade credit) or they may require promissory notes or trade acceptances from buyers. Although
and a good receivables management consists in reducing the collection period to the minimum without adversely affecting the sales. The sellers may make their own internal arrangements to collect receivables or business world.
Miscellaneous Non-Bank Financial Intermediaries
13.9
send the payment directly to the factor. It now becomes the responsibility of the factor to collect receivables.
period). The RBI has been trying to reduce this period by issuing and implementing guidelines regarding factoring service also may be of great help in this respect.
13.3.9 Mortgage Guarantee Companies (MGC)
`
13.3.10 NBFC: Non-Operative Financial Holding Company (NOFHC)
permissible under the applicable regulatory prescriptions.
13.3.11 Residuary Non-Banking Company (RNBC)
13.10
Financial Institutions and Markets
restrictions on the quantum of deposits they can raise. They have certain adverse features: (a) negative net worth in some cases; (b) not submitting periodic returns to the regulatory authority; (c) absence of designation of their banks by some of them; and (d) their mushroom growth.
13.4 NEW REGULATORY FRAMEWORK OF NBFCS REGISTERED WITH RBI ●
The minimum Net Owned Fund (NOF) criterion for existing NBFCs (those registered prior to April ` required minimum levels.
●
●
`
introduced for them. ●
●
●
NBFCs with assets of less than ` accessing public funds and those not having customer interface will not be subjected to conduct of business regulations. Assets of multiple NBFCs in a group shall be aggregated to determine if such consolidation falls within
13.5 GROWTH OF NBFCs REGISTERED WITH RBI
Miscellaneous Non-Bank Financial Intermediaries
Table 13.1
13.11
Number of NBFCs Registered with RBI Year
NBFCs
NBFCs-D
2000
8451
679
2001
13815
776
2002
14077
784
2003
13849
710
2004
13764
604
2005
13261
507
2006
13014
428
2007
12968
401
2008
12809
364
2009
12740
336
2010
12630
308
2011
12409
297
2012
12385
271
2013
12225
254
2014
12029
241
2015
11842
220
2016
11682
202
Source: RBI, RTPBI, Various issues
Table 13.2 Number of RBI Registered NBFCs on the Basis of Ownership Items
2009–2010
2010–2011
2011–2012
NBFCs- NBFND-SI Cs-D
NBFCs- NBFCsND-SI D
NBFCs- NBFND-SI Cs-D
2012–2013
2013–2014
2014–2015
2015–2016
NBFCs- NBFCs- NBFCs- NBFCs- NBFCs- NBFCs- NBFCs- NBFCsND-SI D ND-SI D ND-SI D ND-SI D
Govt Companies
9
9
9
9
9
7
9
7
NA
NA
7
10
5
16
Non Govt Companies
258
302
310
288
366
266
409
247
NA
NA
211
190
194
193
Public ltd Companies
161
293
181
279
198
263
218
245
NA
NA
209
105
188
105
Private ltd Companies
97
9
129
9
168
3
191
2
NA
NA
2
85
6
88
Total no. of Companies
267
311
319
297
375
273
418
254
NA
NA
220
200
199
209
Source: RBI, RTPBI, Various Issues.
13.12
Financial Institutions and Markets
constitute the largest share followed by the investments. Table 13.3 Aggregate Public Deposit of NBFCs-D
(Amount in ` Crore)
Year
Aggregate Public Deposit
1997–1998
13572
2002–2003
5035
2006–2007
2077
2009–2010
2831
2010–2011
4098
2011–2012
5735
2012–2013
7085
2013–2014
10808
2014–2015
28941
2015–2016
37900
Source: RBI, RTPBI, Various issues
13.6 OTHER NBFSCs IN INDIA All the NBFCs are not regulated by RBI. Housing Finance Companies are
LO 3 Know more about other NBFCs which are not regulated by the RBI
of regulation. The characteristics of some of the important NBFCs operating in India regulated by other regulatory bodies are explained as follows:
13.6.1 Housing Finance Companies
3400(1.43)
2016
37900(15.89)
27500(14.28)
26000(13.79)
7100(5.68)
5800(5.0)
4062(3.9
2831(3.0)
2042(4.3)
5035(13.4)
Public Deposit
63000(4.87)
67800(4.74)
2015
2016
941100(72.84)
866900(70.90)
255000(17.85) 1033500(72.34)
227100(17.58)
231100(18.91)
206800(18.50) 798000(71.40)
—
—
—
11100(8.89)
10700(9.1)
14404(13.7)
11229(11.9)
5136(10.7)
589(1.6)
Other liabilities
72500(5.07)
60800(4.71)
60800(4.97)
53700(4.80)
40900(4.44)
45700(6.00)
36082(6.12)
Current Liability and provisions
205200(14.36)
204200(15.81)
188800(15.45)
174200(15.58)
159500(17.31)
150700(19.8)
98170(16.67)
Investment
Balance sheet of NBFC-ND-SI
163500(68.53)
134100(69.67)
131700(69.87)
84700(67.9)
80900(69.2)
69816(66.2)
64078(68.0)
32563(67.8)
24480(64.9)
Borrowing
Balance sheet of NBFC-D
13398(35.5)
1070900(74.95)
951600(73.65)
827300(67.67)
749700(67.07)
590000(64.03)
470900(61.86)
350470(59.52)
Loans and advances
Loans and advances
Assets
211700(88.68)
159000(86.08)
158500(84.12)
91800(73.55)
84100(68.82)
77901(73.9)
71119(75.5)
10602(22.1)
43400(3.03)
46300(3.58)
NA
35800(3.20)
35700(3.88)
31300(4.12)
25407(4.32)
Cash and bank balances
Assets
8500(3.56)
6900(3.73)
5800(3.07)
7200(5.77)
7400(6.05)
21102(20.0)
18498(19.64)
7508(15.64)
4338(11.5)
Investments
Source: RBI, RTPBI, Various issues. Notes: The values in the bracket show the percentage to total
59200(5.30)
63800(5.21)
2013
2014
190100(20.63) 639800(69.45)
159900(21.00) 517500(67.98)
38200(5.02)
50500(5.48)
2011
381850(64.85)
Total Borrowings
111967(19.01)
Reserves and Surplus
Liabilities
33700(14.13)
27600(14.34)
27400(14.54)
18200(14.58)
16200(13.9)
13506(12.8)
12181(12.9)
5969(12.4)
4745(12.6)
Reserves and Surplus
33576(5.70)
2012
2010
3200(1.67)
2015
Share capital
3700(2.9)
3300(1.76)
2012
2013
3200(2.8)
2011
2014
3892(4.1)
3643(3.5)
2010
2860(7.6)
2289(4.8)
2003
Paid up capital
Liabilities
Balance sheet of NBFCs
2007
Year
Table 13.4
37709
921300
761300
588806
Total
238700
184700
188400
124800
122200
105431
94212
47999
109300(7.65)
89900(6.95)
1428800
1292000
206500(16.90) 1222600
158100(14.14) 1117700
136100(14.77)
108300(14.22)
89429(15.19)
Other Assets
18500(7.75)
18800(10.17)
24100(12.8)
25800(20.67)
30700(25.12))
6428(6.1)
4595(4.88)
29888(62.26)
20018(53.0)
Other aseets
Total
(Amount in ` Crore)
Miscellaneous Non-Bank Financial Intermediaries
13.13
13.14
Financial Institutions and Markets
Table 13.5 Financial Performances of NBFCs (Amount in ` Crore) Item/Year
NBFCs-D Income
Expenditure
Tax provision
NBFCs-ND-SI Operating
Total Income
Total Expenditure
2009–2010
13615
11038
1096
2577
1482
60932
43609
12231
2010–2011
15200
10900
1400
4300
2900
75200
52900
16000
2011–2012
17900
12900
1600
5000
3300
98800
74500
17100
2012–2013
18800
13800
1600
5000
3400
127200
103900
23300
2013–2014
21700
7500
1500
5900
4300
138600
102800
25600
2014–2015
28000
11100
1900
6000
4100
147000
108400
28000
2015–2016
35500
15800
2300
7100
4800
171700
129700
29800
Source: RBI, RTPBI, Various issues
Table 13.6 NPA of NBFCs (Gross NPAs to Gross Advances) (Percentages) Year
NBFCs-D
NBFCs-ND-SI
Asset Finance Companies
Loan Finance Companies
All Companies
2009–2010
0.77
2.63
1.35
2.8
2010–2011
0.50
1.3
0.7
1.72
2011–2012
2.4
1.3
2.2
2.08
2012–2013
2.7
1.5
2.4
2.20
2013–2014
3.6
1.5
3.1
4.3
2014–2015
4.1
1.7
3.5
4.3
2015–2016
6.4
2.4
4.9
4.4
Source: RBI, RTPBI, Various issues
companies and Nidhi’s. The governments provide direct loans mainly to their employees. The participation LIC has been a major supplier of mortgage loans in indirect and direct forms. It has been giving loans for
Miscellaneous Non-Bank Financial Intermediaries
13.15
and so on. The Housing Development Finance Corporation Ltd. (HDFC) has been playing an important role in meeting institution was needed to channel household savings as well as funds from the capital market into the housing
located in the areas where there is a keen demand not only for houses but also for commercial and industrial
The State Housing Finance Societies (SHFSs) constitute another major source of funds in the residential
of houses and repayment of earlier mortgage debt. The terms and conditions of loans vary somewhat from
also made. The major sources of funds for these institutions are: (a) investment in their share capital by the individuals and institutions; and (d) issues of debentures guaranteed by the government. National Housing Bank (NHB)
13.16
Financial Institutions and Markets
that is from `
percent to ` percent
percent percent percent was observed in HFCs.
Highlights of Pradhan Mantri Awas Yojana—Housing for All (Urban): Credit Linked Subsidy Scheme
2
resulting in reduced effective housing loan and equated monthly instalment.
any member of his/her family in any part of India.
transgender.
5
NHB, Annual Report, 2014-15.
Miscellaneous Non-Bank Financial Intermediaries
13.17
13.6.2 Merchant Banks (MB)6
It would help in understanding the nature of merchant banking if we compare it with commercial banking.
rather than retail bankers. It means that they deal with selective large industrial clients and not with the general
guarantee the success of issues by underwriting them. Then they provide all the services related to receiving banker does not normally assume all the risk himself while underwriting the issue. There is usually the practice
activities undertaken by merchant banks is much wider than sponsoring public issues of industrial securities. A recent advertisement of one of the merchant bankers mentioned the following as its range of activities
The
prudential norms. 6
Based on Robinson, R I, and Wrightsman, D, Financial Markets, op. cit., pp. 268–71 and 359–61; Edmister, R O, Financial Institutions, op. cit., pp. 250–61; and Nayar, Laxmi, ‘A Preliminary Study on Merchant Banking’ (unpublished).
13.18
Financial Institutions and Markets
(2) Whether they have adequate capital, are taken into account. the merchant banker: ●
banker. ●
●
● ●
●
merchant bankers cannot operate. The minimum net worth of merchant banker should be `
● ● ● ● ● ● ●
nature and range of the activities and the responsibilities. Category I: It consists of merchant bankers who carry on the business of issue management which consists
` Category II: The minimum net worth required is ` Category III: to an issue. The minimum net worth required is ` Category IV: It consists of merchant banker who acts as an advisor or consultant to an issue. There is no minimum net worth required.
13.6.3 Venture Capital Funds (VCF)
Miscellaneous Non-Bank Financial Intermediaries
13.19
and people now talk of ‘venture capital industry’ or ‘venture capital market’ comprising a large number of
term by referring to its uses and scope of activities. The term venture capital fund is usually used to denote
businesses or industries that have long development cycles and that usually do not have access to conventional sources of capital because of the absence of suitable collateral and the presence of high risk. The VCFs play an important role in supplying management and marketing expertise also to such units. The list of assisted
The question that needs to be answered is whether the VCFs supply any capital/services to existing companies. It would appear that it is so in the UK. A distinction is made there between venture capital and development
to established enterprises.
appreciation. Typical VCFs have a seat on the company’s board of directors. They aim at realising high capital gains by selling the equity invested in the venture at a later stage. The corporate venture capitalists
subsidiaries or divisions of large manufacturing corporations.
13.20
Financial Institutions and Markets
obligatory under the FVCI regulations. Venture Capital Funds and Foreign Venture Capital Investors are
A foreign venture capital investor proposing to carry on venture capital activity in India may register with
must achieve the investment conditions by the end of its life cycle. instruments. ●
be listed. ●
● ●
●
A foreign venture capital investor may invest its total corpus into one venture capital fund.
13.6.4
for its operational matters as also the deployment of funds. These companies enjoy exemption from core provisions of the RBI Act viz
and making loans. These companies shall be required to have net owned fund of ` Nidhis potential Nidhi
Nidhi Nidhi companies
Miscellaneous Non-Bank Financial Intermediaries
13.21 `
The main function of Nidhis
terms on which loans are given are quite moderate. The notable points about these institutions are: (a) They offer saving schemes which are linked with assurances to make credit available when required by savers; (b) They make credit available to those whom commercial banks may hesitate to give credit or whom
work on sound principles of banking. Their operations are similar to those of unit banks.
13.7 CREDIT RATING AGENCY A credit rating agency is a company which rates the debtors on the basis of their whether companies or governments. It is usually the effort of investors in Credit Rating (CR) as an act of assigning values to credit instruments by estimating or assessing
LO 4 Understand Credit Rating objectives and the major rating agencies in India
symbols. It is an assessment of the credit quality or investment quality of a particular credit instrument (i) Credit rating is designed exclusively for the purpose of grading bonds according to their investment quality. (ii) Corporate or municipal debt rating is a current assessment of the credit worthiness of the obligator
to purchase or sell or hold security. It is not a general purpose evaluation of the company. It does not create a CRA performs an audit function or attests the veracity of information provided by the borrowers. It is not a
13.22
Financial Institutions and Markets
instruments issued by the same organisation because of the different nature of obligations each instrument
time as a result of new information or other circumstances. The practice of ‘country rating’ or ‘sovereign rating’ as well as ‘debt instruments rating’ has become more common in the recent past. It is worth noting whole country or nation is rated which is against the basic tenet of CR.
13.7.1 Objectives of Credit Rating
regulatory authorities and so on in discharging their functions related to debt issues. (e) It encourages greater
is of great help to the issuer. expertise and honesty of CRAs. Credit rating is a science as well as an art. It has been rightly pointed out that rating is not and never will be a precise science; there are simply too many variables or a tremendous variety
13.7.2 Credit Rating Agencies in India
Credit Rating Information Services of India Ltd. (CRISIL)
Miscellaneous Non-Bank Financial Intermediaries
13.23
reliable and consistent assessments of the fundamental strengths of new public issues. Investment Information and Credit Rating Agency of India Ltd. (ICRA) Investment Information and Credit Rating Agency of India Ltd. (ICRA) (formerly Investment
investment information and credit rating agency. Investment Information and Credit Rating Agency of India is ICRA’s
13.24
Financial Institutions and Markets
Credit Analysis and Research Ltd. (CARE)
Ltd ratings provide the entire spectrum of credit rating that help the corporates to raise capital for their various requirements and assists the investors to form an informed investment decision based on the credit The Index denotes the quality of debt in the country that can be interpreted over time and juxtaposed with
in London. Brickwork Ratings India Private Limited (BWR) (
SME Rating Agency of India Ltd. (SMERA)8
7 8
http://www.icra.in www. smera.in
Miscellaneous Non-Bank Financial Intermediaries
13.25
13.8 CREDIT RATING PROCESS The credit rating process of all the credit rating companies is more or less same.
Client
LO 5 Explain the credit rating process
CRISIL
Request for rating Rating team assigned. Team collects information; conducts preliminary analysis
Signs rating agreement, provides information and rating fees
Interaction with the management Analysis presented to the rating committee Rating assigned and communicated to the issuer Rating reflected on the CRA website
Yes Yes
Does issuer accept the rating? No
Rating kept under surveillance during the tenure of the instrument
No
Does issuer appeal against the rating
Details of unaccepted ratings disclosed on CRISIL website
Source: www.crisil.com
Figure 13.1 Credit Rating Process Followed by CRISIL.
13.8.1 Credit Rating Methodology (CRISIL) The credit rating criteria vary across the nature of the companies. The rating criteria for manufacturing
13.26
Financial Institutions and Markets
Rating Framework for Manufacturing and Service Sector Companies
Source: www.crisil.com
Figure 13.2
CRISIL’s Rating Framework for Manufacturing and Service Sector Companies
Rating Framework for Banks and Financial Institutions
and Liquidity/asset liability management. Capital Adequacy An entity’s capital provides it with the necessary cushion to withstand credit risks and other risks in its medium to long term. The analysis encompasses the following factors: ● Adherence to capital adequacy requirements as per Basel III regulatory norms ●
Miscellaneous Non-Bank Financial Intermediaries
13.27
● ● ●
Resource-Raising Ability analysed considering the following factors: ● ● ● ● ●
Cost of deposits
● ●
Funding mix and cost of funds
●
Asset quality A bank or FI’s asset quality is a measure of its ability to manage credit risks. The asset quality is analysed on the basis of the following parameters: ● ● ● ●
Weak asset levels
● ●
Management and Systems Evaluation The quality of management is an important differentiating factor in the future performance of a bank/FI. The management is evaluated on the following parameters: ● ● ● ●
Appetite for risk Competence and Integrity
Earnings Potential used for analysing earning potential are as follows: ● Level of earnings ● ●
13.28
Financial Institutions and Markets
Liquidity/Asset Liability Management
parameters considered for this analysis are: ● Liquidity risk ● Liquid assets/Total assets ● Liquidity Coverage Ratio (LCR) ● ●
Interest rate risk
13.8.2 The rating symbols are different for different types of assets. The rating symbols of debt instruments are operating in India. Table 13.7 Credit Rating Scales for Long-Term Debt Instruments (CRISIL, ICRA and CARE) AAA
Instruments with this rating are considered to have the highest degree of safety regarding timely servicing of
AA A
Instruments with this rating are considered to have adequate degree of safety regarding timely servicing of
BBB
Instruments with this rating are considered to have moderate degree of safety regarding timely servicing of
BB obligations. B obligations. C obligations. D
Instruments with this rating are in default or are expected to be in default soon
Source: http://www.careratings.com/resources/rating-resources.aspx
Table 13.8 Credit Rating Scales for Long-Term Debt Instruments (CRISIL, ICRA and CARE)
Symbols A1
Instruments with this rating are considered to have very strong degree of safety regarding timely payment of
A2
Instruments with this rating are considered to have strong degree of safety regarding timely payment of (Contd.)
Miscellaneous Non-Bank Financial Intermediaries A3
13.29
Instruments with this rating are considered to have moderate degree of safety regarding timely payment of higher categories.
A4
Instruments with this rating are considered to have minimal degree of safety regarding timely payment of
D
Instruments with this rating are in default or expected to be in default on maturity.
http://www.careratings.com/resources/rating-resources.aspx
13.9 DEPOSITORY AND CUSTODIAL SERVICES
cumbersome and time consuming; they have put the securities industry in a ‘paperwork grid lock’ resulting in the slowing down of its growth. The sudden expansion of this industry has led to a tremendous increase in
depository is an organisation of investors in electronic form at the request of the investors through a registered depository participant. It also provides services related to transactions in securities.
viz
place nationally on a standard basis to prepare the matched transactions for a depository settlement. National
13.30
Financial Institutions and Markets
At present two depositories viz a depository is `
SUMMARY ◆
◆
◆
conduct. viz
◆
◆
◆
of deposit taking NBFCs has been declining continuously. ◆
Nidhi ◆
◆
◆
by the Reserve Bank of India from its regulatory requirements for avoiding duality of regulation. A credit rating agency is a company which rates the debtors on the basis of their ability to pay back the
Miscellaneous Non-Bank Financial Intermediaries
viz
◆
for a depository is `
KEY TERMS
Asset Finance Company Investment Company Loan Company Infrastructure Finance Company
Leasing
Company
Housing Finance Company
Credit Rating Agency
Venture Capital Funds
QUESTIONS
companies operating in India. Pradhan Mantri Awas Yojana
companies.
13.31
Non-Bank Statutory Financial Organisations
14
CHAPTER
Learning Objectives LO 1 LO 2
Know the major NBSFOs operating in India Understand the structure of NBSFOs
LO 3 LO 4 LO 5
Explain the features of assistance Provided by NBSFOs
14.1 INTRODUCTION In this chapter, we will discuss the functioning of an important group of institutions called Non-Bank Statutory Financial Organisations (NBSFOs), though this is not a very precise title for this group. In fact, the number
not mobilise savings from the ultimate surplus spending units and instead obtained their resources primarily from the government and the RBI, but now some of them have begun mobilising public savings directly or
institutions, but some of them may have a much general functional coverage. Subject to such exceptions, NBSFOs may be regarded as a reasonably distinguishing title for these development banks’, or ‘term lending institutions’, or ‘special
them into banks and private companies, we continue to call them NBSFOs because it is only such a title that continuity with the earlier editions of this book.
14.2
Financial Institutions and Markets
14.2 MAJOR NBSFOS OPERATING IN INDIA end-March 2016, there were four viz. the Export Rural
LO 1 Know the major NBSFOs operating in India
Development Bank institutions and further the discussions on all other NBSFOs are provided.
14.2.1 Export-Import Bank of India (EXIM Bank)
India. Including the share capital of 1300 crore received during the year from Government of India, the paid up capital as on March 31, 2015, stood at `5059 crore and the net worth stood at ` tax of the Bank for the year 2014–2015 amounted to `726 crore. It grants direct loans in India and outside for purposes of international trade, re-discounts usance export bills for banks, provides overseas investment
oriented industries. It thus provides fund-based as well as non-fund-based assistance in the foreign trade
overseas buyer’s credit lines of credit to foreign governments, (g) re-lending facility to banks abroad, (h) readvisory and information services. Its sources of funds come from share capital, reserves, re-payment of loans, loans from RBI and the government, bond issues in the domestic and foreign capital markets, loans EXIM Bank has laid strong emphasis on enhancing project exports, the funding options for which have
investment abroad by Indian companies for setting up joint ventures, subsidiaries or undertaking overseas and development (R&D) activities of export-oriented companies. During the year ended 31st March, 2015, EXIM Bank has sanctioned loans of 57,684 crore, while disbursements were amounted to 38,508 crore.
administered by Exim Bank, to sanction loans in the interest of international trade towards meeting strategic objectives was put to use.
Non-Bank Statutory Financial Organisations
14.3
14.2.2 National Bank for Agricultural and Rural Development (NABARD) `100 crore is subscribed by the government
It oversees the entire rural credit system and to that extent, it has taken over a part of the job of the RBI. It co-ordinating agency, in respect of agriculture and rural development activities/policies of the central and state governments, Planning Commission and other institutions. It undertakes inspection of co-operative banks and RRBs without prejudice to the powers of the RBI. It aims at the prosperity of rural areas through small-scale industries, cottage and village industries, handicrafts and other rural crafts and allied economic
banks, commercial banks, RRBs and so on for a wide range of activities in the areas of production, trading, marketing and storage. It also gives long-term loans (up to 25 years of maturity) to SCBs, SLDBs, RRBs, commercial banks and other approved institutions for the purpose of making investment loans. It gives loans up to 20 years of maturity to the state governments to enable them to subscribe to the share capital of
crops, purchase/procurement/distribution of agricultural inputs and so on; (c) medium-term loan facilities for Rozgar Yojana and so on. Its resources comprise bilateral aid agencies, sales of bonds and debentures, direct-borrowings, deposits, gifts, grants, and so on. It
14.2.3 National Housing Bank (NHB)
14.4
Financial Institutions and Markets
14.2.4 Small Industries Development Bank of India (SIDBI) as a wholly owned subsidiary of the IDBI. Its authorised capital is `250 crore with an enabling provision to increase it to `1000 crore. It is the central or apex or principal institution which oversees co-ordinates
shares of the SIDBI held by IDBI have been transferred to select public sector banks, LIC, GIC and other
through the existing credit delivery system comprising NSIC, SFCs, SIDCs, SSIDCs, commercial banks, co-operative banks and RRBs.
functions for SIDBI. ●
●
the term with the expression ‘industrial concern or micro enterprise or small enterprise or medium
●
In addition, the activities included under industrial concern are expanded in the Bill. Industrial concern
construction; and the entertainment industry. ●
Non-Bank Statutory Financial Organisations
●
14.5
infrastructure projects; sourcing materials; marketing and support services for any industrial concern or micro enterprise or small enterprise or medium enterprise. In addition, SIDBI, acting as an agent for a government entity, can enter into a securitisation transaction granted to any industrial concern or micro enterprise or small enterprise or medium enterprise.
●
enterprise or medium enterprise. ●
industrial concern or micro-enterprise or small enterprise or medium enterprise. ● ●
Currently, all securities on account of the transaction (for which accommodation has been granted) should charged in favour of SIDBI. ●
extends SIDBI’s power to have the right of possession, or transfer, of any property mortgaged by a
●
In the case of default, SIDBI can seek assistance from the Chief Metropolitan Magistrate or District
other related document and to forward them to SIDBI.
the whole period.
42681(14.7)
35307(14.2)
3694(1.5)
8676(3.5)
Cash and Bank balances
Investments
18722(7.5)
Other Assets
Source: RBI, RTPBI, Various issues
553(0.2)
2668(1.1)
Fixed Assets
Bills discounted
214671(86.2)
248983
Total
Loans and advances
19037(7.6)
Other liabilities
Borrowings
92782(31.9)
79472(31.9)
Deposits
18682(6.4)
537(0.2)
3542(1.2)
250238(86.1)
11802(4.1)
5814(2.0)
290616
17544(6.0)
90097(31.0)
71011(28.5)
Bonds and Debentures
42612(14.7)
4900(1.7)
2011
39556(15.9)
4600(1.8)
2010
15330.6(4.6)
5364(0.2)
2963.6(0.9)
298199.6(88.7)
12558.9(3.7)
6739.8(2.0)
336328.8
17708.5(5.3)
49520.7(14.7)
109078(32.4)
107297.3(31.9)
46524.3(13.8)
6200(1.8)
2012
Balance sheet of All India Financial Institutions
Reserves
Capital
Item/Year
Table 14.1
18002(4.6)
6258(0.2)
4273.3(1.1)
345984.2(88.8)
11761(3.0)
9180.2(2.4)
389826.5
22038.4(5.7)
56574.1(14.5)
130919.1(33.6)
123340.8(31.6)
48994.8(12.6)
7959.4(2.0)
2013 38119.7(7.09)
10959.4(2.21)
2015
25161.7(5.54)
625.3(0.14)
5838.5(1.28)
391109(86.07)
24334.5(5.36)
7336.4(1.61)
454405.4
26348.6(5.80)
65945.6(14.51)
186542(41.45)
11176.9(2.26)
658.4(0.13)
3573.6(0.72)
427315.5(86.22)
32358.5(6.53)
20530.5(4.14)
495613.3
49901.1(10.07)
46927.1(9.47)
230943.6(46.60)
114180.1(25.13) 118762.5(23.96)
52029.8(11.45)
9359.4(2.06)
2014
12382.2(2.21)
692.2(0.12)
2638.3(0.47)
476176.9(84.83)
42166.3(7.51)
27287.2(4.86)
561343.2
52828.5(9.41)
74111.7(13.2)
238728.2(42.53)
138576.7(24.69)
43501.7(7.75)
13596.3(2.42)
2016
(Amount in ` Crore)
14.6 Financial Institutions and Markets
Non-Bank Statutory Financial Organisations
Table 14.2
Financial Performance of AIFIs
14.7
(Amount in ` Crore)
Item/Year
Income
Expenditure
2010
17965
13337
3808
2554
2011
18501.8
13742.4
3937.4
2655.6
2012
22665
16293.3
4881
3264
2013
27501
19962.6
5586.3
3837.7
2014
32576.5
23680.3
6133
4175.1
2015
35011.3
26264.6
7833.9
5293
2016
39508.4
30066.7
6972.2
4808.8
Source: RBI, RTPBI, Various issues
Table 14.3 Net NPAs to Net Loans of AIFIs of AIFIs
(Percentage)
Year
EXIM BANK
NABARD
NHB
SIDBI
All FIs
2010
0.20
0.30
—
0.20
—
2011
0.20
0.20
—
0.30
0.10
2012
0.30
0.20
—
0.40
0.13
2013
0.47
0.10
0.45
0.55
0.23
2014
0.43
0.10
0.28
0.47
0.19
2015
0.60
0.10
0.32
0.86
0.26
2016
0.86
0.10
0.06
0.77
0.29
Source: RBI, RTPBI, Various issues
Table 14.4 Capital Adequacy Ratio of AIFIs
(Percentage)
Year
EXIM BANK
NABARD
NHB
SIDBI
All FIs
2014
14.30
16.60
15.20
30.5
17.80
2015
15.34
16.91
15.75
36.69
18.72
2016
14.55
17.59
18.52
29.86
18.66
Source: RBI, RTPBI, Various issues
14.2.5 Industrial Financial Corporation of India (IFCI)
system and to have an access to the capital market. With effect from October 1999, its name has been changed
14.8
Financial Institutions and Markets
`10 each from six public sector banks. With this, the shareholding of the Government of India in paid-up share capital of IFCI has been increased to 51.04 percent and Industrial Financial Corporation of India (IFCI) has become a India is also a Systemically Important Non-Deposit taking Non-Banking Finance Company (NBFC-ND-SI), registered with the Reserve Bank of India. During the course of its existence, IFCI has established various subsidiaries as an extension of its business and many other organizations of national and social importance. Recently, tangible steps have been taken for re-orientation and growth of these subsidiaries viz., IFCI Venture Capital Fund (IVCF), IFCI Financial Services Ltd. (IFIN), IFCI Infrastructure Development Ltd. (IIDL), and IFCI Factors Ltd. (previously growth and have shown remarkable progress in the immediate past year. Industrial Financial Corporation of India has also promoted some of the specialized institutions like Management Development Institute (MDI),
to hold stakes in these organizations.
Table 14.5 Select Financial Indicators of IFCI Particulars
Mar-31-11
Mar-31-12
Mar-31-13
Mar-31-14
Mar-31-15
` Crore)
737.84
737.84
1662.04
1662.04
1662.04
Reserves and Surplus (` Crore)
4001.72
4534.07
4757.31
5055.64
5220.28
2480.11
2850.20
2759.30
2951.26
3347.99
1464.18
2005.17
1930.03
1772.45
2196.28
706.25
663.62
450.87
508.10
521.60
25,527.98
28,183.80
25,883.64
28,989.31
34,967.96
` Crore) ` Crore) ` Crore) Balance Sheet Size (` Crore) Return on Assets Gross NPAs Net NPAs Capital Adequacy Ratio Source: www.ifciltd.com
3.16%
2.47%
1.67%
1.85%
1.63%
11.72%
11.36%
19.24%
17.26%
10.28%
0.97%
1.92%
10.18%
11.39%
7.18%
16.43%
21.26%
23.87%
21.34%
18.76%
Non-Bank Statutory Financial Organisations
14.9
factoring and so on. It provides direct rupee and foreign currency loans for setting up new industrial projects
of (a) loans from the RBI, (b) share capital, (c) retained earnings, (d) re-payment of loans, (e) issue of bonds, (f) loans from the government, (g) lines of credit from foreign lending agencies, and (h) commercial borrowings in international capital markets.
14.2.6 National Industrial Development Corporation (NIDC)
development.
14.2.7 Industrial Investment Bank of India (IIBI)/Industrial Reconstruction Bank of India (IRBI)
rationalisation. It is empowered to grant loans and advances; underwrite stocks, shares and bonds and guarantee loans, performance, and deferred payments. It gives assistance for capital expenditure, addition
into Industrial Investment Bank of India Ltd. (IIBI), by registering it as a limited company under the
loans to companies.
14.10
Financial Institutions and Markets
14.2.8 Infrastructure Leasing and Financial Services Ltd. (IL&FS)
Credit Commercial de France, and SBI. Over the years, IL&FS has broad-based its shareholding and Life
communication; (c) Investment banking services including promotion of mutual funds and extension of venture capital; and (d) Participation as a member of stock exchanges with a focus on the development of Delhi Stock Exchange and is awaiting clearance for the membership of Bombay Stock Exchange. Its public sector units. Infrastructure Leasing and Financial Services Limited is a leading participant in the
agencies in positioning infrastructure projects for commercialisation. It has advised state governments on developing non-conventional energy power projects in the role of a sponsor. It has developed institutional capability in commercialisation of surface transport and other transport systems, water supply, power and telecom. IL&FS Financial Service Limited (IFIN) is a 100 percent subsidiary of Infrastructure Leasing and
also established its international presence through its wholly owned subsidiaries; IL&FS Global Financial Services Pvt Ltd. at Singapore, IL&FS Global Financial Services (UK) Ltd at London, IL&FS Global
14.2.9 Tourism Finance Corporation of India (TFCI) `50 crore. It is a specialised all-India loans, underwriting of and subscription to industrial securities, deferred payments/foreign loans guarantees,
car rental services, ferries for inland water transport, airport facilities, hotels, restaurants, holiday resorts, amusement parks, transport, and so on. It would also provide advisory and merchant banking services in
capital cost of at least ` courts, pubs, tour operators, travel agents, transport sector, health spa/centres, recreational facilities and renovation/up-gradation/expansion, lower project cost could also be considered depending on the nature of the project, past track and credit record, commercial viability and the prevailing government policies for the development of tourism in the area/region. In addition, credit facilities for working capital and against credit
Non-Bank Statutory Financial Organisations
14.11
companies with satisfactory credit record. In case of rated companies, the minimum rating should be ‘BB’. percent in respect of large projects involving capital cost, exclusive of the cost of land for the project, of more than `
in case of multiplexes/entertainment centres, the re-payment of the loan shall be over a period of 6–7 years including moratorium period.
14.2.10 Agricultural Finance Consultants Ltd. (AFC) was set up in 1968. It undertakes a variety of consultancy assignments, monitoring and evaluation studies, on agriculture and rural development in India and abroad. It formulates projects at the instance of central
block level planning, integrated tribal development, watershed management, and animal husbandry.
14.2.11 National Small Industries Corporation (NSIC) `20 lakh which was completely subscribed by the GOI. Its main objective is to promote the growth of Micro, Small and Medium Enterprises (MSME).
between small-scale and large-scale units so as to enable the former to act as ancillaries to large units; materials, spares and components to small units.
14.2.12 State Financial Corporations (SFCs)
`50 lakh and 5
14.12
Financial Institutions and Markets
in the country. State Finance Corporation promotes small and medium industries of the states. Besides, SFCs are helpful in ensuring balanced regional development, higher investment, more employment generation
scale industrial concerns formed as public or private limited companies, corporations, forms or proprietary
assistance to industrial units whose paid-up capital and reserves do not exceed `3 crore (or such higher limit up to ` to the debentures issued by the industrial concerns re-payable within 20 years and also underwrites the issue
for their modernisation and technology up-gradation by providing soft loans, re-structuring the sick small
●
●
Concentration only on sanctioning of loans and advances even though they can subscribe to the orientation of the lending policy. State Finance Corporations have failed to bring about a regional balanced industrial growth. It is observed that there has been uneven development of industries with State Finance Corporations assistance in different states and regions.
●
scale units. ●
●
operations of SFCs. Most of the SFCs are facing the serious problem of continuous increasing magnitude of over dues due to delay in implementation of projects.
● ●
●
more funds.
Non-Bank Statutory Financial Organisations
14.13
14.2.13 State Industrial Development Corporations (SIDCs) state government undertakings for promotion and development of medium and large industries. In addition industrial estates, industrial parks and setting up industrial projects either on their own or in the joint sector in collaboration with private entrepreneurs or as wholly owned subsidiaries. State Industrial Development Corporations exist in all the states and have developed industrial infrastructure facilities to enable prospective entrepreneurs in the formulation of the project reports and also provide common facilities in the industrial to the maximum of `
14.2.14 State Industrial Infrastructure and Investment Corporations (SIIICs)
growth centres, export promotion zones, software parks, industrial townships, industrial parks and also Development Corporations insofar as development of industrial infrastructure in the states is concerned.
14.2.15 State Small Industries Development Corporations (SSIDCs)
producing and distributing scarce or imported raw materials, supplying machinery on hire-purchase basis, constructing and managing industrial estates and related infrastructural facilities, providing management (i) Kerala Small Industries Development Corporation Limited, (ii) Small Industries Development Corporation and so on.
14.2.16 National Co-operative Development Corporation (NCDC)
14.14
Financial Institutions and Markets
minor forest product, handlooms, coir, sericulture, and dairy farming. It acts as an on-lending agency for implemented certain projects in the areas of storage, cold storage, soybean processing, oilseeds, cotton processing, mustard seeds, coconut development, and so on. It has started preparing schemes for integrated co-operatives in agricultural, allied and non-farm sectors. One of its special areas of work is to formulate and implement programmes for distribution of consumer articles in rural areas. for institutional development of Co-operatives. National Co-operative Development Corporation supplements
base of societies (100 percent loan), (iii) Working capital to regional/state level marketing federations (100
and (vi) Subsidy for preparation of project reports/feasibility studies. National Co-operative Development
14.2.17 Warehousing Corporations (WCs) sector, is one of the biggest public warehouse operators in the country offering logistics services to a diverse group of clients. Central Warehousing Corporation (CWC) is operating 438 warehouses across the country with a storage capacity of 10 million tonnes providing warehousing services for a wide range of products ranging from agricultural produce to sophisticated industrial products. Warehousing activities of CWC include food grain warehouses, industrial warehousing, custom bonded warehouses, container freight stations, inland area of clearing and forwarding, handling and transportation, procurement and distribution, disinfestation services, fumigation services and other ancillary activities. Central Warehousing Corporation also offers
● ●
expand credit potential of warehoused goods through banking institutions and NBFCs.
Non-Bank Statutory Financial Organisations
14.15
●
consultancy services, multi-modal transport and so on. ● ●
and productivity of employees for achieving customer satisfaction. ● ●
●
warehousing and related infrastructural facilities. Central Warehousing Corporation operates 66 custom bonded warehouses with a total operated capacity to facilitate deferred payment of custom duty to encourage entrepreneurs and export oriented units to carry out their operations with least investment.
●
for smooth movement of goods to and from the discharge points. ●
complexes which is a major step towards providing complete services as a multi-modal transport operator. ●
Singanallur and Virugambakkam besides managing the accompanied/mishandled cargo warehouse at ●
With a category-I licence from the Indian Railways for running container trains on pan India basis, CWC is presently operating container trains transporting EXIM containers between Loni (Delhi) to J.N. Port (Navi Mumbai) and Loni to Mundra. Central Warehousing Corporation runs about 300 trains in these and Kalamboli (Navi Mumbai) on PPP model.
14.2.18
promotion of decentralised distribution of power in rural areas on co-operative basis; and (c) full exploitation various schemes. project developers, central power sector utilities, and state governments for investments in power generation,
●
Power Generation Schemes: (i) Setting up new power generating stations based on conventional sources of energy, that is. thermal, hydro and gas, along with associated areas like development of coal mines. (ii) Renovation and Modernization (R&M) of existing power generating stations based on conventional sources of energy. (iii) Setting up of power generation plants based on renewable energy sources like solar, wind, small hydro, biomass and so on.
14.16 ●
●
●
Financial Institutions and Markets
Power Transmission Schemes: Evacuation of power from new power generating stations and strengthening/improvement of existing transmission system in the designated areas. Power Distribution Schemes: (i) Strengthening and improvement of the power sub-transmission and distribution system in the designated areas. (ii) Conversion of Low Voltage Distribution System
for energisation of agricultural pump sets. Short Term Loans/Medium Term Loans: maintenance including repair of transformers and so on.
schemes of the Government of India, such as acting as the nodal agency for implementation of ‘Deen Dayal Upadhyaya Gram Jyoti Yojana’ Fund’ (NEF), the reform linked interest subsidy scheme for power distribution companies; and for the ‘Outage Management System’ and ‘11 KV Rural Feeder Management System’; besides acting as the ‘Bid Process Coordinator’ for selection of developer through tariff-based competitive bidding process for the establishment of inter-state transmission systems through public-private-participation. Ujjwal Discom Assurance Yojana’ and operational turnaround of the state sector power distribution utilities and in monitoring of progress of the also provides counter-part funding for the ‘Integrated Power Development Scheme’ (IPDS), the Government of India scheme for improvement of the urban power infrastructure in the country. Central Institute for Rural managerial personnel of power utilities as well as in-house programmes for REC personnel round the year, encompassing a broad array of power-related subjects, including technical best practices in transmission and distribution systems, legal aspects of power sector operations, power sector accounting and so on for national and international participants.
14.2.19 Technical Consultancy Organisations (TCOs)
and their aim is to provide under a single roof a package of consultancy services needed in all stages of existing medium and small industries, the state-level business corporations, state governments, state-level
Non-Bank Statutory Financial Organisations
14.17
development programmes; (e) provide technical, management and administrative assistance; (f) taking up technical up-gradation and rehabilitation programmes; (g) accepting turn-key assignments to set up smalland medium-scale projects; (h) helping entrepreneurs in project conception, formulation and implementation, of technology transfer, industrial development in rural areas, merchant banking and retainer consultancy
14.2.20 Biotechnology Consortium of India Limited (BCIL) technology parks and the rapid conversion of laboratory developments into commercial processes and products. `5 crore. It promotes venture capital funds and arranges company, with the objective of providing the linkages amongst research institutions, industry, government and funding institutions, to facilitate accelerated commercialisation of biotechnology. Promoted by the Department `5.37 crore has been contributed mainly corporate sector including Ranbaxy Laboratories, Cadila Laboratories, Glaxo India, SPIC, and so on. Biotechnology Consortium of India Limited is engaged in technology development and transfer, project consultancy, fund syndication, information dissemination and manpower training and placement related to biotechnology. For technology transfer, BCIL acts as an interface between technology sources and
then demonstrated to a select cross section of industries to ascertain their interest following which commercial
are monitored to ensure their timely implementation as per the terms of technology transfer agreements. Biotechnology Consortium of India Limited also organises entrepreneurs’ meets to create large scale awareness about the commercial potential of the indigenously developed biotechnologies. Representatives other support to the entrepreneurs for expeditious commercialisation.
international agencies. Biotechnology Consortium of India Limited has assisted Punjab State Government in preparation of detailed project report for setting up a ‘centre of excellence’ in biotechnology for development and commercialisation of state-of-the-art biotechnologies. Biotechnology Consortium of India Limited is currently assisting the state governments of Uttar Pradesh, Kerala and Pondicherry for setting up the biotechnology club, BCIL disseminates information relevant to commercial biotechnology to industries,
14.18
Financial Institutions and Markets
institutions, universities, and entrepreneurs. It also operates a biotech industrial training and placement programme through which postgraduates in biotechnology with an aptitude in industrial activities are trained in the industry to orient them in commercial biotechnology.
14.2.21 Indian Railway Finance Corporation (IRFC)
14.2.22 Infrastructure Development Finance Company (IDFC) development with an authorised share capital of `5000 crore to be contributed by the GoI, RBI, banks and investment banking. Infrastructure Development Finance Company was incorporated on January 30, 1997
Public Financial Institution. Infrastructure Development Finance Company is registered with the Securities and Exchange Board of India (SEBI) as a merchant banker and as an underwriter in 2000 and in 2001
to set up a new bank in the private sector, as per the RBI guidelines for licensing of new banks in the
14.2.23 North-Eastern Development Finance Corporation Ltd. (NEDFC)
`500 crore and an initial subscribed capital of `100 crore which has been contributed by the promoters, viz.,
venture capital, loans, working capital and other usual types of assistance provided by development banks.
ECGC, and so on.
Non-Bank Statutory Financial Organisations
14.19
and large enterprises for setting up industrial, infrastructure and agri-allied projects in the North Eastern region and advisory services to the state governments, private sectors and other agencies. It conducts sector or agency for disbursal of Government of India incentives to the industries in the North-East India under North-
14.3 STRUCTURE OF NBSFOS: SOME OBSERVATIONS there are too many institutions along with functional overlapping in this
LO 2 Understand the structure of NBSFOs
infrastructure to accelerate the rate of long-term capital formation through the setting up of these many institutions have been re-constituted, re-organised and re-named, which indicates the widening or
the various sectors of the Indian economy are suffering from stagnant growth rates, increasing sickness,
Whether they are set up by the central or state governments; (b) Whether they are meant for providing
we are aware that the functional specialisation is not being strictly observed now.
activities. (iv) Different central or apex institutions have been created to co-ordinate and oversee the working of
14.20
Financial Institutions and Markets
exclusively in respect of assistance provided by them to units in SSI/tiny/decentralised sector and
14.4 FEATURES OF ASSISTANCE PROVIDED BY NBSFOS loans and advances in domestic and foreign currencies. (b) Underwriting of with, IFCI was not allowed to directly buy stocks and shares, although it could purchase industrial debentures. Further, if it had to subscribe to share capital
LO 3 Explain the features of assistance provided by NBSFOs
time period, say 7 years. Now these restrictions have been liberalised. State Finance Corporations even today are generally prohibited from direct subscription to ordinary shares. (d) Guaranteeing of loans and deferred
institutions. (g) Provisions of advisory and consultancy services. (h) Providing machinery to small units on
venture capital. Non-Bank Statutory Financial Organisations provide assistance either to medium- and large-sized units, and/ or to small-sized units. Originally, IFCI was supposed to assist only large-scale units, but now it provides assistance to medium- and small-scale units too. Industrial Financial Corporation of India earlier used to give assistance only to public limited companies, but now private limited companies, partnership and proprietorship concerns, new entrepreneurs, professional managers and technicians are also covered by its operations. Now, all NBSFOs provide assistance to both private and public sector units.
permitted to provide loans up to 25 years; in practice, it has been advancing loans with a maturity of 12–15 years. It has been sometimes felt that these institutions ought to lengthen the maturity period of their loans to 25 years and more. Loans given by NBSFOs are mostly on a secured basis. Industrial Financial Corporation of India makes mortgage loans with about 50 percent margin; earlier it used to seek guarantees from managing agents before making industrial loans. In the case of SFCs also, loans are secured by pledge, mortgage, hypothecation or assignment of stocks, securities, immovable property and other tangible assets. It has been found that from SFCs and other NBSFOs because of their security-oriented lending policies.
Non-Bank Statutory Financial Organisations
14.21
been able to spread and minimise risk, obtain fuller utilisation of their resources and promote co-operation and co-ordination among themselves through this approach. From the point of view of the borrowers also, the approach was a welcome development because in the absence of such an arrangement, as no single
for institutional assistance for projects up to `5 crore. Under this scheme, only one institution (called ‘lead
amortisation schedule. Previously, there used to be a provision in the loan agreement that part of the loan made by the creditor
in loan agreements, the actual exercise of the option had remained negligible. Now, it is not necessary even to include such an option. In a changed environment of liberalisation and privatisation, it is no longer regarded towards privatisation, the clause has lost much of its relevance.
14.5 GROWTH OF FINANCIAL ASSISTANCE SANCTIONED AND DISBURSED BY AIFIs
particular trend as it has increased for some years and also declined in some
LO 4 Review the growth of financial assistance sanctioned and disbursed by AIFIs
14.22
Financial Institutions and Markets
Table 14.6 Financial Assistance Sanctioned and Disbursed by All Financial Institutions (Amount in ` Billions)
Year
IFCI SAN
SIDBI
DIS
IVCF
TFCI
LIC
GIC SAN
TOTAL
SAN
DIS
SAN
DIS
SAN
DIS
SAN
DIS
DIS
2003– 13.92 2004
2.78 82.46
44.14
—
—
1.11
0.72
93.40
79.54 12.23 12.07
2006– 10.50 2007
5.50 111.02 102.25
—
—
2.45
1.20
181.27 270.17
7.35
7.40
2009– 70.07 2010
60.45 355.45 319.42
0.20
0.27
5.70
2.93
630.07 531.49
6.11
2010– 122.60 84.00 422.14 387.96 2011
1.58
1.30
7.38
2 0 11 – 46.74 2012
56.80 433.46 418.12
3.08
2.86
2012– 22.19 2013
15.04 411.20 406.82
2.86
2013– 100.98 86.83 530.33 523.21 2014
SAN
DIS
407.59
301.73
312.59
386.53
6.11 1067.60
920.67
3.79
438.08 389.05 12.37 12.37 1004.15
878.47
7.80
5.63
531.51 507.09 12.59 12.59 1035.12 1003.09
2.81
4.23
3.43
430.14 448.86 17.66 17.66
888.28
894.62
2.15
2.25
7.67
4.41
342.12 303.78
—
—
983.25
920.48
2014– 122.30 86.87 550.39 531.38 2015
4.26
2.98
8.84
5.84
461.63 401.99
—
—
2015– 108.95 74.88 614.83 594.67 2016
4.18
3.47
7.08
4.48
413.11 393.68
0.22
0.22 1148.36 1071.40
1147.42 1029.06
Source: RBI, Handbook of Statistics of Indian Economy, 2015–2016. Notes: SAN: Sanctioned, DIS: Disbursed.
14.6 DEVELOPMENT FINANCIAL INSTITUTIONS: PROSPECTS commercial purposes for small, tiny, cottage, village, medium- and largescale units in the organised and unorganised sectors, for agricultural and rural development, for export promotion and so on. Certain important changes have
LO 5 Describe development Financial Institutions
that all such changes have not taken place to the same degree in the case of all institutions comprising this
because the concessional funds from the government, RBI and international multilateral institutions are no longer available to them, these institutions need not cease to be development institutions, and become
Non-Bank Statutory Financial Organisations
14.23
manner that such institutions are functioning in the US and other countries. It is interesting to note that notwithstanding withdrawal of concessional sources of funds, the operations of DFIs were not adversely affected during the early years of reforms. modus operandi of DFIs during 1990s including the problems faced by some of them in the recent past clearly point out that to suggest the transformation of these institutions into universal banks because some of them are not doing well as to adopt an ideological approach to the issue. Let us note the developments in the DFI sector during 1990s. First, even though concessional sources of funds for them were phased out, they were not adversely raising and deploying external commercial borrowings and raised substantial amounts of funds from the
enjoyed good demand for funds due to acceleration of economic activity in general and industrial sector in particular. In this process, they did reorient their operations by offering innovative products and diversifying their activities into new areas of business.
project namely, Enron and so on. It would be sad if such factors are made the basis for taking away the role of these institutions as development bodies. Development Financial Institutions are facing the problems due
be allowed to disappear or wind up their activities. In fact, it is too important for a group of institutions to
It is true that these institutions were set up when the capital markets were relatively underdeveloped and
imperfections continue to exist, the SSI sector, agricultural and other priority sectors do not have access to
the corporate and many other vital priority sectors, which existed and prompted the setting up of DFIs in
irrelevant?
14.24
Financial Institutions and Markets
SUMMARY ◆
◆
◆
◆
viz., direct rupee and foreign currency loans, direct subscription to and under-writing of industrial securities, consultancy and merchant banking services, venture capital, and so on. Now all NBSFOs provide assistance to private, joint, co-operative and public sector units of all sizes. Earlier, they provide secured loans mostly of medium- and long-term nature. But now, they provide short-term loans also.
◆ ◆
has been deemphasised now. ◆
viz. the Export Import Bank of India (EXIM Bank), National
◆
Industries Development Bank Like banks, they had developed a consortium or participatory approach to their loan business.
◆
KEY TERMS Non-Bank Statutory Financial Organisation
Development Financial Institutions
SIDBI
QUESTIONS India.
EXIM Bank IFCI IIBI
Non-Bank Statutory Financial Organisations
14.25
liberalisation? 6. What are the different sources of funds of the NBSFOs and how they have changed during the recent period?
(i) Financial performance of different NBSFOs. (ii) Relationship between the level of stock market activity and the availability of business to NBSFOs. (iv) Subsidiaries of Industrial Credit and Investment Corporation of India. (v) Objectives of Small Industries Development Bank of India. (vi) Functions of State Industrial Development Corporations. (vii) Objectives of National Small Industries Corporations.
Part 5 Financial Markets
CHAPTERS 15. Call Money Market 16. Treasury Bills Market 17. Miscellaneous Short-term Financial Markets 18. Bond Market 19. Stock Market 20. Derivatives Market
Call Money Market
15
CHAPTER Learning Objectives LO 1 LO 2
Know the call money market Know call money market in US, UK, and India
LO 3 LO 4 LO 5 LO 6 LO 7 LO 8
Compare the size of Indian call market vis-à-vis US and UK Discuss the historical background of call rates Review call money rates in India, US, and UK Infer the reasons for call rate volatility Understand the measures for reducing volatility of call money rate Illustrate volatility of call money rate in India
15.1
INTRODUCTION
Call money market is that part of the national money market where the day- LO 1 to-day surplus funds, mostly of banks, are traded in. Mostly the call money Know the call money market helps the banks to borrow the money without collateral from other market banks to maintain the cash reserve ratio (CRR) with RBI. The loans made in this market are of a short-term nature, their maturity varying between one day and a fortnight. As these loans are repayable on demand and at the option of either the lender or the borrower, they are highly liquid, their liquidity being exceeded only by cash. No collateral is required to carry out the transactions in this market. money and the government securities markets exists, as at times, large positions in government securities are funded through short-term borrowings. The foreign exchange market is affected by the call money market as forward exchange premia is driven by arbitrage condition, with the inter-bank call money market. The aim of this chapter is to explain call money, its market, the volume of call loans, the relation of the call money rate with other short-term interest rates, and the recent developments in the call money market. Before discussing various aspects of the call money market in India, it is necessary to remember that the nature of this market in different countries varies from each other. Differences in institutional structures account for
15.4 differences in the nature, participants, purposes or types of transactions in such markets. All, however, have one common feature: they deal in loans which have a very short maturity and are highly liquid. As R S Sayers this leads to a considerable degree of similarity in balance sheet structures. The similarity cannot amount to uniformity because there is no uniform availability of assets for bankers in different countries.’1 As the market in the United States and the UK and then its working in India.
15.2 CALL MONEY MARKET IN THE UNITED STATES In the United States there are two markets which can be said to form the call money market: (a) federal funds market and (b) call money market proper, as it is known in the the United States.
LO 2 Know call money market in US, UK, and India
15.2.1 Federal Funds Market 2
The purpose of transactions in this market is to adjust the reserves of banks; and the supply of funds to the market arises out of the reserves of banks with the central banking system. Supply of federal funds arises because some member banks have reserves on a given day in excess of reserve requirements. Demand for
minimum of average daily excess reserves over the course of reserve averaging period.3 The maturity period of funds is 1 day. There appears to be a difference of opinion with regard to the participants in the market. From the account of Monhollon, while one gets the impression that the transactions are among the member banks alone, Sayers4 thinks that demand for federal funds is a demand by banks and dealers in government securities; the supply of federal funds is mainly by banks, but dealers in government securities and agents of foreign supply banks may also occasionally supply funds to this market.
15.2.2 Call Money Market Proper
customers’ purchases of common stock.’5 Banks’ loans to dealers in government securities also form part of the call loans. These loans are secured loans and the call provision allows the termination of the loan by either the lender or borrower on 1 day’s notice. The term ‘call loans’ as it is understood in the United States 1
Sayers, R S, Modern Banking, Oxford University Press, Oxford, 1967. Monholln, J R, ‘Federal Funds’ in Fenstermaker, J V, Readings in Financial Markets and Institutions, Appleton, New York, 1969, p. 52. 3 1bid., p. 53. 4 1bid., p. 274. 5 Federal Reserve Bank of Cleaveland, ‘Call loans’, in Fenstermaker, op. cit. 2
15.5 does not include customer borrowings from security brokers, although these latter borrowings are also on a such as state and local governments, foreign institutions and insurance companies. Only dealer loans from banks are included under call loans. In short, in the United States, the call money market comprises an inter-bank call market, and the market between banks on the one hand and security brokers and dealers on the other. Because of the greater are known by different names.
15.3 CALL MONEY MARKET IN THE UNITED KINGDOM In the UK, the call money market consists of three parts:6 (a) clearing banks’ loans to discount houses; (b) inter-bank loans; and (c) mobilisation of surplus money by discount houses among themselves before they banks, the existence of an intermediary in the form of discount houses is a peculiar organisational feature of the British money market.
15.3.1 Clearing Banks’ Loans to Discount Houses Commercial banks give loans to discount houses on call basis. These loans are normally repayable when demanded. They are mostly secured loans, being secured against treasury bills or other bills of exchange as collateral. Commercial banks regard these loans as highly liquid because they know that discount houses can repay them when called, as the latter have an access to the Bank of England. Discount houses use call loans for holding bills of exchange, treasury bills and other short-term government paper. Commercial banks are able to settle inter-bank indebtedness7 daily without impairing their cash ratios by manipulation of their call loans to the discount houses. In other words, call loans in the UK help banks in their reserve adjustment process as the federal funds do in the United States. However, there is this difference that while in the United States, the transactions are between banks, in the UK, they are between clearing banks and discount houses. Apart from borrowings from banks, discount houses bid for marginal funds among themselves before they resort to the discount window at the Bank of England. According to Sayers, this market for funds among discount houses is somewhat similar to the federal funds market in the United States.8
15.3.3 Inter-bank Call Market Inter-bank call market in the UK developed in the 1960s, particularly after 1964. This is a market for lendings and borrowings among Scottish banks, merchant banks, British overseas banks, and foreign banks—all outside the clearing banks which are the major commercial banks in the UK. The clearing banks do not participate in this market. Unlike call loans to discount houses, inter-bank loans are unsecured. These loans may be simply overnight loans or they may be for a period of 6 months, but, generally, they are only for a few 6
Based on Sayers, op. cit. It arises from the transfer of deposits between persons and different banks. Inter-bank indebtedness is different from inter-bank borrowings referred to later. 8 Sayers, op. cit., p. 273. 7
15.6 days. The transactions in this market are usually, but not always, arranged by brokers. This market has some similarity with the federal funds market in the United States, although the scope of the former is relatively much more restricted because the major commercial banks in the country do not participate in that market.
15.4 CALL MONEY MARKET IN INDIA In India there are no separate short-term money markets of the types that have been discussed above. S K Muranjan9 has pointed out that call loans in India are given: (a) to the bill market, (b) for the purpose of dealing in the bullion markets and stock exchanges, (c) between banks, and (d) frequently to individuals
and other markets has been modest. Over a period of time, non-inter-bank uses of call money have further declined in relation to inter-bank transactions. Banks borrow from other banks in order to meet a sudden demand for funds, large payments, large remittances, and to maintain cash or liquidity with the RBI. Thus, to the extent that call money is used in India for the purpose of adjustment of reserves, it is similar to federal funds in the United States; to the extent that call loans are given to security brokers they are similar to call loans proper in the the United States; to the extent that call money is traded among banks, it is similar to the ‘outside’ inter-bank loans in the UK. As there are no discount houses in India, there is no parallel in India to the loans between commercial banks and discount houses in the UK. Until March 1978, transactions in the call money market were usually effected through brokers. Each day, these brokers obtained information about money on offer and money demanded, and then effected transactions. Since then, however, the RBI has prohibited banks paying brokerage on operations in the call money market as it has stopped payment of brokerage on deposits.
15.4.1 Participation In the beginning, participants in the call money market were (a) scheduled commercial banks, (b) nonscheduled commercial banks, (c) foreign banks, (d) state, district and urban, cooperative banks, (e) Discount and Finance House of India (DFHI), and (f) Securities Trading Corporation of India (STCI). The DFHI and STCI borrow as well as lend, such as banks and primary dealers, in the call market. At one time, only a few large banks, particularly foreign banks, operated in the call money market. Over time, however, the market has expanded and now small banks and non-scheduled banks also participate in this market. Earlier foreign banks were primarily lenders in this market. However, now their participation as borrowers has increased in the cost of servicing (FCNR) deposits have also compelled foreign banks to borrow in the call market, converting them from net lenders to net borrowers. Among the large commercial banks, the SBI kept itself away from the call market till 1970 after which it has been regularly participating in this market. Because of its large size and formidable cash position, its participation made the market more active. The SBI group is a major lender but a small borrower in the call market. Over the time owing to the participation of LIC, UTI and other institutions the supply of call loans on the money market by these institutions has been advantageous in certain ways. Earlier, these institutions were keeping their funds with a very small number of big 9
Muranjan, S K, Modern Banking in India, Kamala Publishing House, Bombay, 1952, p. 98, and p. 138.
15.7 banks which had a sort of ‘monopoly use’ of the vast cash resources of these institutions. Through the call market, it has now become possible for many other banks to fall back upon these institutions in times of
and policyholders. Further, continuous participation in the call market by them would help to integrate the long-term and short-term money markets in the economy. This development, however, raised certain important issues. First, whether institutions with long-term funds
predominantly short-term liabilities create long-term assets. Similarly, as banks can always approach the RBI as a lender of last resort, the possibility of their not honouring the call provision is extremely remote, which means that the lenders’ risk involved in this activity is almost nil. It is also to be noted that call loans these institutions’ direct participation in the call market along with the growth of the market for participation the banking system means that they can weaken the effect of monetary techniques such as, changes in reserve requirements, bank rate, and selective credit controls. In this context, the Working Group on the Money Market (Vaghul Working Group) appointed by the RBI in 1987 had recommended that the call market should be the exclusive preserve of commercial banks without any ceiling on call rates. It recommended that LIC, UTI, and others can be temporarily allowed to stay in the call market and that their funds be subject to a ceiling rate of interest of 10 percent per year. The authorities have removed the ceiling on call rate for all the participants but they have not banned LIC, UTI and others from participating in the market. As per the latest RBI policy, LIC, UTI, GIC, IDBI, and NABARD are allowed to participate in the call market and it announced that the access to call market as lenders would be provided to such entities that are able to provide evidence to the RBI about their having bulk lendable resources, and which have no outstanding borrowings from banks. They will be required to observe a minimum size of operations of `20 crore per transaction. They can participate with prior permission of the RBI, and only through the DFHI. In 1996-97, the RBI permitted four primary dealers (PDs) to participate in this market as both borrowers and lenders. Seven mutual funds also have been allowed to participate as lenders now. It has been observed that the participation on the supply side of the market has remained limited. There is a view, that there are imperfections in the call market in the sense that only a few cash-rich banks supply funds and they tend to make quick gains by pushing up call rates by forming informal cartels. Another view is that even if cartels may not be existing, there is no call market proper in India because there is a very small group of lenders and a large number of borrowers in this market. In the recent past, the authorities have initiated certain measures to develop a pure inter-bank call market. With effect from 6 August, 2005, the call money market has become a pure inter-bank market. The participants in call/notice money market currently include scheduled commercial banks (excluding RRBs), co-operative banks (other than land development banks) and primary dealers (PDs), as borrowers and lenders. As on 13 June 2014, the standalone banks and primary dealers, which are existing in India, are as follows: ICICI Securities Primary Dealership Limited, Morgan Stanley India Primary Dealer Pvt. Ltd., Nomura Fixed Income Securities Pvt. Ltd., SBI DFHI Ltd., STCI Primary Dealer Limited, Goldman Sachs (India) Capital Markets Pvt. Ltd., Bank of America, Bank of Baroda, Canara Bank, Citibank N.A, Corporation Bank, HDFC
15.8 Bank Ltd., Hong Kong and Shanghai Banking Corp. Ltd. (HSBC), J P Morgan Chase Bank N.A, Mumbai Branch, Kotak Mahindra Bank Ltd., Standard Chartered Bank, Axis Bank Ltd., IDBI Bank Limited, and Deutsche Bank AG. Non-bank institutions (other than PDs) are not permitted in the call/notice money market. The prudential limits in respect of both outstanding borrowing and lending transactions in call/notice money market for scheduled commercial banks, co-operative banks and PDs are given in Table 15.1. All the money market transactions should be reported on the electronic platform called the negotiated dealing system (NDS). These transactions take place in the OTC market and are required to be reported on FIMMDA platform within 15 minutes of the trade for dissemination of information. They are also to be reported on the clearing house of any of the exchanges for the purpose of clearing and settlement. Table 15.1 Prudential limits for transactions in call/notice money market Participants
Borrowing
Lending
Scheduled commercial banks
On a fortnightly average basis, borrowing outstanding should not exceed 100 percent of capital funds (i.e. sum of Tier I and Tier II capital) of latest audited balance sheet. However, banks are allowed to borrow a maximum of 125 percent of their capital funds on any day, during a fortnight.
On a fortnightly average basis, lending outstanding should not exceed 25 percent of their capital funds. However, banks are allowed to lend a maximum of 50 percent of their capital funds on any day, during a fortnight.
Co-operative banks
Outstanding borrowings of State Co-operative No limit. banks/district central co-operative banks/urban cooperative banks in call/notice money market, on a daily basis should not exceed 2.0 percent of their aggregate deposits as at end March of the previous
PDs
PDs are allowed to borrow, on average in a reporting PDs are allowed to lend in call/notice money fortnight, up to 225 percent of their net owned funds market, on average in a reporting fortnight, up to 25 percent of their NOF.
Source: RBI, Master Circular on Call/Notice Money Market Operations on 1 July, 2014.
15.4.2 Maturity Period and Seasonal Demand Under call money market, funds are transacted on an overnight basis; under notice money market, funds are transacted for a period between 2 and 14 days and under term money market, funds are dealt for 15 days to 1 year. Money at call and short notice in the balance sheets of commercial banks is a highly liquid asset. Unlike in other countries, call loans in India are unsecured. It is well-known that money and credit situation call money market is also believed to be characterised by seasonal variations. The seasonal ups and downs
decline in money at call and short notice should be greater in the slack season than in the busy season of a given year; (ii) an increase in money at call and short notice should be greater in the busy season than in the slack season. The need for call money borrowings is the highest around March every year which may be due institutions to meet their statutory obligations. Call money borrowings tend to increase when there is an increase in the CRR.
15.9
15.4.3 Location In the beginning, the Call money markets are mainly located in big industrial and commercial centres such as Mumbai, Calcutta, Chennai, Delhi, and Ahmedabad. These are also the places where stock exchanges are and buoyancy of the market. The predominant role of Mumbai in this context is understandable as the head in the country. There is a tendency for funds to gravitate to Mumbai and Kolkata. The development of a call markets, however, is still far from perfect resulting in considerable differences in call rates prevailing in different centres. It has been reported that, apart from the well-recognised markets in big cities, there are a large number of local call markets developed and operated by ingenious local bankers. For example, in Saurashtra in Gujarat when large payments or remittances are to be made, the local banks help each other with overnight funds. Among some banks, there are regular arrangements without the payment of interest. For other banks, the price of overnight money is two paise per 100 rupees per night. When one bank presents a cheque for, say, ` banker to let the funds remain with it overnight and pays at the rate of interest just mentioned.
15.4.4 Variations in Demand and Supply of Call Loans Variations in the volume of demand for and supply of call loans are caused by many factors. The resources determining the resources position of the banking system is the extent of deposits accrual. Increase in deposits with banks, other things being equal, would induce banks to explore possibilities of investment. Since call loans are one of the avenues for investment, the supply of call loans would increase when there is an increase in deposits. It is to be noted that if deposits accrue to all banks, it is unlikely that inter-bank call loan would increase. In a case such as this, the supply of funds to the outside (of the banking system) borrowers would increase. One can, however, visualise a differential growth in the deposits of different banks as a result of which the volume of inter-bank call loans would tend to increase. The demand for call loans would depend upon the buoyancy of the stock market and the increase in demand for loans for industrial and commercial purposes. The size of call loans is also determined by the possibility of quick investment or liquidation of government securities, treasury bills, and other short-term investments. It has been observed that, when subscriptions to government loans open, the demand for call loans tends to increase. Demand for call money tends to broaden in December, March and June, that is, when quarterly advance tax payments are to be made. The speed with which the remittance and clearance system in the country works also has a great determining impact on the day-to-day volume of call loans. The policy of the RBI in respect of its loans to banks and the implementation of the reserve ratio requirements is another important factor having a bearing on the banks’ decision to borrow on the call market. When the banks have a liberal access on cheap terms to the discount window of the RBI, their need to resort to the call market would be relatively less. On the other hand, in a period of restrictive monetary policy, banks would attempt to utilise their resources on a weekly basis, coupled with the manipulation of the statutory liquidity ratio, makes banks operate in the call money market as lenders and borrowers. In addition, the pressure on the market reaches a peak towards
15.10 the end of the banking week, that is, on Friday, when there is a scramble for funds to make up the shortfall in the amount of required reserves. As we shall see, the foreign exchange market activity has also become a
15.5
SIZE OF THE CALL MONEY MARKET IN INDIA
Table 15.2 shows the average daily turnover of call money market in India during the period 1997–1998 to 2015–2016. It is found that call money market turnover has not followed a particular trend and it has lowest in 2004–2005. It could be due to the increase in the relative size of the collateralised markets such as Collateralized Borrowing and Lending Obligations (CBLO) market, market repo and term money market vis-à-vis the uncollateralised market like call money market. The analysis on these markets is given in the later part of the chapter. Table 15.2 Average daily turnover of call money market Year
Amount (`Crore)
1997–1998
22709
1998–1999
26500
1999–2000
23161
2000–2001
32157
2001–2002
36144
2002–2003
29421
2003–2004
17191
2004–2005
14170
2005–2006
17979
2006–2007
21725
2007–2008
21393
2008–2009
22436
2009–2010
15924
2011–2012
23070
2012–2013
21700
2013–2014
30230
2014–2015
25570
2015–2016
26950
Source: RBI, Bulletins, Various Issues.
15.6
SIZE OF INDIAN CALL MARKET vis-à-vis THE UNITED STATES AND THE UNIDED KINGDOM
The size of the call market in India has been smaller than that of the United States and UK. This could have been due to the following factors among others. First, the bill market in India is underdeveloped and so the call loans to the bill market cannot but be small. The volume of call loans depends upon the
LO 3 Compare the size of Indian call market vis-àvis US and UK
15.11 extent of trading in bills of exchange, treasury bills, and so on. Wherever these markets are developed, the amount of call loans demanded and supplied is also large. In addition, banks in India are not inclined to offer loans to brokers and dealers in bills and securities.10 Second, unlike in the UK, direct discounting facilities with the RBI are available to banks as a result of which they have much less need for loans from the money market. Further, Indian commercial banks hold fairly large cash reserves; therefore, their need to borrow in the call market is much less. Third, unlike in the United States, loans to security dealers cannot be large for certain reasons. Government securities are directly sold by the RBI or to the RBI without much intervention by brokers and dealers. The volume of industrial securities traded on the stock exchanges is also relatively Indian milieu. There are also several regulations which have been imposed by the RBI on banks in respect of advances against shares. Therefore, much of the trading activity on stock exchanges in India is undertaken by the members using funds which are mostly derived from private sources.
15.7 CALL RATES The rate of interest paid on call loans is known as call rate. The call rate is highly variable from day to day, and often from hour to hour. It is very sensitive to changes in demand for and supply of call loans.
15.7.1 Historical Background The call rate in India used to be determined until 1973 by market forces. On account of the RBI’s policy of credit squeeze introduced in May 1973 in
LO 4 Discuss the historical background of call rates
facilities, the call rate had reached as high a level as 30 percent in December 1973. As this was truly an alarming level for any short-term rate of interest to reach, and as banks defaulted in a major way in respect of cash and liquidity requirements at that time due to the prohibitively high cost of call money, it became necessary to regulate call rates within reasonable limits. Therefore, the Indian Banks’ arrangement for regulating the level of interest rate and had no legal sanction. Since then, the IBA lowered this ceiling of 15 percent to 12.5 percent in March 1976, 10 percent in June 1977, 8.6 percent in March 1978, and 10.0 percent in April 1980. The actual level of the call rate in India since 1973 had remained within the rate in the call market. Subsequently, the call rate was freed from the ceiling in two stages: Effective from October 1988, the operations of DFHI were exempted from the ceiling. Further, with effect from May 1, 1989, the ceilings on the call rate and inter-bank term money rate were withdrawn. As a result, the call rate interbank call rate.
10
Muranjan, op. cit., p. 143.
15.12
15.7.2
Call Money Rate in India
Table 15.3 presents the call rate (Mumbai) in relation to the bank rate and repo LO 5 rate. The call money rate generally changes with the repo rate as repo rate is Review call money rates the only policy rate used by the RBI currently. The operating framework of in India, US, and UK monetary policy is based on the short-run equilibrium in the money market. Therefore, bank rate has not been used as one of the monetary policy instrument by the RBI recently. The detailed discussion on this issue has been provided in Chapter 6. The call money rate has been varied between 2.75 and 17.73 percent during 1955–56 to 2015–2016. During the period 2000–2001 to 2015–2016, the call money rate has been stable and within the corridor that is, between the reverse repo rate and marginal standing facility rate Table 15.3 presents the call rate (Mumbai) in relation to the bank rate and repo rate. The call money rate generally changes with the repo rate as repo rate is the only policy rate used by the RBI currently. The operating framework of monetary policy is based on the short-run equilibrium in the money market. Therefore, bank rate has not been used as one of the monetary policy instrument by the RBI recently. The detailed discussion on this issue has been provided in Chapter 6. The call money rate has been varied between 2.75 and 17.73 percent during 1955–56 to 2015–2016. During the period 2010–11 to 2015–16, the call money rate has been stable and within the corridor, that is, between the reverse repo rate and marginal standing facility rate. Table 15.3 Call rates in India Year
( annual averages)
Inter-bank rate (Mumbai)
Bank rate
Repo rate
Reverse repo rate
MSF rate
Average
High
Low
1955–1956
2.75
—
—
—
—
1960–1961
4.24
—
—
4.00
—
—
—
1965–1966
6.26
—
—
6.00
—
—
—
1970–1971
6.38
—
—
6.00
—
—
—
1975–1976
10.55
—
—
9.00
—
—
—
1980–1981
7.12
—
—
10.00
—
—
—
1985–1986
10.00
—
—
10.00
—
—
—
1990–1991
11.49
—
—
10.00
—
—
—
1995–1996
17.73
41.62
7.64
12.00
—
—
—
2000–2001
9.15
35.00
0.20
7.00
8.75
—
—
2005–2006
5.60
8.25
0.60
6.00
6.75
5.50
2010–2011
5.75
12.00
0.25
6.00
6.75
5.15
9.00 9.00
2011–2012
8.22
15.00
0.70
6.00
7.50
6.60
2012–2013
8.09
18.00
5.00
9.00
7.50
6.60
2013–2014
8.28
35.00
0.50
9.12
7.62
6.62
9.12
2015–2015
7.97
25.00
0.25
8.62
7.62
6.62
8.62
2015–2016
6.98
16.00
2.50
7.66
6.83
6.00
7.66
Source: RBI, Handbook of Statistics, Various Issues.
9.00
15.13
15.8
CALL RATES AND BANK RATES IN THE US AND UK
Table 15.4 shows the pattern of call money rates and bank rates in the United States and UK during 2004 2013. In UK, overnight inter-bank average lending rate has changed from 4.36 percent in the year 2004 to 0.82 percent during the year 2013 and the bank rate has changed from 4.39 to 0.5 percent during the said period. In the United States, the federal fund rate has varied between 0.11 and 5.02 percent during the period 2004 2013. It reached its lowest during 2013 and highest during 2007. After that, it has come down drastically, which means that the liquidity position in the market has continuously declined. It can be observed that the discount rate varied between 5.85 and 0.5 percent during 2004–2013. Table 15.4 Call rates and bank rates in the United States and UK Year
The United States
(percentage per annum) UK
Federal fund rate
Discount rate
Inter-bank lending rate
Bank rate
2004
1.35
2.34
4.36
4.39
2005
3.22
4.19
4.68
4.65
2006
4.97
5.96
4.67
4.64
2007
5.02
5.86
5.58
5.51
2008
1.96
2.39
3.10
4.68
2009
0.16
0.50
1.37
0.64
2010
0.18
0.72
1.50
0.5
2011
0.10
0.75
1.88
0.5
2012
0.14
0.75
1.01
0.5
2013
0.11
0.75
0.82
0.5
Source: Bank of England and Federal Reserve Bank Statistics.
15.9
REASONS FOR CALL RATE VOLATILITY
The volatility of the call rate can be attributed to factors such as the following: (a) Large borrowings on certain dates by banks to meet the CRR requirements and sharp reduction in the demand for call money once CRR
LO 6 Infer the reasons for call rate volatility
fortnight, and subside in the second week when banks have covered their cash reserve requirements. (b) The credit operations of certain banks tend to be much in excess of their own resources. These banks with overextended credit position treat call market as a source of funds for meeting structural disequilibria in their sources and uses of funds. (c) The occasional factors in the market also affect the volatility. For example, in the recent past, the call rate had shot up due to disruption in the banking industry.
15.14 (d) The withdrawal of funds by institutional lenders to meet their business needs, and by the corporate sector for payment of advance tax leads to steep increase in the call rate. (e) The liquidity crisis or illiquidity in money markets also contributes to the call rate volatility. Banks invest funds (when call market is easy) in government securities, units, and public sector bonds in order to maximise earnings from their funds management. But with no buyers in the markets, these instruments tend to become illiquid which accentuates liquidity crisis in the call market pushing up the (f) The mismatch between assets and liabilities of commercial banks arising out of massive demand for non-food credit as against sluggish growth in bank deposits is another relevant factor. (g) In the recent past, the forex market and call money market have become quite closely interlinked; on 3 November, 1995, and again between the middle of February to the middle of March, 1996 were largely due to the turbulence in the forex market, and the RBI intervention in the forex market. The RBI intervention in order to prevent the unusual depreciation of the rupee, and the temporary withdrawal
(h) The technical modalities of the calculation of reserves requirements also leads to sharp swings in the call rate. deposits also have been the important contributory factors in this context. The banking system tries to build up deposits towards the end of the year and in some cases, an increase in deposits in a week towards the end of the year is greater than an increase in them in the whole year.
15.10 MEASURES TAKEN TO REDUCE VOLATILITY OF CALL MONEY RATE The central bank has taken certain steps to reduce the volatility of call money rates in India. All the measures are as follows: (a) intervention by the DFHI has increased, (b) more funds have been channelized by the RBI through the DFHI, funds, (d) penalties on CRR shortfalls are softened, (e) the liquidity adjustment facility was introduced from June 2000 onwards to manage short-term liquidity
LO 7 Understand the measures for reducing volatility of call money rate
liabilities were freed from reserve requirements in 1997.
15.11 VOLATILITY OF CALL MONEY RATE IN INDIA The volatility in call money rates has reduced after the introduction of LAF and the setting up of an informal corridor of reverse repo and repo rates. The stability as a key consideration of monetary policy (Tables 15.5).
LO 8 Illustrate volatility of call money rate in India
15.15 Table 15.5 Volatility in the call money market (percentage) Item Average
April 1993–March 1996
April 1996–March 2000
April 2000–March 2007
April 2007–March 2013
11.1
8.0
6.3
6.4
SD
6.7
3.7
1.9
1.8
CV
0.6
0.6
0.3
0.28
Source: Calculated from the Monthly Data Collected from RBI, Handbook of Statistics, Various Issues.
15.12 MUMBAI INTER-BANK BID RATE (MIBID) AND MUMBAI INTER-BANK OFFER RATE (MIBOR) was felt. Then the National Stock Exchange (NSE) developed Mumbai inter-bank bidrate (MIBID) and Mumbai inter-bank offer rate (MIBOR) for the money market and it was launched on 15 June, 1998 as an overnight rate. It is the interest rate at which banks can borrow funds, in marketable size, from other banks in the Indian inter-bank market. It is calculated daily by the National Stock Exchange of India (NSE). This rate by major banks throughout India. It is calculated on the basis of data collected from the panel of 30 banks and primary dealers. The panel has a mix of public sector banks including SBI, CBI; private sector banks including Axis Bank Ltd, HDFC Bank Ltd; foreign banks including Citibank NA and Deutsche Bank; and primary dealers including ICICI Securities Ltd and PNB Gilts Ltd. The rates are then calculated by a combination of two methods—polling and bootstrapping. In the polling method, the rates are taken from a few market participants and the reference rates are arrived at. However, there is no guarantee that participants will give real and honest rates, therefore, in India, polling is combined outliers in the data collected from market participants. The combination is said to be better than applying the polling method alone. It is also expected to help against any attempt by the market participants to come certain developments have taken place in this regard. The NSE launched the 14-day MIBOR on 10 November 1998 and the 1-month and 3-month MIBORs on 1 December, 1998. Further, the exchange introduced a 3-day FIMMDA-NSE MIBID-MIBOR on all Fridays with effect from 6 June, 2008 in addition to existing overnight rate. as the corporate debt market is developing in India, with increased domestic and international participation,
deposits in Indian markets.
15.13 LONDON INTER-BANK OFFER RATE (LIBOR) It is an interest rate at which banks can borrow funds in marketable size from other banks in the London inter-
15.16 banks work out how much money they need to borrow from their peers to plug any holes in their balance sheets or, if they have an excess of available cash, how much they can afford to lend. LIBOR formally measures the cost of this inter-bank lending and setting out the average rate banks pay to borrow from one another. It is a very popular benchmark and is issued for the United States Dollar, GB Pound, Euro, Swiss Franc, Canadian Dollar and the Japanese Yen. There are 150 different LIBOR rates calculated on a daily basis by Thomson Reuters for 15 borrowing periods ranging from overnight to a year, spanning 10 different currencies. These rates are calculated based on data submitted by a panel of major banks (the number of banks on the panel varies according to the currency). The UK’s sterling rate is based on submissions from 16 banks, and the United States dollar rate on the other hand, is calculated using a panel of 18 banks. Each bank is asked the same question, that is, if you need to borrow cash from your fellow banker friends, how much would they charge you for it? Once the rates are submitted, the four highest and the four lowest rates are ignored, and the average of those left are used to calculate the LIBOR rate which, along with the individual rates submitted by each bank, are then published before midday
term interest rates. Complex derivative products used by professional traders in the multi-trillion-pound bond and currency markets are commonly priced using LIBOR. Table 15.6 shows the trends in the average MIBID, MIBOR and LIBOR rates during the period 1998–2013. It is found that relatively the LIBOR rates have been lower than the MIBOR and MIBID rates for the same maturity. It could be due to the different demand and supply of funds available for borrowing and lending. wide range of variation between the highest and the lowest rates for all three types of rates. Table 15.6 MIBID, MIBOR and LIBOR Rates Year
MIBID 1-month maturity
1998
(annual averages percentage) MIBOR
3-month maturity
1-month maturity 9.95
LIBOR 3-month maturity 11.04
1-month Maturity
3-month maturity
5.55
5.61
9.25
10.08
1999
9.28
10.04
10.02
10.81
5.30
5.48
2000
9.44
9.82
10.29
10.71
6.43
6.52
2001
8.02
8.49
8.69
9.18
3.71
3.63
2002
6.48
6.86
6.97
7.42
1.75
1.78
2003
5.02
5.15
5.3
5.52
1.20
1.21
2004
4.63
4.78
5.48
5.08
1.54
1.67
2005
5.32
5.61
5.61
6.01
3.45
3.63
2006
6.55
6.9
7.05
7.44
5.13
5.22
2007
7.35
8.27
8.3
9.11
5.25
5.29
2008
8.37
9.13
9.24
9.92
2.66
2.91
2009
4.15
5.12
4.57
5.57
0.33
0.69 (Contd.)
15.17 2010
5.35
5.85
5.74
6.29
0.27
0.34
2011
8.6
9.15
8.95
9.51
0.23
0.33
2012
8.99
9.19
9.24
9.48
0.23
0.43
2013
8.85
9.13
9.03
9.32
0.18
0.26
2014
8.52
8.89
8.65
9.01
0.25
0.23
2015
8.59
8.48
8.76
8.64
0.26
0.27
Source: www.nseindia.com, World Street Journal.
15.14 OTHER SHORT-TERM MONEY MARKETS IN INDIA term money market where the tenor of the transactions is from 15 days to 1 year. The gradual phasing out of non-banks from the call money market has led to development of collateralised markets such as the repo market and the collateralized borrowing and lending obligations (CBLO) market. The migration to the collateralised segments has also reduced the volatility in the overnight money market rates as availability of alternative avenues for mobilising short-term funds has enabled market rates to align with the informal interest rate corridor of repo and reverse repo rate under the liquidity adjustment facility (LAF).
15.14.1 Repo Market11 Repo or ready forward contact is an instrument for borrowing funds by selling securities with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed. The reverse of the repo transaction is called ‘reverse repo’ which is lending of funds against buying of securities with an agreement to resell the said securities on a mutually agreed future date at are two legs to the same transaction in a repo/reverse repo. The duration between the two legs is called the ‘repo period’. Predominantly, repos are undertaken on overnight basis, that is, for 1-day period. Settlement of repo transactions happens along with the outright trades in government securities. The consideration amount at the agreed ‘repo rate’ is calculated and paid along with the consideration amount of the second leg of the transaction when the borrower buys back the security. The overall effect of the repo transaction would be borrowing of funds backed by the collateral of Government securities.
15.14.2 Collateralised Borrowing and Lending Obligation (CBLO)12 CBLO is another money market instrument operated by the Clearing Corporation of India Ltd. (CCIL), for access in terms of ceiling on call borrowing and lending transactions. It was operationalised with effect from 20 January, 2003. It is explained as follows: (i) an obligation by the borrower to return the money 11 12
RBI, Government Securities Market in India—A Primer Ibid.
15.18
future date with an option/privilege to transfer the authority to another person for value received, and (iii) an underlying charge on securities held in custody (with CCIL) for the amount borrowed/lent. CBLO is a discounted instrument available in electronic book entry form for the maturity period ranging from 1 to 90 days (up to 1 year as per RBI guidelines). In order to enable the market participants to borrow and lend funds, CCIL provides the dealing system through Indian Financial Network (INFINET), a closed user group to the members of the negotiated dealing system (NDS) who maintain current account with RBI and through Internet for other entities who do not maintain current account with RBI. Membership to the CBLO segment is extended to entities who are RBI- NDS members, viz., nationalized banks, private banks, foreign banks, Associate membership to CBLO segment is extended to entities who are not members of RBI-NDS, viz., co-operative banks, mutual funds, insurance companies, NBFCs, corporates, provident/pension funds and so on. By participating in the CBLO market, CCIL members can borrow or lend funds against the collateral of eligible securities. Eligible securities are central government securities including treasury bills, and such
through proper documentation. Table 15.7 Average daily turnover of market repo, CBLO and term money markets in India (` in Crore) Year
Market repo (outside LAF)
Collateralized borrowing and lending operation (CBLO)
Term money market
1999–2000
6895
—
—
2000–2001
10500
—
—
2001–2002
30161
—
195
2002–2003
46960
30
341
2003–2004
10435
515
519
2004–2005
17135
6697
525
2005–2006
21183
20039
833
2006–2007
33675
32390
1012
2007–2008
54736
55626
704
2008–2009
57320
61552
794
2009–2010
47706
109125
NA
2011–2012
98680
119630
540
2012–2013
51920
76930
490
2013–2014
74780
83270
940
Source: RBI, Bulletins, Various Issues.
15.19 From Table 15.7 it is found that the combined average daily transactions of market repo and collateralised borrowing and lending obligation (CBLO) was proportionately higher than those in the uncollateralised call/notice money market (Table 15.2). It may be noted that after phasing out of non-bank participants, except primary dealers from the call/notice money market, the supply of institutional funds from insurance companies and mutual funds has shifted to the collateralised market, which also offers funds at the rates, generally lower than in call money market. The average turnover of CBLO market has been highest followed by market repo and term money market. The average turnover of term money market has been negligible.
SUMMARY ◆
◆
◆
◆
◆
◆
◆
◆
The call money market is the market for very short-term funds repayable on demand and with maturity period varying between 1 day and a fortnight. Commercial banks and co-operative banks are the major participants on both the supply and demand sides of this market. In the United States, the call money market has two components, that is, (a) federal funds market, and (b) call money market proper. In the UK , the call money market consists of three parts: (a) clearing banks’ loans to discount houses, (b) inter-bank loans, and (c) mobilisation of surplus money by discount houses among themselves. With effect from 6 August, 2005, the call money market has become a pure inter-bank market. The participants in call/notice money market currently include scheduled commercial banks (excluding RRBs), co-operative banks (other than land development banks) and primary dealers (PDs), both as borrowers and lenders. All the money market transactions should be reported on the electronic platform called the negotiated dealing system (NDS). Under call money market, funds are transacted on an overnight basis, under notice money market; funds are transacted for a period between 2 and 14 days; and under term money market the funds are dealt for 15 days to 1 year and call loans in India are unsecured. Call money market is mainly located in big industrial and commercial centres like Mumbai, Kolkata, Chennai, Delhi, and Ahmedabad.
◆ ◆
The volume of call loans depends on the extent of deposits accrual, the possibility of quick investment
◆
The rate of interest in the call market—call rate—in India was market-determined till 1973. Subsequently,
◆
widely; its volatility has increased over the years. The large amount of borrowings by banks on certain dates to meet CRR requirements, overextended credit position of some banks, occasional disturbances in the banking system and money market, sudden forex market turbulence are the major factors behind extreme volatility of the call rate.
15.20 ◆
◆
◆
◆
The average call money rate has been more or less during the period 2000–2001 to 2012–2013. The average call money rate has been very much volatile during the period. The gradual phasing out of non-banks from the call money market has led to development of collateralised markets such as the repo market and the collateralized borrowing and lending obligations (CBLO) market. Average daily turnover of market repo, CBLO and term money markets in India have increased in the current period. The LIBOR rate has been consistently lower than the call money rate in India.
KEY TERMS Federal Funds Market Call Money Market Proper Inter-bank call market
Primary dealers Call money rate Call rate volatility
Mumbai inter-bank offer rate London inter-bank offer rate
QUESTIONS States, UK and its working in India. 2. Who are the participants in the call money market? Give a brief idea about the distribution of call loans according to types of participants in this market. 3. Comment on the following statements: Financial Institutions with long-term funds should enter at all into the short-term market. The size of the call money market has increased in India. 4. What are the factors that affect the demand for and supply of call loans? 5. Analyse the trends in different call rates in India. 6. Discuss the factors, which are responsible for the volatility of call rate. 7. Write short notes on following: (a) Locations of call money market in India. (b) Maturity of call loans in India. (c) Difference between the UK and Indian call money market. (d) Relation between call rate and bank rate (e) Collateralised borrowing and lending operations (f) Term money market (g) Market repo (h) Clearing Corporation of India (i) London inter-bank offer rate
Treasury Bills Market
16
CHAPTER Learning Objectives LO 1 LO 2 LO 3 LO 4 LO 5 LO 6 LO 7
Know treasury bill and the implications of the working of its market for bank deposits and monetary policy Identify various types of treasury bills List other short-term central government securities Explain treasury bill rate Understand the calculation of the yield of a treasury bill Outline major policy developments and market size of T-bills in India Summarise treasury bill rates and its limitations in India
16.1 INTRODUCTION In this chapter, we will discuss the market for treasury bills (TBs), the main instrument of short-term borrowing Developed treasury bills market has been the precondition for effective open market operation by the RBI. Being default risk-free, the yields on treasury bills at different maturities are always used as the benchmark
for 91-day, 182-day, 364-day and 14-day treasury bills.
16.2 NATURE AND CHARACTERISTICS 1 A or a promissory note put out by the government of the country. Treasury bills (T-bills) offer short-term investment opportunities, generally up to 1 year. They are, thus,
until 1950, since then it is only the central government that has been selling them. Treasury bills are not self1
A bill which does not arise from any genuine transaction in goods is called a finance bill.
16.2
Financial Institutions and Markets
cannot be a better guarantee of repayment than the one given by the government and because the central bank of the country is always willing to purchase or discount them. As unlike ordinary trade bills, treasury bills Treasury bills are zero coupon securities and pay no interest. They are issued at a discount and redeemed at of default, (c) ready availability on tap, (d) assured yield, (e) low transactions cost, (f) eligibility for inclusion
16.3 FUNDING OF TREASURY BILLS, BANK DEPOSITS AND MONETARY POLICY It is necessary to understand the implications of the working of the TBs market for the process of multiple deposit creation by banks and for the working of monetary policy. The selling of treasury bills to banks impinges on the working
LO 1 Know treasury bill and the implications of the working of its market for bank deposits and monetary policy
and thereby reduces their credit-creating capacity. But, at the same time, large holdings of TBs by banks create a potentially dangerous situation. Banks can always make up for the loss of cash by rediscounting treasury bills with the central bank or by replenishing cash resources when these bills mature. In India, the fact that during the rediscounted by them with the RBI have increased considerably indicates that the danger of undermining period of unprecedented tight money policy itself may be regarded as the reaction of banks to the tight money policy. The rule that certain liabilities of the government, such as the TBs, should form a part of the minimum reserve ratio to be maintained by banks implies that the creation of TBs will increase the power of deposit creation of banks. How far variations in the volume of TBs will undermine monetary policy will depend upon the
by banks. In India, it is the dated government securities and not so much the TBs which form a large part of the SLR. On this account, therefore, the danger posed by the expansion of the TBs market to the success of monetary policy is relatively less. In order to counteract the threat posed by TBs to monetary policy, the Radcliff Committee recommended the policy of funding, that is, converting TBs into long dated or undated securities.2 As already explained, funding means an extension in the maturity of government debt, generally involving a reduction in the TBs issued. The outcome of funding operations is a lengthening of maturities of the cost of servicing the debt as a result of the higher interest rate payable on long-term debt. In the context 2
HMSO, Radcliffe Committee Report, London, 1959.
Treasury Bills Market
16.3
undated government securities, while the latter means TBs, and ways and means advances (WMA). ad hocs only, but it is no longer so. It has been argued
has been suggested that since TBs are discounted with the RBI and this amounts to a transfer of credit to the government from commercial banks to the RBI, it would be in the interest of the success of monetary action banks. Some of the reasons why this cannot be done, and why such a policy is likely to fail are as follows: the RBI. Treasury bills discounted with the RBI as a proportion of total outstanding bills with the banks have may not prefer short-dated securities to TBs. In the absence of well-developed markets for commercial bills
at some time; and if banks are given unlimited access to the RBI credit by way of pledging dated securities, the monetary action would not be aided by the replacement of treasury bills. Third, the issue of treasury bills cannot be entirely looked at from the point of view of monetary policy. There are certain advantages which the government enjoys by issuing treasury bills and it may not be willing to forego them. It raises short-term
16.4 TYPES OF TREASURY BILLS Two types of TBs have been in vogue in India so far: ordinary and ad hoc. Ordinary TBs
LO 2 Identify various types of treasury bills
are freely marketable, can be bought and sold at any time and have a secondary market also. On the other hand, ad-hoc TBs (also known as ad hocs in short) are always issued in favour of the RBI only. They are not sold through tender or auction. They are purchased by the RBI, and the RBI is always sell them back to the RBI. The instrument of ad hoc treasury bill and the system of issuing it was introduced in India in 1937. As per the agreements made between the GOI and RBI in 1937 and 1955, it was decided that the government shall maintain with the RBI a cash balance of not less than `50 crore on Fridays and ` four crore on other days, free of obligation to pay interest thereon, and whenever the balance falls below these minimums, the government account would be replenished by the creation of ad hocs in favour of the RBI. The system thus put in place was used extensively during the period of World War II; the ad hocs
16.4
Financial Institutions and Markets
the strength of sterling balances. In short, the arrangements then were such that there were safeguards against imprudent creation of money. The system of ad hoc of the planning era. The government issued these bills to replenish their cash balances. They also provided a medium to the state governments, semi-government departments and foreign central banks to invest their which would have resulted if the state governments had to compete with regular investors in TBs issued to the public. However, ad hocs came to be issued at an unduly low (market unrelated) rate, actually a negative real rate, for a long period of time. The rate of interest on them remained pegged at 4.6 percent for many years. The ad hocs The GOI and RBI entered into a formal agreement on 9 September, 1994 to phase out the system of ad hocs. The agreement provided (a) that at the end of the year 1994–1995, the net issue ad hocs would not exceed `6000 crore; (b) that the net issue of ad hocs should not exceed `9000 crore for more than 10 continuous
ceilings for the net issue of ad hocs will be stipulated for 1995–1996 and 1996–1997; and (e) the system of ad hocs would be totally discontinued from 1997–1998. How did the agreement work? Within-the-year and end-year, limits were observed in 1994–1995 but not in 1995–1996 and 1996–1997. There were prolonged effect, be avoided because the government securities issued to replace ad hocs often during 1995–1996 and 1996–1997. In keeping with the provisions of 1994 agreement, the GOI and RBI entered into a fresh agreement on 26 March, 1997 which provided (a) that the system of ad hocs will be discontinued with effect from 1 April, 1997; (b) that the outstanding ad hoc TBs and tap TBs as on 31 March, 1997 would be funded on 1 April, (c) that a system of ways and means advances (WMA) by the RBI to the GOI will be introduced with effect from 1 April, 1997 to accommodate temporary mismatches in GOI receipts and payments, the limit of and interest rate on which will be mutually agreed upon by the GOI and RBI; (d) that when 75 percent of WMA limit is utilised, the RBI will trigger fresh issues of government securities; and (e) that the overdraft will not be permissible for periods exceeding 10 consecutive working days after 31 March, 1999. There is not much substantive difference between the system of ad hocs and that of WMA. It has been pointed out that in receipts and payments of the government; that it implies periodic vacation of advances made and not their accumulation year after year. But the 1937 agreement about ad hocs also had a similar intention and yet it became a source of funds. There is a great likelihood that WMA also would become a source of funds as it had happened in the case of WMA to the states. It has been further pointed out in favour of WMA that there will be limits on such advances. Again, there were limits on ad hocs also as per 1994 agreement, but they were often exceeded in practice.
16.4.1 91-Day, 182-Day and 364-Day Treasury Bills At present, the Government of India issues three types of treasury bills through auctions, namely, 91-day, 182-day and 364-day treasury bills. Among these 91-day treasury bills are oldest short-term instrument used
Treasury Bills Market
16.5
by the central government. With a view to widening the short-term money market, and to providing more outlets for temporary surplus funds, the authorities in India had introduced, in November 1986, a major 182-day treasury bill. It was said that the introduction of this bill was a contribution by the GOI towards the development of short-term money
It used to be sold in the market by the RBI in auctions which were monthly in the beginning; they were be raised through the auctions of these bills. The amount raised in each auction depended upon the funds available with the market participants, and the funds they desired to invest in these bills. Thus, the new bill
of `1 lakh and its multiples thereof. These bills were eligible securities for SLR purpose and for borrowing
they were not purchased by state governments and provident funds. It is also to be noted that the RBI did not purchase these bills at all. The usual participants in the market for this bill were foreign commercial banks, stock companies, DFHI and others. On the whole, the market for these bills was much narrower than that for 91-day bills. Upon discontinuing the 182-day treasury bill the authorities introduced a new money market instrument, namely 1992, and since then, it is being auctioned regularly every fortnight. Its features are very similar to those which the 182-day bill had. The RBI does not purchase and rediscount this bill. It has evoked a moderate tendered at the time of each auction. The investor response to it appears to depend, among other things, on the uncertainties in the government securities market, variations in the SLR and the yield. The number of bids and amount accepted also have been moderate to large.
16.4.2 14-Day Treasury Bills With a view to further diversify the TBs market, the authorities have introduced two types of 14-day TBs: One on 1 April, 1997 which is known as intermediate treasury bill (ITB); and the second on May 20, 1997. The ITB has replaced the 91-day tap treasury bill. It is sold only to state governments, foreign central banks TBs for investment of their temporary cash surpluses. It is issued in a book entry form, that is, by credit to subsidiary general ledger account; it is not transferable; it can be repaid/renewed at par on the expiration of
at 50 basis points higher than the discount rate, and on rediscounting, it is extinguished. With effect from 13 rediscounted at 50 basis point higher than the discount rate. The surplus cash balances of state governments are automatically invested in 14-day intermediate treasury bills (ITBs).
16.6
Financial Institutions and Markets
16.5 OTHER SHORT-TERM CENTRAL GOVERNMENT SECURITIES Apart from these types of TBs, the RBI also issues two types of short-term follows:
LO 3 List other short-term central government securities
16.5.1 Cash Management Bills (CMBs) Government of India, in consultation with the Reserve Bank of India, has decided to issue a new shortterm instrument, known as cash management bills (CMBs), to meet the temporary mismatches in the cash than 91 days. Like T-bills, they are also issued at a discount and redeemed at face value at maturity. The Government. The announcement of their auction is made by Reserve Bank of India through a Press Release which is issued 1 day prior to the date of auction. The settlement of the auction is on T+1 basis. The noncompetitive bidding scheme has not been extended to the CMBs. However, these instruments are tradable government securities by banks for SLR purpose under Section 24 of the Banking Regulation Act, 1949. First set of CMBs were issued on 12 May, 2010. After its introduction following a cumulative increase of 125 bps in the repo rate during April–July 2011, money market rates moved in step with the policy rate hikes. The issuances of cash management bills to the tune of `58,000 crore during April–July 2011 to meet temporary mismatches between government receipts and expenditure also exerted pressure on money market rates. To viz., Government of India dated securities, treasury bills (T-bills), cash management bills and state development loans, the timings for primary auction under competitive bidding have been revised from 10.30 am–12.30 pm to 10.30 am-–12.00 noon from 13 April, 2012. This will permit more time for secondary market transactions for the securities auctioned on that day.
16.5.2 Ways and Means Advances (WMA) Under Section 17(5) of RBI Act, 1934, the RBI provides ways and means advances (WMA) to the states Such advances, under the Act are repayable in each case not later than 3 months from the date of making special WMA are secured advances provided against the pledge of Government of India dated securities. The operative limit for special WMA for a State is subject to its holdings of Central Government dated securities up to a maximum of limit sanctioned. In addition, the RBI has determined limits for normal and special WMA State. These limits have been revised periodically.
16.6 INVESTORS AND SALE OF T-BILLS NBFCs, FIIs (as per prescribed norms), NRIs and OCBs can invest in T-Bills. Treasury bills are available
Treasury Bills Market
16.7
for a minimum amount of `25,000 and in multiples of `25,000. T-bills are sold through auction. Auction is a process of calling of bids with an objective of arriving at the market price. It is basically a price discovery mechanism. There are several variants of auction. Auction can be price-based or yield-based. A yield-based auction is generally conducted when a new government security is issued. Investors bid in yield terms up to two decimal places (e.g. 7.49 percent, 8.21 percent and so on.). Bids are arranged in ascending order and the taken as the coupon rate for the security. Successful bidders are those who have bid at or below the cut-off yield. Bids which are higher than the cut-off yield are rejected. A price-based auction is conducted when `100 of face value of the security (e.g. `102.00, `101.00, `100.00, `99.00 and so on, per `100). Bids are arranged in descending order and the successful bidders are those who have bid at or above the cut-off price. Bids which are below the cut-off price are rejected. uniform pricebased and multiple price-
The uniform price-based auction process minimizes the uncertainty and encourages broader participation, but it also encourages the irresponsible bidding and reduces the incentive to bid. On the other hand, in a respective price/yield at which they have bid. In other words, each winning bidder pays the price it bid. The basic merit of this method is that the RBI obtains the maximum price what each participant is willing to pay. It can encourage the bidders to bid as each of them is aware that they will have to pay the price they bid, not the minimum price. This process has certain disadvantages also as it may happen that bidders who paid higher prices could face larger capital losses if the trading in these securities starts below the lowest price set winner’s curse’. An investor may bid in an auction under either of the following categories: (i) Competitive Bidding:
companies. The minimum bid amount is `10,000 and in multiples of `10,000, thereafter. Multiple bidding is also allowed, that is, an investor may put in several bids at various price/yield levels. (ii) Non-Competitive Bidding: With a view to providing retail investors, who may lack skill and knowledge to participate in the auction directly, an opportunity to participate in the auction process, the scheme of non-competitive bidding in dated securities was introduced in January 2002. Non-competitive institutions, provident funds, and trusts. Under the scheme, eligible investors apply for a certain amount at the weighted average price/yield of the auction. In the case of auction for treasury bills, the amount However, non-competitive bidding in treasury bills is available only to state governments and other select entities and is not available to the co-operative banks. Only one bid is allowed to be submitted by an investor either through a bank or primary dealer.
16.8
Financial Institutions and Markets
T-bills auctions are held on the Negotiated Dealing System (NDS) and the members electronically submit their bids on the system. Non-competitive bids are routed through the respective custodians or any bank or PD which is an NDS member. The Reserve Bank of India conducts auctions usually every Wednesday to issue T-bills. Payments for the T-bills purchased are made on the following Friday. The 91-day T-bills are auctioned on every Wednesday. The treasury bills of 182 days and 364 days tenure are auctioned on alternate Wednesdays. T-bills of 364 days tenure are auctioned on the Wednesday preceding the reporting Friday whereas 182 T-bills are auctioned on the Wednesday prior to a non-reporting Fridays. The Reserve Bank
week.
16.7 TREASURY BILL RATE Treasury bill rate is the rate of interest at which treasury bills are sold by the LO 4 RBI. The effective return on treasury bills is the discount at which they are Explain treasury bill rate sold, and is based on the difference between the price at which they are sold and their redemption value. It used to be an administered as well as the lowest rate of interest until 1993. It increased from 2.52 percent in 1955–56 to 4.60 percent in 1974. However, there had been no change in this rate since that year. It had been completely out of line with other short-term rates such as call money rate and commercial bill rate. In view of the narrow and inactive nature of the TBs market, the Chakravarty Committee and Vaghul Committee3 had made a number of suggestions to correct the situation. The major suggestion made by them was to deregulate and revise the discount rate suitably upwards with a view to rate on TBs should provide a yield which is marginally positive in real terms. Suggestions were also made for developing an active secondary market for TBs by providing suitable support to brokers and dealers, and permitting banks also to avail of their services. Such measures were expected to create a more active and wider market for TBs, which could provide an additional avenue for open market operations. In this context,
almost 20 years (1974–1993), the TB rate became market-determined.
16.8 HOW IS THE YIELD OF A TREASURY BILL CALCULATED? It is calculated as per the following formula: 100 - P 365 Yield = ¥ ¥ 100 P D where P = purchase price, D = days to maturity Day Count: For treasury bills, D = (actual number of days to maturity/365) 3
RBI, Report of the Working Group on the Money Market, (Vaghul Working Group), Bombay, 1987.
LO 5 Understand the calculation of the yield of a treasury bill
Treasury Bills Market
16.9
Example Assuming that the price of a 91-day treasury bill at issue is `98.20, the yield on the same would be as follows: 100 - 98.20 365 ¥ ¥ 100 = 7.3521% 98.20 91 After say, 41 days, if the same Treasury bill is trading at a price of `99, the yield would then be Yield =
100 - 99 365 ¥ ¥ 100 = 7.3737% 99 50 Note that the remaining maturity of the treasury bill is 50 days (91 – 41). Yield =
16.9 ●
●
● ●
●
●
●
●
●
MAJOR POLICY DEVELOPMENTS IN TREASURY BILLS MARKET IN INDIA
The instrument of ad hoc treasury bill and the system of issuing it were LO 6 introduced in India in 1937. As per the agreements made between the Outline major policy GOI and RBI in 1937 and 1955, it was decided that the government shall developments and maintain with the RBI a cash balance of not less than `50 crore on Fridays market size of T-bills in and `4 crore on other days free of obligation to pay interest thereon, and India whenever the balance falls below these minimums, the government account would be replenished by the creation of ad hocs in favour of the RBI. In the mid-1960s, the auction system for the issue of 91-day T-bills was replaced by on-tap bills. Until 1974, the tap bills rate changed with changes in the bank rate which sustained the interest of the participants in the T-bills market. After 1974, the discount rate on ad hoc Ad hoc treasury bill was abolished on 1 April, 1997 and the new system of wage and means advances is introduced. With the discontinuance of ad hoc treasury bills, the system of 91-day tap treasury bills was also discontinued with effect from 1 April, 1997. The interest in T-bills revived with the introduction of the 182-day T-bills on an auction basis in November 1986. Initially it was sold in the market by RBI at the beginning of every month. In July 1988, they were made fortnightly. The 182-day T-bills were discontinued from 16 October, 1992 and replaced by the 364-day auction T-bills (ATB) in April 1992 as part of reform measures. After the introduction of 364-day treasury bills, 14-day treasury bills were introduced. These bills are of two types: one was intermediate treasury bills (ITB) issued on 1 April, 1997 and the other was Auction T-bills (ATB) issued on 20 May, 1997 The ITB has replaced the old treasury bills of 91 days. State government, foreign central Banks and in place of 91-day treasury bills for investing their temporary cash surpluses.
●
●
bills are discontinued by RBI since 2002 and 2003. In May 1999, 182-day T-bill was reintroduced and again it was discontinued from May 2001 to March 2005 and again it was reintroduced in April 2005.
16.10
Financial Institutions and Markets
16.10
SIZE OF THE T-BILLS MARKETS IN INDIA
Tables 16.1, 16.2 and 16.3 show the trends in the auction of 91-days, 182-day and 364-day treasury bills market in India. It is evident from Table 16.1 during the period 1992–1993 to 2012–2013 that there is an increasing trend in the receipt of both competitive and non-competitive bids and the ratio of bids accepted to bids received has been varied between 33 and 65 percent. Increasing trend in the auction of the noncompetitive bidding implies the relative importance of the 91-day treasury bills for the retail investors. The outstanding amount of 91-day treasury bills has also been increasing, which implies the importance of 91-day treasury bills in the money market operation in India. Table 16.1 Auction of 91-day treasury bills Year
Bids accepted (BA) Competitive
1992–1993
203.10
Total
Noncompetitive
(in ` crore) Bids received (BR)
Competitive
—
203.10
494.10
Total
Noncompetitive — —
494.10
BA/BR Outstanding (%) at the end of the year 41.40
1350.00
1993–1994
15511.50
—
15511.50
41609.40
41609.40
37.27
6050.00
1994–1995
8124.70
1471.00
9595.70
17623.00
1722.00
19345.00
49.62
750.00
1995–1996
11956.00
4199.92
16165.71
18325.39
8061.02
26386.41
61.26
6500.00
1996–1997
14758.20
6551.00
21309.20
14780.40
37094.28
51874.70
41.07
4231.00
1997–1998
4235.45
7006.33
11241.78
10067.59
9839.82
19907.41
56.00
1600.00
1998–1999
6576.00
5597.00
12173.00
13109.00
5597.00
18706.75
65.07
1500.00
1999–2000
3650.00
2955.00
6605.50
8734.00
3035.00
11769.50
56.00
1520.00
2000–2001
4415.00
2405.00
6820.00
10025.00
2405.00
12430.00
55.00
2280.00
2001–2002
12100.00
7665.89
19765.89
28089.50
7665.89
35755.39
55.00
5000.00
2002–2003
20090.00
6312.12
26402.12
51286.79
7177.12
58463.91
45.15
9627.12
2003–2004
34500.00
2785.56
37285.56
89906.00
2785.56
92691.56
40.22
7121.54
2004–2005
95455.00
6762.03
102217.03
236270.42
1239.10
237509.52
43.03
27916.93
2005–2006
74056.63
25242.70
99299.33
189966.24
25242.69
215208.33
46.14
16318.00
2006–2007
74221.61
57355.11
131576.72
168643.16
57355.11
225998.27
58.22
45229.00
2007–2008 109341.12
101023.83
210364.95
301904.65
101023.83
402928.48
52.20
39957.00
2008–2009 199000.00
66558.62
265558.62
519301.34
66559.62
585860.96
45.32
75549.00
2009–2010 296500.00
5003.00
301503.00
884677.64
5003.00
889680.64
33.88
71503.00
2010–2011 219000.00
38983.10
257983.10
593323.10
38983.10
632306.20
40.80
70345.00
2011–2012 339841.00
114962.30
454803.30
902379.00
114962.30 1017341.30
44.70
124410.00
2012–2013 346657.20
196268.30
542925.50
1255447.69
196268.30 1451905.99
37.39
105096.00
2013–2014 316346.00
263723.00
580069.00
1007826.00
263676.00 1271502.00
45.62
725484.00
2014–2015 422874.00
247441.00
670315.00
1457708.00
247441.00 1705149.00
39.31
864587.40
Source: RBI, Handbook of Statistics of Indian Economy.
16.11
Treasury Bills Market
Table 16.2 provides the data for the auction of 182-day treasury bills. It is found that although the importance of 91-day treasury bills has been more then 182 days, the auction of this type of treasury bills has been increasing over the years and the percentage of bids accepted of the total bids received has been varied between 32 and 79 percent. But the trend has concluded that the percentage of bids accepted to total bids received has declined in the recent period and the amount of non-competitive bids for 182-day treasury bills is not popularly demanded by the retail investors. It could be due to the less developed market or it does not
Table 16.2
Auction of 182-days treasury bills Bids accepted (BA) Competitive
Total
Noncompetitive
(in ` crore) Bids received (BR)
Competitive
Total
Noncompetitive
BA/BR (%)
Outstanding at the end of the year
1987-–1988
NA
NA
329.66
NA
NA
653.96
50.40
132.80
1988-–1989
NA
NA
1371.60
NA
NA
2141.11
64.06
566.50
1989-–1990
NA
NA
1740.15
NA
NA
2364.20
73.60
774.30
1990-–1991
NA
NA
3425.93
NA
NA
4336.43
79.00
1077.59
1991-–1992
NA
NA
7317.72
NA
NA
13694.32
53.40
3985.52
1992-–1993
NA
NA
245.00
NA
NA
538.00
45.50
3935.57
1999–2000
1655.00
600.00
2255.00
NA
NA
3038.50
95.44
1300.00
2000–2001
2349.00
0.00
2349.00
NA
NA
5676.00
46.00
1300.00
300.00
NA
NA
731.50
41.00
2001–2002
NA
NA
NA
2005–2006
24578.00
2250.00
26828.87
69423.00
2317.00
71740.00
37.40
9771.00
2006–2007
29125.00
7787.00
36912.25
66647.00
7787.00
74434.00
49.60
17206.00
2007–2008
36105.00
7321.00
46426.44
108388.00
7321.00
115709.00
43.30
16785.00
2008–2009
46000.00
8303.00
44303.00
105206.00
8303.00
113509.00
39.00
20175.00
2009–2010
42500.00
375.00
42875.00
119411.00
375.00
119786.00
38.20
21500.00
2010–2011
42000.00
1301.00
43301.00
127843.00
1301.00
129144.00
34.90
22001.00
2011–2012
89950.00
3651.00
93601.00
245127.92
3651.25
248779.17
37.60
52201.00
2012–2013
129192.00
242.00
129434.00
396358.00
242.00
396600.00
32.63
64196.00
2013–2014
129000.00
8520.00
137520.00
426022.00
8520.00
434542.00
31.64
161582.40
2014–2015
145638.00
1972.00
147610.00
429170.00
1972.00
431142.00
34.23
193856.50
Source: RBI, Handbook of Statistics of Indian Economy.
but the percentage of bids accepted to total bids received has declined in the recent years. The auction of non-competitive bidding of 364-day treasury bills has been started late in comparison to other two types of treasury bills and the amount of bids received in the form of non-competitive bidding has increased during
16.12
Financial Institutions and Markets
continuously during the said period and at present, 364-day TBs account for the major proportion of the outstanding TBs (Table 16.3). Table 16.3 Auction of 364-days treasury bills Bids accepted (BA)
(in ` crore)
Bids received (BR) Competitive
Total
BA/BR (%)
Outstanding at the end of the year
Competitive
Non competitive
Non competitive
1992–1993
NA
NA
8796.47
NA
NA
14709.09
60
8796.47
1993–1994
NA
NA
21019.76
NA
NA
46927.36
45
8385.97
1994–1995
NA
NA
16857.00
NA
NA
30727.22
55
8163.12
1995–1996
NA
NA
1874.70
NA
NA
3370.94
55
1874.00
1996–1997
NA
NA
8240.60
NA
NA
15244.90
54
8240.00
1997–1998
NA
NA
16246.60
NA
NA
25246.63
64
16246.00
1998–1999
NA
NA
10200.00
NA
NA
18845.87
43
10200.00
1999–2000
NA
NA
13000.00
NA
NA
24039.84
45
13000.00
2000–2001
NA
NA
15000.00
NA
NA
32506.88
41
15000.00
2001–2002
19500.00
88.57
19588.57
50772.00
88.57
50861.08
39
19588.00
2002–2003
26000.00
126.36
26126.36
68145.00
126.36
68271.36
38
26126.00
2003–2004
27000.00
136.00
27136.00
61242.10
136.00
61378.10
44
26136.00
2004–2005
47981.00
153.00
48134.00
115630.00
153.00
115773.00
43
47132.00
2005–2006
41000.00
2019.00
43019.00
101254.00
2019.00
103273.00
55
45018.00
2006–2007
46440.00
7372.41
53812.00
134231.97
7372.41
141604.38
38
53813.00
2007–2008
54000.00
3205.30
57205.30
170500.27
3205.30
173705.57
33
57205.00
2008–2009
50000.00
4517.80
54517.80
161821.23
4517.80
166339.03
33
54550.00
2009–2010
41000.00
497.14
41497.14
140961.90
497.14
141459.04
29
41997.00
2010–2011
42000.00
481.20
42481.20
139091.25
481.20
139572.45
30
42482.00
2011–2012
89742.25
639.60
90381.85
317031.86
639.60
317671.46
21
90382.00
2012–2013
13000.00
470.80
13470.80
419671.17
470.80
420141.97
31
130471.00
2013–2014
135901.00
1055.00
136956.00
477257.00
1055.00
478312.00
28.63
345487.90
2014–2015
147875.00
1326.00
149201.00
560222.00
1326.00
561548.00
26.56
372100.70
Source: RBI, Handbook of Statistics of Indian Economy.
The commercial banks, state governments and others continue to be the participants in the TBs markets. State governments and commercial banks are the dominant user of TBs than other individual participants and RBI has discontinued using the TBs since 2002 (Table 16.4).
Treasury Bills Market
Table 16.4
Ownership of 91-day auction T-bills
16.13
(in ` crore)
Year
RBI
Banks
State government
Others
1993
1147
155
—
22
1994
605
3428
—
935
1995
68
38
618
77
1996
3211
408
2285
595
1997
1468
2365
1262
605
1998
627
29
530
95
1999
224
827
—
249
2000
288
557
—
455
2001
67
868
—
153
2002
154
2292
450
360
2003
6427
800
780
2004
3948
600
1452
2005
21176
1755
4829
2006
5943
9762
576
2007
12684
24250
6743
2008
6057
23825
10075
2009
49914
544
25092
2010
30875
—
40628
2011
23560
11590
34450
2012
48820
21590
48260
2013
34560
28200
42330
Source: RBI, Bulletins Various Issues.
16.11
TREASURY BILL RATES IN INDIA
Table 16.5 throws some light on the behaviour of all the three types of treasury LO 7 bills during the study period. It is found that the average cut-off yield of the Summarise treasury bill 91-day treasury bills has been varied between 4.59 percent in 2003–2004 to rates and its limitations 12.97 percent in 1996–1997. In the recent years it has been around 8 percent. in India The trend in the cut-off yield has not followed any pattern and it has been highly volatile. The same type of pattern has also been observed for 182-day and 364-day treasury bills. All the three types of TBs more or less provide same amount of yield over the period.
16.14
Financial Institutions and Markets
Table 16.5 Implicit cut-off yield of treasury bills (in percent) Year
91-Day T-Bills Min.
182-Day T-Bills
Max. Average End of period
364-Day T-Bills
Min. Max. Average End of period
Min.
Max. Average End of period
1992–93
8.99
10.97
10.03
10.97
NA
NA
NA
NA
10.96
11.42
11.23
1993–94
7.08
11.09
8.87
7.46
NA
NA
NA
NA
9.97
11.36
11.01
11.09 9.97
1994–95
7.21
11.99
9.16
11.99
NA
NA
NA
NA
9.41
11.94
10.15
11.94
1995–96
11.40 12.97
12.67
12.97
NA
NA
NA
NA
12.08
13.16
12.87
13.12 10.10
1996–1997
6.92
12.97
9.67
7.96
NA
NA
NA
NA
10.10
13.12
11.16
1997–1998
5.72
7.33
6.83
7.33
NA
NA
NA
NA
7.98
9.42
8.46
7.98
1998–1999
7.17
10.05
8.57
8.75
NA
NA
NA
NA
7.97
10.72
9.51
10.07
1999–2000
8.25
9.46
9.03
9.17
9.16
9.92
9.66
9.46
9.31
10.33
10.09
9.93
2000–2001
7.91
10.41
8.98
8.75
8.52
10.41
9.42
8.92
8.66
10.91
9.76
8.96
2001–2002
6.05
8.50
6.88
6.13
NA
NA
NA
NA
6.16
8.85
7.30
6.15
2002–2003
5.10
7.00
5.73
5.88
NA
NA
NA
NA
5.35
6.99
5.93
5.89
2003–2004
4.16
5.47
4.59
4.36
NA
NA
NA
NA
4.31
5.50
4.67
4.31
2004–2005
4.37
5.61
4.89
5.32
NA
NA
NA
NA
4.43
5.77
5.15
5.61
2005–2006
5.12
6.69
5.51
6.10
5.29
6.73
5.76
6.60
5.58
6.81
5.87
6.42 7.97
2006–2007
5.41
8.10
6.80
7.97
5.60
8.20
6.87
8.20
5.90
7.98
7.07
2007–2008
4.46
7.94
7.11
7.22
5.81
7.98
7.40
7.36
6.58
7.80
7.50
7.35
2008–2009
4.58
9.36
7.10
4.95
4.55
9.34
7.21
5.10
4.51
9.56
7.15
5.50
2009–2010
3.11
4.50
3.57
4.37
3.42
4.70
4.00
4.61
3.50
5.50
4.37
5.14
2010–2011
3.97
7.31
6.17
7.31
4.55
7.53
6.47
7.48
4.91
7.67
6.56
7.64
2011–2012
8.10
9.06
8.43
9.02
7.44
8.74
8.41
8.66
7.54
8.85
8.35
8.40
2012–2013
7.93
8.27
8.19
8.18
7.94
8.57
8.17
8.00
7.79
8.34
8.04
7.79
2013–2014
7.26
12.02
8.90
8.85
7.24 12.00
8.86
8.85
7.21
10.46
8.63
8.88
2014–2015
8.18
8.93
8.49
8.26
8.13
8.96
8.52
8.13
7.89
9.01
8.48
7.97
2015–2016
7.06
7.97
7.42
7.26
7.10
7.96
7.45
7.16
7.10
7.90
7.43
7.10
Source: RBI, Handbook of Statistics of Indian Economy.
16.12
TREASURY BILL RATES IN THE UNITED STATES AND UNITED KINGDOM Table 16.6
Three months treasury bills rates in the United States and UK (annual averages of percentages). Year
The United States
UK
2001
3.4
4.76
2002
1.61
3.86 (Contd.)
Treasury Bills Market 2003
1.01
3.56
2004
1.37
4.44
2005
3.15
4.55
2006
4.72
4.65
2007
4.36
5.53
2008
1.37
4.28
2009
0.15
0.48
2010
0.14
0.49
2011
0.05
0.48
2012
0.09
0.31
2013
0.06
0.29
2014
0.03
0.37
16.15
Source: Federal Reserve Bank and Bank of England Statistics
From Table 16.6, it is evident that the treasury bill rates have been lower in the case of both the United States and UK as compared to India. The 3-month treasury bills rate for the United States has decreased from 3.4 percent in 2001 to 0.03 percent in 2014. In the case of UK, it has decreased from 4.76 percent in 2001 to 0.29 percent in 2013 and then it has slightly increased to 0.37 percent during the year 2014. Overall for both the
16.13 LIMITATION OF TB MARKET IN INDIA Why is the treasury bills market in India limited, narrow and inactive? A part of the explanation can be given by comparing the institutional arrangements in India with those in England where this market is active. In the UK, banks deal in TBs because they can buy or sell them to discount houses for settling interbanking indebtedness and for coping with the vagaries of government payments and receipts. The volume of transactions between banks and discount houses has been large because, for historical reasons, banks prefer 4 Over a period of time, although the prejudice against approaching the Bank of England has declined, the previous arrangements have continued to stay. The facility to buy treasury bills from discount houses also mean the banks are in a position to buy them when the discount houses have held the bills for 4 or 5 weeks. In other words, it is possible for banks to obtain treasury bills when a part of the maturity of bills has elapsed and they have the treasury bills market because they have ample opportunities for business in TBs. This is so because, apart from clearing banks, British as well as foreign banks in London, and overseas clients, hold treasury bills for business purposes. Discount houses also hold TBs because they can offer them as security for obtaining call loans from banks. In India, the setting up of the Discount and Finance House of India (DFHI) in 1988 has
4
Sayers, R S, Modern Banking, Oxford, 1967, p. iii
16.16
Financial Institutions and Markets
DFHI does not hold or deal in 91-day TBs. Although there were no discounting houses in India, banks had rediscounting facilities with the RBI in ample measure. In fact, since the RBI has been freely rediscounting
Another important factor in this context is the extremely low rate of return on investment in TBs. As we shall see later, the treasury bill rate in India has been the lowest rate of interest in the entire interest rate structure. The difference between the treasury bill rate and deposit rates has been wide enough to dissuade investors, such as, companies from investing in treasury bills. Further, there has been almost no decrease in the differential between the treasury bill rate and the deposit rates. This situation in India is in complete contrast with that prevailing in the UK where since 1955, there has been a widening of the TBs market in happened because of a greater increase in the rate of treasury bill compared to that of the time deposit. It is noteworthy that while in England the former is the higher of the two, in India it is the other way round and
hold them for short periods before rediscounting them with the RBI. If the return on TBs is raised to such avenue for deploying their temporarily surplus funds, the amount of TBs which will be rediscounted with the Reserve Bank would not be as large as is the case at present. This would mean that Reserve Bank credit to 5
A related factor which needs to be mentioned here is the relationship between the TBs market and the to invest in government securities for maintaining a SLR and stable conditions in the government securities market has reduced the importance of treasury bills as an investment medium. The readiness of the RBI to maintain stable prices of government securities has offered banks an opportunity to invest in government
have to invest the remaining funds in assets which offer a higher rate of return.
SUMMARY ◆
◆
country and it offers short-term investment opportunities, generally up to 1 year. The treasury bills are issued at discount and redeemed at par.
◆
availability on tap, (d) assured yield, (e) low-transactions cost, (f) eligibility for inclusion in statutory ◆
5
At present, the Government of India issues 91-day, 182-day and 364-day treasury bills through auctions.
See RBI, Report of the Committee (Chakravarty Committee) to review the Working of the Monetary System, Bombay, 1985, pp. 153–54.
Treasury Bills Market ◆
16.17
The CMBs have the generic character of T-bills but are issued for maturities less than 91 days. Like
◆
◆
◆
NBFCs, FIIs (as per prescribed norms), NRIs and OCBs can invest in T-Bills. T-bills are sold through auction and auction can be price-based or yield-based. A yield-based auction is generally conducted when a new government security is issued. A price-based auction is conducted when Government of India re-issues securities issued earlier. uniform price-based and multiple price
◆
at the respective price/yield at which they have bid. ◆
dealers, mutual funds and insurance companies. ◆
corporate bodies, institutions, provident funds and trusts. Under the scheme, eligible investors apply for
◆
◆
◆
allotted securities at the weighted average price/yield of the auction. T-bills auctions are held on the Negotiated Dealing System (NDS) and the members electronically submit their bids on the system. Non-competitive bids are routed through the respective custodians or any bank or PD which is an NDS member. The outstanding amount of 91-day treasury bills has been increasing in comparison with 182 and 364day treasury bills. The trend in the cut-off yield of treasury bills in India has not followed any pattern and it has been higher than the T-Bill rates in the United States and UK.
KEY TERMS Treasury bill Ordinary treasury bill Adhoc treasury bill Cash management bill
Ways and means advances Yield-based auction Price-based auction Uniform price-based auction
Multiple price-based auction Competitive bidding Non-competitive bidding Treasury bill yield
QUESTIONS 1. What is treasury bill? Explain the types, nature and characteristics of treasury bills market in India.
16.18
Financial Institutions and Markets
4. Highlight the various auction process of the sale of treasury bills in India. 6. What are the major policy developments taken to develop the treasury bills market in India? 7. Calculate the yield of a 364-day treasury bill issued at a price of `97 after 90 days having the par value of `100. 8. What are the limitations of treasury bills market in India? 9. Write short notes on the following: (i) Cash management bill (ii) Non-competitive bidding (iii) Ways and means of advances (iv) Ad-hoc treasury bill (v) Negotiated Dealing System
Miscellaneous Short-Term Financial Markets
CHAPTER
Learning Objectives LO 1 LO 2
Know the working and development of commercial paper
LO 3 LO 4 LO 5
17.1 INTRODUCTION
17
17.2
Financial Institutions and Markets
17.2 COMMERCIAL PAPERS AND CERTIFICATE OF DEPOSITS MARKETS LO 1 Know the working and development of commercial paper
17.2.1 What is a Commercial Paper?
Industrial Paper Finance Paper and Corporate Paper Paper
Industrial or Commercial Finance Paper Corporate Paper
Euro-Commercial Papers Characteristics of CPs
1
The years in which CPs came to be introduced in some foreign countries are as follows: UK= 1986; France = 1985; Japan = 1987; Canada = 1950s; Sweden = early 1980s; Spain = 1982; Norway = 1984; Netherlands = 1986; Hong-Kong = 1982; and Singapore = 1984.
Miscellaneous Short-Term Financial Markets
Why the Importance of CPs has increased abroad? the process of securitization.
17.3
17.4
Financial Institutions and Markets
CPs in India
Guidelines in Respect of the Issue of CPs
`
2
RBI, Master Circular—Guidelines for Issue of Commercial Paper, 1 July, 2013.
Miscellaneous Short-Term Financial Markets
Investors in the CP Market
17.5
17.6
Financial Institutions and Markets
Impact of CPs on Commercial Banks
CP Market in India: Size and Interest Rates
`
`
Miscellaneous Short-Term Financial Markets
Table 17.1
17.7
Issue of Commercial Paper by scheduled commercial banks
Year
Outstanding (rupees in crore) End-year
Rate of discount (%) End-year
WADR (%)
1993–1994
3264
11.0–12.0
—
1994–1995
603
14.0–15.50
—
1995–1996
76
1996–1997
20.2
—
646
11.3–12.5
—
1997–1998
3413
8.3–12.0
—
2001–2002
7224
7.41–10.25
—
2002–2003
5749
6.0–7.75
—
2003–2004
9131
4.70–6.5
—
2004–2005
14235
5.2–7.25
—
2005–2006
12718
6.69–9.25
2006–2007
17898
10.25–13.00
2007–2008
32952
9.50–14.25
11.33
2008–2009
44171
6.40–12.50
10.38
2009–2010
75506
7.93–15.00
9.79
2010–2011
80305
9.75–15.25
2011–2012
91188
8.05–13.42
12.2
2012–2013
109255
8.64–12.61
11.9
2013–2014
106614
8.64–12.61
9.30
2014–2015
193268
7.44–14.92
8.80
2015–2016
260244
7.35–13.14
8.10
— 8.59
6.29
Source: RBI Annual reports, Monthly Bulletins, Various reports, Handbook of Statistics on Indian Economy (2010–2011, 2011–2012, and 2012–2013). Note: (–) refers the absence of information.
Problems Hindering the Development of CP Market
17.8
Financial Institutions and Markets
17.2.2 3
LO 2 Explain certificate of deposits in India and abroad
3
For a comprehensive discussion of markets for CDs abroad, refer to Shetty, S L, ‘‘The Evolution, Characteristics and Growth of Certificates of Deposit (CDs) in Selected Foreign Countries’’, Reserve Bank of India Occasional Papers, June 1989.
Miscellaneous Short-Term Financial Markets
17.9
Motives for Introduction of CDs Abroad
4
The years of introduction of CDs in few other countries were as follows: Japan = 1979; France = 1985; W. Germany = 1986; Australia = 1969; New Zealand = 1971; South Korea = 1974; Malaysia = 1979 and Indonesia = 1971. 5 Shetty, S L, op. cit., p. 74.
17.10
6
Financial Institutions and Markets
Revell, Jack, The British Financial System, Macmillan, London, 1973, p. 277. Robinson, R I, and Wrightsman, D., Financial Markets, McGraw-Hill International Book Co., New York, 1980, p.225. 8 Ritter, L S and Silber, W L, Principles of Money, Banking, and Financial Markets, Basic Books, New York, 1977, pp. 106–07. 9 RBI, Master Circular-Guidelines for Issue of Certificates of Deposit, 2 July, 2012. 7
17.11
Miscellaneous Short-Term Financial Markets
` `
`
Steps taken by RBI to Develop the CP and CD Market `
17.12
Financial Institutions and Markets
`
Growth Potential of CDs Market in India
`
Miscellaneous Short-Term Financial Markets
17.13
CD Market in India: Size and Interest Rates
Year
Outstanding (rupees in crore) End-year
1993–1994
5142
Rate of discount (%) End-year 7.0–12.0
WADR —
1994–1995
8017
10.0–15.0
—
1995–1996
16316
12.0–22.25
—
1996–1997
12134
7.0–14.25
—
1997–1998
8491
7.0–14.0
—
2001–2002
1576
5.0–10.03
—
2002–2003
908
5.7–10.0
—
2003–2004
4461
3.87–5.16
—
2004–2005
12078
4.2–6.34
—
2005–2006
43568
6.5–8.94
—
2006–2007
93272
10.23–11.90
8.62
2007–2008
147792
9.00–10.75
10.75
2008–2009
210954
6.00–11.50
6.48
2009–2010
341054
4.52–7.12
6.07
2010–2011
424740
9.00–10.60
9.96
2011–2012
419530
9.30–11.90
11.1
2012–2013
389612
8.80–10.12
11.2
2013–2014
375796
8.94–10.35
9.20
2014–2015
280968
8.38–9.10
8.70
2015–2016
210593
7.18–8.55
7.80
Source: RBI Annual reports, Monthly Bulletins, Various reports, Handbook of Statistics on Indian Economy (2010–11, 2011– 12, and 2012–13). Note: (—) refers to absence of information.
17.14
Financial Institutions and Markets
Problems Hindering CD Market in India
17.3 COMMERCIAL BILLS MARKET 17.3.1 Bill of Exchange LO 3 Understand in detail how commercial bills market work in India
Miscellaneous Short-Term Financial Markets
17.15
17.3.2 How does a bill of exchange come into existence?
17.3.3 Historical Perspective of Bill Financing
context of foreign trade replaced coin exchange and that the practice of granting credit to the holder of the
10
See the next part of this chapter on Commercial Paper. Sayers, R S, Modern Banking, Oxford, 1967, p. 47. 12 Bedi, M L, and Hardikar, V K, Practical Banking, Bombay, 1971. 11
17.16
Financial Institutions and Markets
Hundies darshani nam jog
muddati Darshani hundi dekhamar jog fermani jog jokhami
dhani jog
hundies shah jog darshani hundi that
muddati hundi muddati hundi darshani hundi
darshani hundi
hundis
hundis multani hundi hundis
hundis
13
RBI, Report of the Working Group on Discounting of Bills by Banks (Chairman: K R Ramamoorthy) September 2000.
Miscellaneous Short-Term Financial Markets
demand bill . Usance or time bill clean bills
Inland bills
Foreign bills
17.3.5 Accommodation and Supply Bills
documentary bills
17.17
17.18
Financial Institutions and Markets
17.3.6
Acceptance
hundis
17.3.7 Maturity of a Bill
hundis
14
Quoted by Muranjan, S K, Modern Banking in India, Kamala Publishing House, Bombay, 1952, p. 193.
Miscellaneous Short-Term Financial Markets
17.19
17.3.8 Bill Market Rates
hundi hundi hundis
17.3.9
Purpose
17.3.10 Characteristics of a Well-Developed Bills Market
15
Yaswani, T A, Indian Banking System, Lalvani, Bombay, 1968, pp. 57–59.
17.20
Financial Institutions and Markets
17.3.11 Measures to Promote Bill Market in India
Bill Market Scheme (1952)
The
` `
` ` 16
Eligibility requirements are laid down in Section 17 of the RBI Act, 1934. These requirements relate to the purchaser of the bill, activity to be financed by it, its maturity and so on.
17.21
Miscellaneous Short-Term Financial Markets
`
`
`
Bill Market Scheme (1970)
` `
17.3.12 Appraisal of the Schemes
` `
`
17.22
17
Financial Institutions and Markets
The ‘conversion’ facility makes one doubt whether the real motivation behind the earlier scheme was to induce increases in the supply of bills at all. The timing and circumstances of the introduction of the scheme suggest that the real motivation was to stabilise the government securities market, and to enable the government to undertake the sales of government securities. As in the case of aMOs, bill market policy also appears to have acted as an adjunct to the policy of stabilising government securities market. Another motivation appears to have been to provide liberal export finance as part of the policy to solve the foreign exchange crisis.
Miscellaneous Short-Term Financial Markets
17.3.13 Size of Bill Market in India
17.23
17.24
Financial Institutions and Markets
` in crore) Year
Inland bills
Foreign bills
P[1]
D[2]
1950–1951
—
—
13
1960–1961
—
—
159
—
753
—
—
1970–1971
—
1980–1981
1421
1990–1991
3375
2001–2002
5031
860
T[3]
P[4]
D[5]
T[6]
—
—
—
—
—
49
Grand total
Total bank credit
7/8%
[7]
[8]
[9]
13
547
2.42
208
1320
15.80
210
963
4660
20.87
909
3190
25371
12.57
1851
4609
10320
116301
8.87
9714
18803
42117
589723
7.14
2281
628
281
2336
5711
2758
18283
23314
9089
2002–2003
5584
20184
25768
9750
11624
21374
47142
729215
6.46
2003–2004
6969
21730
28699
10113
12733
22846
51545
840785
6.13
2004–2005
7554
25233
32787
10828
16602
27430
60217
1100428
5.47
2005–2006
12914
30816
43730
13075
19817
32892
76622
1507077
5.08
2006–2007
15919
31314
47233
16142
23944
40086
87319
1931189
4.52
2007–2008
12594
40553
53147
16499
30691
47190
100337
2361914
4.24
2008–2009
11740
43332
55072
18181
26555
44736
99808
2770012
3.60
2009–2010
12010
62220
74230
16130
32270
48400
122630
3244790
3.77
2010–2011
13440
79870
93310
18580
36180
54760
148070
3942080
3.75
2011–2012
16320
97910
114230
21150
40090
61240
175470
4611630
3.80
2012–2013
25270
111050
136320
21730
45610
67340
203660
5429960
3.75
2013–2014
38940
112180
151120
26740
50100
76840
227960
6198450
3.67
2014–2015
34970
122110
157080
24270
46030
70300
227380
6770360
3.35
Note: P = purchase; D = discounted; T = total Sources: RBI, RCF, Various issues; RBI Bulletin, various issues.
17.3.14 Some Issues in Bill Financing in India First
Miscellaneous Short-Term Financial Markets
17.3.15 Factors behind Underdevelopment
Development of Banking System
Pre-eminence of Foreign Trade
Change in Structure of Internal Trade
Development of Alternative Flexible Sources of Credit System
per se
18
This discussion closely follows the excellent account in this regard in Muranjan, S K, op. cit., pp. 138–49.
17.25
17.26
Financial Institutions and Markets
Declining Popularity of Hundi as a Credit Instrument
hundi market hundies Hundies hundi ` hundi `
darshani hundi
Other Factors
17.4
DISCOUNT MARKET
17.4.1 Discounting Service LO 4 Illustrate the Discount and Finance House of India
Miscellaneous Short-Term Financial Markets
17.27
17.4.2 Discount Houses in the UK19
19
Based on HMSO, Report of the Committee on the Working of the Monetary System, London, 1959, pp. 58–64; and Revell, Jack, The British Financial System, Macmillan, 1973, pp. 211–38.
17.28
Financial Institutions and Markets
17.4.3 Discount and Finance House of India
17.29
Miscellaneous Short-Term Financial Markets
`
` `
` `
20
`
RBI, Report of the Working Group to Review the System of Cash Credit, Bombay, 1979, pp. 42–46.
17.30
Financial Institutions and Markets
17.5 MARKET FOR FINANCIAL GUARANTEES 17.5.1 Nature and Types of Guarantees LO 5 Describe the market for financial guarantees
While the latter cover performance of
21
Sometimes the term secured guarantee is used to represent a guarantee which is secured by the debtor by providing a tangible security. The distinction between the two types of secured guarantees is that in case of the latter, security is offered by the principal debtor, whereas in case of the former, it is offered by the guarantor and may be in addition to the fact that the debtor has already given a collateral. 22 Strictly speaking, it is difficult to make a clear distinction between the two because financial guarantees in certain cases have an element of performance assessment, whereas performance guarantees are expressed in the form of money values.
Miscellaneous Short-Term Financial Markets
17.5.2 Suppliers of Guarantees
Personal Guarantees
Guarantees by the Government
17.31
17.32
Financial Institutions and Markets
Guarantees by Financial Institutions
Commercial Banks
23
RBI Bulletin
Miscellaneous Short-Term Financial Markets
Insurance Companies
24
Report of the Informal Advisory Committee on Bank Guarantees”, RBI Bulletin, May 1967, p. 589.
17.33
17.34
Financial Institutions and Markets
Other Financial Institutions
Specialised Public Guarantee Institutions
Deposit Insurance and Credit Guarantee Corporation (DICGC)
Miscellaneous Short-Term Financial Markets
17.35
viz.
`
Effective from
Insurance limit (`)
1 May 1993
100,000
1 July 1980
30,000
1 January 1976
20,000
1 April 1970
10,000
1 January 1968
5000
Premium rates per deposit of `100 Date from
Premium (in `)
1-04-2005
0.10
1-04-2004
0.08
1-07-1993
0.05
1-10-1971
0.04
1-01-1962
0.05
and so on except the
17.36
Financial Institutions and Markets
Export Credit and Guarantee Corporation (ECGC)
`
25
http://www.ecgcindia.in/en/Pages/ECGCAPObjectives.aspx?qstrSelVal=Objectives, dated 14 June, 2014.
Miscellaneous Short-Term Financial Markets
SUMMARY ◆
◆
◆
◆
◆ ◆
◆
◆
◆ ◆ ◆
` `
`
◆
◆ ◆
◆ ◆
◆
◆
◆
◆
◆
hundi
17.37
17.38
Financial Institutions and Markets
◆
hundi
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
hundi
Miscellaneous Short-Term Financial Markets ◆
and so on
◆
◆
KEY TERMS
QUESTIONS
17.39
17.40
Financial Institutions and Markets
Bond Market
18
CHAPTER Learning Objectives LO 1 LO 2
Identify the features of bond and the risks involved in it
LO 3
Compare the relationship between coupon rate, discount rate, values of the bond and par value Discuss various types of yield measures and yield curves Understand government security market in detail Review the corporate bond market in India Explain the Public Sector Undertaking (PSU) bond market in India
LO 4 LO 5 LO 6 LO 7
18.1 INTRODUCTION coupon of a bond term to maturity term bond, which has a single maturity date and a serial obligation bond principal or the par value bearer bond the bearer from the bearer bond is obtained by clipping coupons attached to the bonds and sending them to the issuer registered bond maintains the records of the owner and pays the
securities that are sovereign securities issued by the Reserve Bank of India (RBI) on behalf of the Government
18.2
Financial Institutions and Markets
various aspects of the working of the market in government securities, corporate bond market and public
18.2 BASIC FEATURES OF BONDS Issue Price of non-coupon-bearing bond (zero coupon bond), security is generally issued
LO 1 Identify the features of bond and the risks involved in it
Face Value (FV)
Coupon/Interest Coupon Frequency Maturity date Call/Put option date Maturity/Redemption Value one gets less than the face value, then they are redeemed at a discount and if one gets the same as their face
18.2.1 Types of Risks Involved in Bonds Credit or Default risk is the risk that a company will fail to timely make interest or principal payments
indenture) often includes terms called covenants Interest Rate Risk:
Bond Market
18.3
Liquidity Risk: Bonds that are traded frequently and at high volumes may have stronger liquidity than bonds that are traded
Call Risk:
18.2.2 Valuation of Bond
M
V0 =
CF
LO 2 Know how to find the value of a bond CF
CF
CF
 (1 + Rt )t = (1 + R1 )1 + (1 + R2 )2 + º + (1 + RM)M
t =1
V0 CFt
t’
R = Discount rate (Investor’s required rate of return) M = term to maturity of the bond
M
V0 =
C
F
 (1 + R )t + (1 + R )M
t =1
F V0 =
C C C F + +º+ + (1 + R )1 (1 + R ) 2 (1 + R ) M (1 + R ) M M
1 F + t (1 + R ) M t = 1 (1 + R )
V0 = C Â M
where
1
 (1 + R )t
denotes the present value of `1 received each period for N
t +1
1 È ˘ 1- Í M ˙ + (1 ) R Î ˚ R, M) = R Example: `
18.4
Financial Institutions and Markets
R = 10%, N = 10 years, Coupon rate = 9%, Principal = `1000 10
1 1000 + t + + (1 0.1) (1 0.1)10 t =1
V0 = 90 Â
1000 =` (1 + 0.1)10
20
1 1000 + t (1 + 0.05) 20 t = 1 (1 + 0.05)
V0 = 45 Â
000 =` (1 + 0.05) 20 In general if n be equal to the number of payments per year, M be equal to the maturity in years, RA be the discount rate on an annual basis (simple annual rate) and R CA
M
V0 =
Â
t =1Ê
A ˆt
+
R ÁË1 + ˜ n ¯
F Ê RA ˆ ÁË1 + ˜ n ¯
M
where, CA n n RA = Required periodic rate M
18.3 RELATION BETWEEN COUPON RATE, DISCOUNT RATE, VALUE OF THE BOND AND PAR VALUE ●
If coupon rate (CR) = Discount Rate (R), then the value of the bond will be
●
If CR < R and V0 < F If CR > R and V0 > F
●
18.3.1 Relation between Bond Value and Rate of Return
LO 3 Compare the relationship between coupon rate, discount rate, values of the bond and par value
increases, then value of the bond decreases (R≠ fi V0 Ø or RØ fi V0≠ a bond’s price and rate of return is represented by the negatively sloped curve, which is popularly known as price-yield curve
Bond Market
18.5
consider our previous example where we have taken a 9 percent coupon paying (annually) of maturity 10 years and face value ` of the bond as `
Interest rate
Value of the bond
4%
1405.545
5%
1308.869
6%
1220.803
7%
1140.472
8%
1067.101
9%
1000
10%
938.5543
11%
882.2154
12%
830.4933
13%
782.9503
14%
739.1942
15%
698.8739
Relationship between Bond’s Price Sensitivity to Interest Rate Changes and Term to Maturity
Example R = 10%, V0 = ` R = 9%, V0 = `1000
R = 10%, V0 = ` R = 9%, V0 = `1000
Relationship between a Bond’s Price Sensitivity to Interest Rate Changes and Coupon Payments
18.6
Financial Institutions and Markets
Example: `1000 10
1 1000 + = `1000 t (1 + 0.1)10 t = 1 (1 + 0.1)
V0 = 100 Â be 10
1 100 + =` t (1 + 0.1)10 t = 1 (1 + 0.1)
V0 = 20 Â
Let the discount rate for both the bonds be changed to 9 percent, then 10
1 100 + =` t (1 + 0.09)10 t = 1 (1 + 0.09)
V0 = 100 Â Proportional change =
1064.18 - 1000 1000 10
1 1000 + =` t (1 + 0.09)10 t = 1 (1 + 0.09)
V0 = 20 Â Proportional change =
550.76 - 508.43 508.43
18.4 YIELD MEASURES
M
V0 =
C
F
 (1 + R )t + (1 + R )M
t =1
LO 4 Discuss various types of yield measures and yield curves
Using this model and computing different values such as coupon rate, discount rate, term to maturity as Example:
`
(i) Nominal Yield (ii) Current Yield
CY =
Bond Market
18.7
(iii) Yield to Maturity It is the rate of interest which equates the price of the bond with the present value ` can be determined as 10 90 1000 Â (1 + R )t + (1 + R )10 t =1 R
C + [( F - V0)/ M ] 90 + (1000 - 938.55)/10 = ( F + V0)/2 (1000 + 938.55)/2 (vi) Yield to Call
(v) Realised Yield
H
V0 =
 (1
t =1
Vt C + t (1 + R ) H R)
Vt represents the future selling price of the bond and H is the number of period the bond is held having term to maturity as M, M -H
Vf =
Â
t =1
7
Vf =
C M + t (1 + R ) (1 + R ) M - H
90
1000
 (1 + 0.1)t + (1 + 0.1)7
=`
t =1
3
90
951.31
 (1 + R )t + (1 + R )3
t =1
Hence, the realized yield will be that R C + [(Vt - V0)/ H ] 90 + (951.31 - 938.55)/3 = (Vt + V0)/2 (951.31 + 938.55)/2
18.8
Financial Institutions and Markets
18.4.1 Yield Curve
(i) investors’ expectations for future interest rate, and (ii) risk premium that investors require to hold long-
Types of Yield Curve
Yield to maturity
Rising yield curve (a)
Flat yield curve (b)
Humped yield curve (d) Falling yield curve (c) Years to maturity
Figure 18.1
Types of yield curves.
rising yield curve is formed when the yields on short-term bonds are low and increase consistently declining yield curve or inverted yield curve is formed when is humped yield curve is formed when yields on intermediate-term bonds are above those on short-term bonds and the rates on long-term bonds decline to levels below those
18.5 GOVERNMENT SECURITY MARKET government security is a tradable instrument issued by the central government Such securities are of short term (usually called treasury bills, with original
LO 5 Understand government security market in detail
Bond Market
18.9
(usually called central government issues both, treasury bills and bonds or dated securities while the state governments issue only bonds or dated securities, which are called the
18.5.1 Importance of Government Securities Market (GSM)
broad and liquid government securities market is essential for the conduct and effectiveness of open market
institutions such as commercial banks are required to maintain their secondary reserve requirements in the
and foreign exchange, of central government bonds, they constitute the ultimate source of liquidity in the
risk or credit risk, which, ceteris paribus, leads to a reduction in market risk, and an increase in liquidity in
18.10
Financial Institutions and Markets
riskless because only the government has the power to print domestic currency (Herring and Chatusripitak,
government, a deep and liquid government securities market facilitates its borrowings from the market at
central bank, a developed government securities market allows greater application of indirect or market-
of whether the central bank acts as manager of public debt or not, there are three main channels through viz. quantity of debt, composition markets are underdeveloped, often raises concerns about public debt management as there could be recourse GDP ratio declines and government securities market develops with introduction of new instruments (such as index-linked gilts), new issuing techniques (such as auctions) and improved market infrastructure, practical
when maturity structure of debt is short so as to minimise the future rollover cost resulting from higher long maturity debt or conventional versus index-linked debt may affect real yields, depending upon the
by banks act as a substitute for lending to the private sector and, therefore, reduce the supply of bank credit
Bond Market
18.11
United Kingdom was, however, contrary as the available evidence found that debt sales to banks had only a
government securities such as auctions, tap sales, syndication, book building, and so on, the auction method
based system of issues and the system of borrowing at market-related interest rates have helped to increase the amounts borrowed from the market, to modulate better the maturity structure of government borrowings,
18.5.2 Principles of a Deep and Liquid GSM
critical issue in this regard is trading liquidity, that is, the ability of the market to execute transactions at short notice, low cost and with little impact on price (Lagana et al. is usually captured by any or all of the four indicators, viz., width (width of the bid-ask spread), depth (the
In the case of exchanges, even when their number is limited, dynamic competition between the leading
securities market needs to have a low level of fragmentation offering instruments which have high degree of
18.12
Financial Institutions and Markets
homogeneous product of large volume and some heterogeneity can be resolved by having a system of issuing
Higher transaction costs widen the gap between the effective price received by sellers of the instrument and Some transaction costs, however, are inevitable such as those associated with ensuring sound payment and
and settlement systems; (ii) the regulatory and supervisory framework; and (iii) market monitoring and
promote heterogeneity of market participation in terms of transaction needs, risk assessments and investment
liberalisation to encourage foreign participation has to be calibrated appropriately after paying due attention
18.5.3 GSM in the Pre-Liberalisation Period in India
non-remunerative yields and captive nature of the government securities market impeded secondary market 1
1
Narendra Jadav, Development of Securities Market—The Indian Experience.
Bond Market
18.13
In the pre-liberalized period the government securities were normally issued in the denomination of `100 or ` `100 till the middle of the 1980s was raised to `
along with income in the form of interest or dividends on other approved investments, is exempt from income
of state governments and semi-governments is relatively restricted; therefore, they are less liquid than central
of any other loan or vice versa
relating to the application tendered at any branch of the SBI or its subsidiary is sent to the applicant directly by
the announcement of new issue, the RBI suspends the sale of existing loans till the closure of subscriptions
government is transferable to the other government whose loan is still open for subscription, at the option
18.14
Financial Institutions and Markets
of issue of blocks of securities and their redemption on single maturity dates continues in form, but, when the issue of bonds is announced, a part is taken over by the RBI which sells the amount gradually through the bonds gradually through the stock exchange until usually; only a small proportion remains to be paid off on
18.5.4 Existing Structure and Organization of Dated GSM in India Participants in Dated GSM
Sometimes, there are triangular switch transactions in which one investor’s sale or purchase is matched annual quota, based on the size of the bank, for switch transactions of each bank from time to time with a
purchase the securities around the interest due date and unload them in the market after availing themselves
broad-based, (b) to ensure development of underwriting and market-making capabilities for government securities outside the RBI so that the latter is able to shed these functions gradually, (c) to improve secondary market trading system which would contribute to price discovery, enhance liquidity and turnover and encourage voluntary holding of government securities among a wider investor base, (d) to make PDs an
Bond Market
18.15
by committed participation in auctions, (f) to provide active secondary market by giving two-way quotes,
Forms of Dated Government Securities
dematerialized or scripless form is the safest and the most convenient alternative as it eliminates the problems relating to custody, viz. SGL Account:
Gilt Account:
the primary dealer would maintain the holdings of its constituents in a CSGL account (which is also known
the current account of the custodian bank/primary dealer (PD) with the RBI and the custodian (CSGL account Primary Market Issuance of Dated Government Securities
types of auction process, in this section we have explained the process through some hypothetical examples
Yield-based Auction of a New Security: ● ● ● ● ●
`1000 crore
18.16
Financial Institutions and Markets
*
T
T
Details of bids received in the increasing order of bid yields Bid No.
Bid yield
Amount of bid (` Crore)
1 2 3 4 5 6 7 8
8.19% 8.20% 8.20% 8.21% 8.22% 8.22% 8.23% 8.24%
300 200 250 150 100 100 150 100
Cummulative amount Price* with coupon as (` Crore) 8.22% 300 500 750 900 1000 1100 1250 1350
100.19 100.14 100.13 100.09 100.00 100.00 99.93 99.87
pro-rata
not
` are higher than the Price-based auction of an existing security 8.24% GS 2024 ● ● ●
*
●
`1000 crore
●
*
T
T
Details of bids received in the decreasing order of bid price Bid no.
Price of bid
Amount of bid (` Crore)
Implicit yield
1 2 3 4 5 6 7 8
100.31 100.26 100.25 100.21 100.20 100.20 100.16 100.15
300 200 250 150 100 100 150 100
8.1912% 8.1987% 8.2002% 8.2062% 8.2077% 8.2077% 8.2136% 8.2151%
the same yield, bid numbers
Cumulative amount 300 500 750 900 1000 1100 1250 1350
amount `
Bond Market
18.17
uniform pricebased and multiple price uniform price auction, all the successful bidders are required to pay for the allotted quantity of securities at the same rate, that is, at the auction cut-off rate, irrespective of the rate multiple price auction, the successful bidders are required to pay for (ii) above, if the auction was uniform price-based, all bidders would get allotment at the cut-off price, that is, ` at the price he/she has bid, that is, bidder 1 at ` ` in an auction under either as a competitive or non-competitive categories of bidding has been provided in Chapter 16 amount for a single bid is `10,000 and ` `100 of application money as
allotted securities on a pro-rata
position or when investors expect very high yields, the RBI wants to keep the borrowing costs in check, so that it may not be possible for the RBI to hold an auction; therefore, the RBI places the securities with
Trading of Dated Government Securities in Secondary Market
(i) Over the Counter (OTC)/Telephone Market: In this market, a participant, who wants to buy or sell a a broker registered with SEBI and negotiate for a certain amount of a particular security at a certain
buy or sell a security, the bank’s dealer (who is authorised by the bank to undertake transactions in government securities) may get in touch with other market participants over telephone and obtain
(ii) Negotiated Dealing System: members to submit electronically, bids or applications for primary issuance of government securities
18.18
Financial Institutions and Markets
is an order-driven electronic system, where the participants can trade anonymously by placing their
(iii) Stock Exchanges: the country (including retail investors) in government securities, the Government, RBI and SEBI have The Wholesale Debt Market segment provides trading facilities for a variety of debt instruments including government securities,
market was purely an informal market with most of the trades directly negotiated and struck between
system and is displayed to the whole market, until a fresh order which matches, comes in or the earlier order
and sells available in the market, the quantity traded in that security, the high, the low and last-traded prices
Bond Market
18.19
` Reporting of Government Securities Transactions
trading by small participants in smaller lots of less than `
Settlement of the Government Securities In the primary market, participants are advised of the consideration amounts that they need to pay to the government on settlement T T amounts and their securities accounts (SGL accounts) are credited with the amount of securities that they tender a cheque, the proceeds of which will be collected through clearing process after which securities are Secondary Market securities/current accounts maintained with the RBI, with delivery of securities and payment of funds being
on the settlement date by becoming a central counter-party to every trade through the process of novation,
18.20
Financial Institutions and Markets
in government securities are settled on T T
settled through delivery versus payment (Dv
T
vP is the mode of settlement of securities wherein
securities are not delivered and vice versa v vP settlements, viz., Dv (i) DvP I (ii) DvP II basis, that is, the funds payable and receivable of all transactions of a party are netted to arrive at the (iii) DvP III
18.5.5 Major Policy Measures Taken in the Period of Liberalization constrained by captive investors (predominantly banks and insurance companies) and administered coupon
of government securities was promoted by allowing trading of government securities in the stock
ad hoc treasury bills was phased out
2
RBI, Government Securities Market in India—A Primer, www.rbi.org.in scripts/FAQView.aspx?Id=79#16.
Bond Market
18.21
STRIP (Separate Trading of Registered Interest and Principal of Securities)
` coupon (`
`100 at maturity)
Eligible government securities held in the subsidiary general ledger (SGL)/constituent subsidiary
stripping/reconstitution will be `
Settlement risk has been lowered with the introduction of delivery versus payment (DvP) system in Dv
electronic connectivity with CCIL and Dv mode instead of physical fashion, which had carried the potential risks of irregularities through non-
18.22
Financial Institutions and Markets
has been carried out on T successful bidder in primary market on the day of allotment between CSGL (constituents subsidiary
When Issued’(WI
facilitates the distribution process for government securities by stretching the actual distribution period for each issue and allowing the market more time to absorb large issues without disruption, and (b) it
deliver securities to the buyer after the auction on the settlement (or issue) date, the transaction will be settled as per the default settlement mechanism of CCIL
3
RBI, ‘When Issued’ transactions in Central Government Securities RBI/2005-06/382 IDMD.No/3426/11.01.01 (D)/2005–2006.
Bond Market
18.23
settlement of securities leg of government securities transactions undertaken by the non-banks and nonfunds leg will be settled through the fund accounts maintained by these entities with select commercial
Retail Market Development
most suitable in India; it would contribute more than other models to the successful broadening and
the RBI has introduced a scheme for retail investors to buy and sell government securities on stock (b) order-driven system, (c) anonymous trade matching, (d) rolling settlement, (e) intra-day multilateral
market is permitted under Rolling Settlement, wherein each trading day is considered as a trading period and T
T
netted out member-wise and then security-wise so as to determine the net settlement and payment obligations
18.24
Financial Institutions and Markets
of the members for securities and funds who then give the necessary instructions to their clearing banks and
● ●
Lower average volatility in bond prices
●
deposits, which also contain credit risk ● ●
● ●
Growing liquidity and the increased turnover in recent times in the Indian debt markets
provide additional channel of investment for the average and risk-averse investors, which can help to increase
Sovereign Gold Bond Scheme (SGB) 20154
4
https://www.rbi.org.in/Scripts/FAQView.aspx?Id=109
Bond Market
18.25
annually to the bank account of the investor and the last interest will be payable on maturity along with the
the SGB may help the government in reducing the physical demat and thus bring down the import bill for
18.5.6 Primary Market Transactions of Government Securities
percentages of central government market borrowings to total borrowings have been quite higher than the state governments’ market borrowings, which mean that the state governments’ securities market is quite
Table 18.1 Market borrowings of central and state governments (Percentage) Year
Central government
State government
Gross
Net
Gross
Net
1
2
3
4
1980–1981
89.61
92.67
10.39
7.33
1985–1986
80.30
83.98
19.70
16.02
1990–1991
77.77
75.70
22.23
24.30 (Contd.)
18.26
Financial Institutions and Markets 1995–1996
86.59
81.87
13.41
18.13
2000–2001
89.65
85.14
10.35
14.86
2005–2006
88.04
86.41
11.96
13.59
2006–2007
89.60
88.63
10.40
11.37
2007–2008
73.52
66.07
26.48
33.93
2008–2009
72.95
70.02
27.05
29.98
2009–2010
94.06
77.44
25.04
22.56
2010–2011
82.17
78.69
17.83
21.31
2011–2012
79.10
77.99
20.90
22.01
2012–2013
79.52
77.58
20.48
22.42
2013–2014
76.70
72.52
23.30
27.48
CAGR
18.12
17.08
21.33
22.44
Source: Reserve Bank of India, Handbooks Various Issues Notes: (1) Net market borrowing of centre and state combined for 2008–2009 includes `5.47 billion pertaining to a security with call and put option. (2) Gross state government market borrowing includes additional market borrowings of 100 billion for 2002–2003, 266.23 billion for 2003–2004 and 169.43 billion for 2004–2005 under the State Debt Swap Scheme. (3) Gross borrowings of the state governments for 2013–2014 have been estimated while those of centre are budget estimates. (4) Market borrowing of the centre includes dated securities and 364-day treasury bills.
(a) Central and state governments whose holdings represent inter-governmental transfer of resources which do not necessitate any transfer of funds between the public and private sectors; (b) banking sector comprising RBI, SBI, other commercial banks and co-operative banks; (c) primary dealers; (d) insurance companies,
RBI does not hold any state government securities; its ownership of the central government securities has
of insurance companies in the central government and state government securities has remained more or less
Bond Market
18.27
investment in government securities in recent years on account of rise in interest rates and increased credit
Table 18.2
Ownership pattern of outstanding government securities (percentage)
Government and year
RBI
Banks
Primary dealers
Insurance Financial companies institutions
Mutual fund
Provident fund
Others
Central govt.
1
2
3
4
5
6
7
8
1969
37.5
20.4
—
11.5
—
—
23.3
4.3
1991
24.80
55.11
—
—
—
—
—
5.37
1992
22.30
59.83
—
—
—
—
—
2.05
1996
8.98
64.33
—
—
—
—
—
3.45
1997
3.46
67.50
—
—
—
—
—
5.93
1998
12.84
57.70
—
—
—
—
—
7.97
1999
10.90
58.92
—
—
—
—
—
9.67
2000
8.33
60.67
—
—
—
—
—
10.11
2001
9.20
60.99
1.69
—
—
—
—
6.03
2007
9.25
47.92
0.42
—
—
—
—
15.55
2008
7.83
50.74
0.24
19.23
1.06
0.34
2.91
17.64
2009
8.55
48.76
0.11
17.03
1.41
0.54
3.03
20.57
2010
11.04
50.43
0.09
17.42
1.91
0.25
3.40
15.46
2011
10.86
51.37
0.09
19.46
1.79
0.53
3.69
12.20
2012
13.34
54.56
2.45
18.74
0.20
0.58
3.83
6.29
2013
16.99
43.74
0.28
18.55
0.74
0.68
7.37
8.79
2014
16.05
44.52
0.11
19.53
0.72
0.78
7.18
10.14
2015
13.47
43.30
0.30
20.86
2.06
1.89
7.58
9.58
2016
13.46
41.81
0.32
22.17
0.71
2.08
6.00
12.48
State govt.
1
2
3
4
5
6
7
8
1969
0.3
37.9
—
—
—
—
—
8.0
1991
—
78.55
—
—
—
—
—
10.91 (Contd.)
18.28
Financial Institutions and Markets
1992
—
79.12
—
—
—
—
—
9.78
1996
—
67.65
—
—
—
—
—
16.21
1997
—
—
—
—
—
—
—
15.79
1998
—
64.77
—
—
—
—
—
15.63
1999
—
62.43
—
—
—
—
—
13.44
2000
—
61.87
—
—
—
—
—
13.72
2001
—
60.74
—
—
—
—
—
14.19
2007
—
42.75
—
—
—
—
—
25.02
2008
—
52.25
0.55
22.40
0.53
0.02
9.79
14.45
2009
—
58.22
0.27
20.49
0.94
0.45
8.83
10.80
2010
—
58.46
0.21
21.71
2.74
0.02
8.09
8.77
2011
—
51.44
0.11
24.66
2.64
0.06
8.02
13.08
2012
—
51.19
4.05
25.78
0.01
0.05
7.99
10.92
2013
0.038
52.47
0.20
28.51
0.40
1.40
18.53
1.11
2014
0.055
52.40
0.23
30.44
0.40
0.82
15.04
0.58
2015
0.022
45.97
0.17
33.15
0.38
0.35
15.77
4.15
2016
0.039
46.02
0.27
32.50
0.24
1.04
15.94
3.91
Note: Percentages do not add to 100 due to small amount being left out—means no or negligible ownership. Source: RBI, RCF, Handbook Various Issues
increased demand for securities can usually be encouraged by making a small number of relatively large new issues because institutional investors fall into fairly homogeneous groups with broadly similar investment
5
The growth of a secondary market tends to be inhibited when the Central Bank undertakes refunding of debt on a significant scale. If the extent of refunding is small, investors would deal among themselves for changing maturities. 6 Bank of England, ‘Official transactions in the gilt-edged market’ in H G Johnson (ed.), Readings in British Monetary Economics, Clarendon Press, Oxford, 1972, p. 444.
Bond Market
Table 18.3
Ownership pattern of Government of India dated security Year
S.N.
18.29
Category
2007
2008
2009
2010
2011
2012
2013
1
2
3
4
5
6
7
1
Commercial banks
41.57
42.51
38.85
38.03
38.42
36.28
34.50
2
Bank-primary dealers
26.19
24.78
8.05
9.22
8.61
9.83
9.36
3
Non-Bank PDs
8.11
8.75
0.29
0.14
0.11
0.10
0.11
4
Insurance companies
0.41
0.34
23.20
22.16
22.22
21.08
18.56
5
Mutual funds
0.44
0.79
0.82
0.40
0.18
0.17
0.68
6
Co-operative banks
2.97
3.22
2.92
3.35
3.41
2.98
2.81
7
Financial institutions
0.70
0.41
0.41
0.35
0.35
0.37
0.75
8
Corporates
4.79
3.48
4.72
2.99
1.94
1.38
1.14
9
FIIs
0.18
0.52
0.24
0.59
0.97
0.88
1.61
10
Provident funds
6.68
6.38
6.59
6.76
7.06
7.45
7.37
11
RBI
6.51
4.78
9.71
11.76
12.84
14.41
16.99
12
Others
1.86
4.38
4.20
4.24
3.89
5.07
6.12
Note: Government of India dated securities includes securities issued under the Market Stabilisation Scheme and the special securities such as bonds issued to the oil marketing companies and so on. Source: RBI-Bulletin, 2007, 2009, 2011, 2013.
18.30
Financial Institutions and Markets
(maturity over 10 years)
securities has undergone a transformation with the sharp increase in the share of securities with more than
Table 18.4
Year
Maturity pattern of outstanding central government securities 1951–2016 (Percentage) Below 5 Years
Between 5 and 10 Years
Over 10 Years
Undated
1951
22.2
23.8
36.1
17.9
1956
26.1
40.9
16.0
17.1
1961
33.7
29.4
26.9
10.0
1971
36.6
14.5
43.0
5.9
1980
13.6
14.3
70.0
2.0
1984
12.4
14.2
72.4
1.0
1989
9.2
9.0
81.8
—
1991
8.6
5.6
85.8
—
1995
25.3
27.4
16.12
—
2000
35.01
39.25
25.74
—
2001
30.61
35.57
33.82
—
2002
26.39
34.66
38.95
—
2003
22.41
30.94
46.65
—
2004
23.80
30.53
45.67
—
2005
23.78
29.77
46.45
—
2006
23.98
30.23
45.78
—
2007
30.13
29.88
39.99
— (Contd.)
7
It is necessary to be clear about the terminology in this context. According to a very widespread usage, claims with maturity of 1 year or less are regarded as short-term, those between 1 and 5 years as medium-term, and those beyond five years as long-term. In the context of maturity of government securities, however, these conventional demarcations of maturity dates appear to have been abandoned not only in India, but also abroad. In the context of government securities, the RBI seems to be using a different terminology. It regards securities of less than five-year maturity as ‘short-dated’, those between five to ten years as ‘medium’ or ‘medium-short’; those between 10 and 15 years as ‘medium-long’; and those beyond 15 years as ‘long-dated’.
Bond Market 2008
25.90
34.50
39.60
—
2009
23.78
38.67
37.55
—
2010
28.95
34.09
36.95
—
2011
23.75
37.62
38.63
—
2012
21.47
24.80
53.72
—
2013
30.98
34.95
34.07
—
2014
29.93
31.92
38.53
—
2015
28.23
30.35
41.40
—
2016
26.84
29.60
43.54
18.31
—
Source: RBI, Handbook of Statistics, Various Issues.
the borrower issues a bond of `
purchases the bond at less (greater) than its face value, that is, at a discount (premium), the redemption yield
by assuming that the bond is held or retained by the investor till its maturity, the running yield represents the return available to the investor where he to sell his security on the market at a prevailing price; it is a notional
process of maturity elongation was facilitated by the benign interest rate regime which prevailed during the
Table 18.5 Interest rates on central and state Government dated security Year
Central government securities
State government securities
Coupon rate range
Weighted average
Coupon rate range
Weighted average
1980–1981
5.98–7.50
7.03
6.75
6.75
1981–1982
6.00–8.00
7.29
7.00
7.00 (Contd.)
18.32
Financial Institutions and Markets
1982–1983
6.25–9.00
8.36
7.50
7.50
1983–1984
7.75–10.00
9.29
8.25–8.75
8.58
1984–1985
7.75–10.50
9.98
9.00
9.00
1985–1986
9.00–11.50
11.08
9.75
9.75
1986–1987
10.00–11.50
11.38
11.00
11.00
1987–1988
10.50–11.50
11.25
11.00
11.00
1988–1989
10.00–11.50
11.4
11.50
11.50
1989–1990
10.50–11.50
11.49
11.50
11.50
1990–1991
10.50–11.50
11.41
11.50
11.50
1991–1992
10.50–12.50
11.78
11.50–12.00
11.84
1992–1993
12.00–12.75
12.46
13.00
13.00
1993–1994
12.00–13.40
12.63
13.50
13.50
1994–1995
11.00–12.71
11.90
12.50
12.50
1995–1996
13.25–14.00
13.75
14.00
14.00
1996–1997
13.40–13.85
13.69
13.75–13.85
13.82
1997–1998
10.85–13.05
12.01
12.30–13.05
12.82
1998–1999
11.10–12.60
11.86
12.15–12.50
12.35
1999–2000
10.73–12.45
11.77
11.00–12.25
11.89
2000–2001
9.47–11.70
10.95
10.50–12.00
10.99
2001–2002
6.98–11.00
9.44
7.8010.53
9.20
2002–2003
6.57–8.62
7.34
6.60–8.00
7.49
2003–2004
4.62–6.35
5.71
5.78–6.40
6.13
2004–2005
4.49–8.24
6.11
5.60–7.36
6.45
2005–2006
6.70–7.79
7.34
7.32–7.85
7.63
2006–2007
7.06–8.75
7.89
7.65–8.66
8.10
2007–2008
7.55–8.64
8.12
7.84–8.90
8.25
2008–2009
7.69–8.81
7.69
5.80–9.90
7.87
2009–2010
6.07–8.43
7.23
7.04–8.58
8.11
2010–2011
5.98–8.67
7.92
8.05–8.58
8.39
2011–2012
7.80–10.01
8.52
8.36–9.49
8.79
2012–2013
7.86–8.82
8.36
8.42–9.31
8.84
2013–2014
7.16–9.40
8.45
7.57–9.94
9.18
2014–2015
7.65–9.42
8.51
8.00–9.66
8.58
2015–2016
7.54–8.27
7.89
7.95–8.88
8.28
Source: RBI, Handbook various issues
18.33
Bond Market
average yield has declined, the weighted average maturity has increased; and these changes have been quite
account of the hardening of interest rates due to uncertainty surrounding international oil prices, upturn in
Table 18.6 Yield and maturity of central government securities issued in recent years (Percentages/Years)
Years
Range of YTMs at primary issues
WAY (%)
Range of maturities of new loans (Yrs.)
WAM (Yrs.)
WAM of outstanding stocks (Yrs.)
Under 5 Years
5–10 Years
Over 10 Years
(1)
(2)
(3)
(4)
(5)
(6)
(7)
13.25–13.73
13.25–14.0
—
13.75
2–10
5.7
—
1996–1997
13.40–1.72
13.55–13.85
—
13.69
2–10
5.5
—
1997–1998
10.85–12.14
11.15–13.05
—
12.01
3–10
6.6
6.5
1998–1999
11.40–11.68
11.10–12.25
12.25–12.60
11.86
2–20
7.7
6.3
1999–2000
—
10.73–11.99
10.77–12.45
11.77
5–19
12.6
7.1
2000–2001
9.47–10.95
9.88–11.69
10.47–11.70
10.95
2–20
10.6
7.5
2001–2002
—
6.98–9.81
7.18–11.0
9.44
5–25
14.3
8.2
2002–2003
—
6.65–8.14
6.84–8.62
7.34
7–30
13.8
8.9
2003–2004
4.69
4.62–5.73
5.18–6.35
5.71
4–30
14.94
9.78
2004–2005
5.90
5.53–7.20
4.49–8.24
6.11
5–30
14.13
9.63
2005–2006
—
6.70–7.05
6.91–7.79
7.34
5–30
16.90
9.92
2006–2007
7.69–7.94
7.06–8.29
7.43–8.75
7.89
4–30
14.72
9.97
2007–2008
-
7.58–8.44
8.34–8.64
8.23
6–30
14.32
10.39
2008–2009
7.71–8.42
7.69–8.77
7.77–8.81
7.69
6–30
13.80
10.45
1995–1996
2009–2010
6.09–7.25
6.07–7.77
6.85–8.43
7.23
5–15
11.16
9.82
2010–2011
5.98–8.67
7.17–8.19
7.64–8.63
7.92
5–30
11.62
9.78
2011–2012
8.21–8.49
7.80–10.01
8.25–9.28
8.52
7–30
12.66
9.60
2012–2013
8.82–8.21
7.86–8.76
7.91–8.06
8.36
5–30
13.50
9.67
2013–2014
7.22–9.00
7.16–9.40
7.36–9.40
8.45
6–30
15.05
10.00
2014–2015
—
7.66–9.28
7.65–9.42
8.51
6–30
14.66
10.23
2015–2016
—
7.54–8.10
7.59–8.27
7.89
6–40
16.03
10.50
Note: YTM = Yield to maturity; WAY = Weighted average yield; WAM = Weighted average maturity Source: RBI, RCF, 2006–2007; RBI, Annual Reports, 2014, 2010, 2016.
18.34
Financial Institutions and Markets
18.5.7 Secondary Market Transactions of Government Securities
securities increased from ` increased from `
`
Table 18.7 Secondary market transactions in government securities Year
Central government securities (CGS)
State government securities (SGS)
Outright (` crore)
% to Total CGS
Repo (` crore)
% to Total CGS
Outright (` crore)
% to Total SGS
Repo (` crore)
% to Total SGS
1995
18072.13
18.33
80520.86
81.67
231.75
100.00
0
0.00
1996
40295.84
46.99
45461.69
53.01
796.84
100.00
0
0.00
1997
119355
87.85
16514.32
12.15
1279.97
100.00
0
0.00
1998
115358.1
79.71
29369.66
20.29
1414.2
100.00
0
0.00
1999
330336.1
83.56
65008.64
16.44
3346.59
100.00
0
0.00
2000
429665.5
81.02
100658.7
18.98
2796.63
99.44
15.69
0.56
2001
1036952
80.58
249892.9
19.42
4551.56
90.88
457
9.12
2002
1285666
74.16
448018.5
25.84
8816.08
99.32
60
0.68
2003
1593575
68.14
745256.3
31.86
13713.1
65.92
7088.47
34.08
2004
985990
43.60
1275264
56.40
26564.86
76.13
8329.73
23.87
2005
710428
35.91
1268151
64.09
20652.46
42.69
27726.07
57.31
2006
824556.7
28.63
2055547
71.37
12857.82
17.78
59450.7
82.22
2007
1094069
26.99
2958822
73.01
14087.31
25.70
40720.77
74.30
2008
1933226
35.60
3497635
64.40
23978.3
29.69
56791.62
70.31
2009
2681838
36.64
4637920
63.36
72391.2
73.46
26151.11
26.54 (Contd.)
Bond Market
18.35
2010
2652720
42.95
3523562
57.05
59283.81
78.23
16500.66
21.77
2011
2602239
51.35
2465561
48.65
46683.65
70.56
19474.84
29.44
2012
4628529
65.49
2438782
34.51
99721.07
58.69
70176.68
41.31
2013
8685864
66.15
4445064
33.85
150993.2
86.11
24353.99
13.89
2014
8523107
68.99
3829811
31.00
164003
60.27
108080
39.72
2015
8672019
60.82
5585876
39.17
297658
67.32
144458
32.67
2016
14821889
63.60
8481659
36.39
559055
55.88
441371
44.11
Source: RBI, RCF, RBI-Handbook of Statistics 2011, 2014, 2016.
Table 18.8
Features of wholesale debt market (WDM) segment of National Stock Exchange (NSE)
Year
Turnover (in percentage)
Business growth (in crores)
Share of govt. securities (%)
Trading member
FIs/MFs
PDs
Indian banks
Foreign banks
Net traded value
Average daily value
No.of trades
2000–2001
23.2
4.2
22.1
33.5
16.9
428581.5
1483
64470
89.5
2001–2002
23.5
4.2
22.5
36.6
13.2
947191.2
3277.5
144851
94.4
2002–2003
24.8
3.8
22.0
38.8
10.6
1068701.4
3598.3
167778
94.5
2003–2004
34.8
4.6
17.0
36.4
7.3
1316096.2
4476.5
189518
92.9
2004–2005
34.0
5.1
18.5
29.9
12.5
887293.6
3028.3
124308
78.5
2005–2006
32.0
3.9
21.9
28.1
14.1
475523.5
1754.7
61891
41.3
2006–2007
30.9
2.7
19.8
26.0
20.6
219106.5
898
19575
69.0
2007–2008
38.2
2.3
8.6
23.8
27.1
282317.0
1138
16179
70.8 (Contd.)
18.36
Financial Institutions and Markets
2008–2009
44.7
3.4
6.6
18.1
27.3
335951.5
1411.6
16129
81.7
2009–2010
49.2
2.6
4.6
19.8
23.7
563815.9
2359.1
24069
69.9
2010–2011
53.5
2.4
4.2
13.1
26.8
559446.8
2255.8
20383
72.5
2011–2012
54.5
4.5
4.2
15.3
21.6
633178.6
2649.3
23447
68.7
2012–2013
60.5
3.4
4.2
10.5
21.3
792213.9
3260.1
26974
74.1
2013–2014
62.3
3.3
3.8
8.8
21.8
851433.6
3503.8
21143
66.2
2014–2015
56.0
7.2
2.7
13.6
20.6
772369.1
3017.1
18789
64.3
Source: Indian Security Market-A Review, ISMR, NSE, 2015.
18.5.8 Implications for Monetary Policy
the gilt-edged market has also a considerable bearing on the advances and liquidity of commercial banks,
government securities is to maximise the demand for them, does its achievement suffer when interest rates are
for government securities even at low rates of return has to be explained in terms of the lack of alternative
of rupee loans arises because, in India, the volume of currency and treasury bills as a proportion of the total purchasers of gilt-edged securities will lead to a further calamitous rise in the volume of currency (through
Bond Market
18.37
to deal in such amounts, yet if it thought that there was a risk of its not being able to do so at any time that it wished, it would feel that its liquidity and its freedom of manoeuvre were becoming impaired and would 8
and promptness inter alia, for reasons connected with its impact on the government securities market, the
effects of variations in the bank rate by pegging interest rates on them, encouraging sales of treasury bills by
moderation in executing bank rate policy, there was a need for controlling bank liquidity by using a technique
In the past many years, while the bank rate was left unchanged, the reserve ratio was changed a number of
of variations in cash reserves and SLR may be regarded as an attempt by the RBI to strike a mean between
8
Bank of England, op. cit., p. 441.
18.38
Financial Institutions and Markets
lender by the borrowing dealer with a commitment on the part of the latter to repurchase the securities within
from what we have said earlier that in the absence of dealer activity on a large scale in India, also because to the lack of interest in government securities by companies, there has not been much danger until very to spread the cult of investment and trading in the gilts through portfolio management, buy-back dealings, securities have been provided to a few institutions which keep their accounts exclusively with the RBI and do funds by purchasing government securities from the RBI at ruling rates, and can unload the same to the RBI
18.6 CORPORATE BOND MARKET backing for the bond is usually the payment ability of the company, which
LO 6 Review the corporate bond market in India
main investors in the corporate bond market are banks, insurance companies, provident funds and mutual
debt market is primarily regulated by three institutions namely the Reserve Bank of India, the Securities and
Bond Market
Based on issuer
Based on maturity
18.39
Based on coupon
Based on option
Based on redemption
Issued by corporates
Short-term: Maturity period less than 1 year
Zero coupon bonds: No coupons are paid. The bond is issued at a discount to its face value, at which it will be redeemed.
Put option: This feature gives bondholders the right but not the obligation to sell their bonds back to the issuer at a predetermined price and date. These bonds generally protect investors from interest rate risk.
Single redemption: In this case, principal amount of bond is paid at the time of maturity only.
Issued by banks
Medium term: Maturity period between 1 and 5 year.
Fixed coupon: Coupon rate that remains constant throughout the life of the bond.
Call option: This feature gives a bond issuer the right, but not the obligation, to redeem his issue of bonds before the bond’s maturity at predetermined price and date.
Multiple redemption/ Amortizing bond: A bond, in which payment made by the borrower over the life of the bond, includes both interest and principal, is called an amortizing bond.
Issued by Long Term: Public Sector Maturity period Undertakings more than 5 years Issued by Local Bodies
Floating coupon: Coupon rates are reset periodically based on benchmark rate
Perpetual: no Maturity
18.6.1 Importance of Corporate Bond Market
the perspective of developing countries, a liquid corporate bond market can play a critical role in supporting
is an increasing realisation of the need for a well-developed corporate debt market as an alternative source e.g. forefront the limitations of even a well-managed, regulated and supervised banking system in countries such
18.40
Financial Institutions and Markets
instruments and provides a full spectrum of investment vehicles whose payoffs across contingencies insurance companies like to hold low-risk debt instruments, with a stable income stream, which, in
18.6.2 Challenges to Corporate Bond Market in India ●
●
Corporations prefer bank loans due to the prevalence of the cash credit system in the banks in which the
●
●
●
90 percent debt is raised through private placement, which limits the quantum of bonds available for in the public issue and relatively stringent regulatory requirements associated with public issues that
Bond Market
18.41
●
● ●
●
●
●
● ● ●
●
●
bankruptcy has not been very effective in reviving the corporate bond market as foreign lenders are not ●
●
Banks prefer to issue loans than buying bonds of corporate as the banks receive higher interest rate on
●
18.6.3 Patil Committee (2005) and Raghuram Rajan Committee (2009) Recommendations to Develop the Corporate Bond Market
18.42
Financial Institutions and Markets
Recommendations of Patil Committee (2005) 1. Development of Primary Market ●
● ●
Enhance the issuer base by encouraging corporations to borrow from the bond market rather than from
●
Develop market makers in the corporate bond market similar to the primary dealers in the government
●
Enhance the scope of investment by provident/pension/gratuity funds and insurance funds in corporate
●
●
2. Development of Secondary Market ●
●
Use the existing infrastructure of national stock exchanges to establish a system to capture all the information related to trading in corporate bonds and disseminate it SEBI should set up a separate trading platform for institutional investors in line with bond market as in
● ● ●
Introduce exchange traded derivatives to provide ways to hedge risk of holding Reduce the minimum market lot for corporate bonds from 10 lakh to 1 lakh to encourage participation these instruments issues need to be sorted out to facilitate of secondary market for securitisation would help transfer risks
●
by repackaging ●
of infrastructure
Bond Market
18.43
Recommendations of Raghuram Rajan Committee (2009) ●
Reforms in the corporate bond market cannot be considered in isolation and should be a part of the overall a number of missing markets such as exchange traded interest rate and foreign exchange derivatives
● ● ●
●
●
18.6.4 Policy Measures Taken to Develop the Corporate Bond Market9
●
SEBI would be responsible for primary market (public issues as well as private placement by listed
●
mandatory to report inter-scheme transfers of corporate bonds by mutual funds on either of the reporting
9
Raghavan, S et al. (2014), A Study of Corporate Bond Market in India: Theoretical and Policy Implications, Development Research Group, Study No. 40, RBI.
18.44
Financial Institutions and Markets
●
bond instruments issued in demat form and listed on recognised stock exchanges in order to implement
●
order to create a centralised database for corporate bonds, a system to capture secondary market trades
●
In order to encourage participation of retail investors, SEBI reduced trade lot size for all classes of investors from `10 lakh to `
●
●
SEBI had vide
venture capital funds, foreign venture capital investors, portfolio managers, and RBI-regulated entities
●
haircut applicable on the market value of the corporate debt securities has been revised by the Reserve ●
RBI has recently decided to implement the guidelines relating to introduction of CDS effective
could help in the development of corporate bond market, as it provides a hedging opportunity for both ●
Bond Market
18.45
●
as popular benchmark for equities, designing debt indices has posed challenges in India as the breadth
this context is the ICICI securities (ISEC) bond index (I-Bex) which measures performance of the bond
●
18.6.5 Development of Corporate Bond Market in India primary corporate market, which comprises the public issues and the private placement market, is
there was a preference for raising resources in the primary market through debt instruments, and the private placement
Table 18.10 New debts issued by non-government public limited companies Year
Debts
2 as % of Gross Capital Formation of Private Corporate Sector
No. (1)
Amount (` in crore) (2)
1990–1991
115
3015
12.03
1991–1992
145
4275
10.81
1992–1993
171
9850
19.19
1993–1994
149
9370
18.11
1994–1995
121
8871
11.90
1995–1996
63
3970
3.26
1996–1997
32
4233
3.54 (Contd.)
18.46
Financial Institutions and Markets 1997–1998
12
1972
1.50
1998–1999
12
2391
1.97
1999–2000
10
2401
1.71
2000–2001
9
3068
2.88
2001–2002
13
4832
3.99
2002–2003
4
1418
0.98
2003–2004
3
1251
0.67
2004–2005
3
1627
0.49
2005–2006
2
245
0.05
2006–2007
3
850
0.14
2007–2008
2
809
0.09
2008–2009
1
1500
0.24
2009–2010
4
2680
0.34
2010–2011
6
2626
0.26
2011–2012
14
7528
0.82
2012–2013
6
2217
0.24
2013–2014
17
5869
12.03
Source: RBI Handbook of Statistics on Indian Economy, 2014.
Table 18.11
Resources raised by corporate sector
Years
Percentage share in the total resource mobilisation (%) Public equity issue
Right issue
Debt public issue
Debt private placement
2000–2001
4.20
—
7.01
88.79
2001–2002
2.06
—
10.15
87.80
2002–2003
1.92
—
8.67
89.42
2003–2004
25.25
—
6.13
68.62
2004–2005
26.55
—
5.07
68.37
2005–2006
22.44
—
0.00
77.56
2006–2007
21.30
—
0.00
78.70
2007–2008
26.0
16.2
0.5
57.4
2008–2009
1.1
6.6
0.8
91.5
2009–2010
18.9
3.4
1.0
76.7
2010–2011
18.7
3.7
3.6
74.0
2011–2012
3.5
0.8
11.9
83.9
2012–2013
1.7
2.3
4.4
91.6
2013–2014
2.7
1.4
13.0
83.0
2014–2015
0.7
1.5
2.1
95.7
Source: Indian Securities Market—A Review, Various Issues.
18.47
Bond Market
Table 18.12 Private placement of corporate debt reported to BSE and NSE Year
NSE No. of issues
BSE
Amount (crores)
No. of issues
Common Amount (crores)
No. of issues
Total
Amount (crores)
No. of issues
Amount (crores)
2007–2008
580
90718
120
11711
44
16056
744
118485
2008–2009
699
124810
285
17045
57
31426
1041
173281
2009–2010
647
143286
597
49739
34
19610
1278
212635
2010–2011
774
153370
591
52591
39
12825
1404
218785
2011–2012
1152
189803
783
56974
18
14505
1953
261282
2012–2013
1295
206187
1094
72474
100
82801
2489
361462
2013–2014
837
140713
997
78805
12
56536
1924
276054
Source: SEBI, Bulletin, May 2014.
Table 18.13 Trading in corporate bonds Years
BSE
NSE
No. of trades
Amount (crores)
No. of trades
Amount (crores)
2007–2008
11203
40957.56
3787
31453.14
2008–2009
8327
37320.47
4902
49505.39
FIMMDA No. of trades
Grand Total
Amount (crores)
No. of trades
Amount (crores)
4089
23479.01
19079
95889.71
9501
61534.84
22730
148360.7
2009–2010
7408
53323.50
12522
151920.00
18300
195954.55
38230
401198.04
2010–2011
4465
39581.09
8006
155951.23
31589
409741.92
44060
605274.24
2011–2012
6424
49842.00
11973
193435.00
33136
350506.00
51533
593783.00
2012–2013
8639
51622.00
21141
242105.11
36603
444904.15
66383
738632.00
2013–2014
10187
103027.0
20809
275701.00
NA
NA
NA
NA
Source: SEBI, Bulletin, May 2014.
secondary corporate bond market
continuously, which show the growing importance of the secondary corporate debt market in India, but still
18.7 DEVELOPMENT OF PUBLIC SECTOR UNDERTAKING (PSU) BOND MARKET PSU bonds are medium- or long-term debt instruments issued by public sector
LO 7 Explain the Public Sector Undertaking (PSU) bond market in India
18.48
Financial Institutions and Markets
, viz.,
the taxable and tax-free bonds the taxable bonds have been more popular than the tax-free bonds and during
Table 18.14 Bonds issued by public sector undertakings (` in crore) Year
Tax-free bonds
Taxable bonds
Total
1991–1992
2469
3422
5891
1992–1993
11
1052
1063
1993–1994
1414
4172
5586
1994–1995
1198
1872
3070
1995–1996
547
1744
2291
1996–1997
67
3327
3394
1997–1998
570
2412
2982
1998–1999
406
3957
4363
1999–2000
400
8297
8697
2000–2001
662
15969
16632
2001–2002
274
14162
14436
2002-2003
286
7243
7529
2003-2004
—
5443
5443
2004–2005
—
7541
7541 (Contd.)
Bond Market 2005–2006
—
4846
4846
2006–2007
—
10325
10325
2007–2008
—
13404
13404
2008–2009
—
20546
20546
2009–2010
1926
46483
48409
2010–2011
1642
58791
60433
2011–2012
28082
59983
88065
2012–2013
14860
37857
52717
2013–2014
34244
16621
50865
18.49
Source: RBI, Handbook of Statistics in Indian Economy, 2014. Notes: (1) Data for 2013–2014 are provisional. (2) The data for the table include both public issues of bonds and privately placed bonds.
SUMMARY ◆ ◆
◆
◆ ◆
◆
◆
companies and co-operative banks, and (iii) retail segment consisting of individuals and non-institutional ◆
◆
◆
◆
◆
T
18.50
Financial Institutions and Markets
versus payment (Dv
◆
vP is the mode of
◆
◆
◆
◆
◆
◆
◆
◆ ◆
continuously, which show the growing importance of the secondary corporate debt market in India, but ◆
◆ ◆
KEY TERMS Coupon Par value Bearer bond Registered bond Credit risk Interest rate risk
Corporate bond PSU bonds Primary dealer
Delivery versus payment system Zero coupon yield curve Zero coupon bond
Bond Market
Liquidity risk Call risk Government securities market
Price-based auction
Sovereign gold bond
Competitive bidding
Uniform price
QUESTIONS
(ii) Competitive bidding (iv) Delivery versus payment system
(vii) Sovereign Gold Bond Scheme (viii) PSU bonds
18.51
18.52
Financial Institutions and Markets
`1100 and ` (a) Its yield to maturity (c) Current yield `
`1000 and trading at a simple annual rate of 9 percent, determine the values and effective annualized rates given the bond has following payment (i) Semi annual (ii) Continuously `
` coupon payments and current price as `
Stock Market
19
CHAPTER Learning Objectives LO 1 LO 2 LO 3 LO 4 LO 5 LO 6 LO 7 LO 8
19.1
Know the case for and against the role of equities market Explain the types of market segments in the stock markets, securities traded and valuation techniques of stocks Understand primary market Discuss secondary equity market Explain market microstructure in Indian stock market Describe major policy developments in equity market in India Review the measures to develop equity market Show the drawbacks of the Indian stock markets
INTRODUCTION
The objective of this chapter is to discuss various aspects of the working of the stock market in India with special reference to recent developments and policy initiatives. The term stock market can be used to denote individual stock exchanges at various places or one market comprising all individual stock exchanges in the country. The stock market or equities market, occupies a disproportionately large space in the discussions in the print and electronic media. The industry, business, rich and middle classes tend to be highly preoccupied with this market, and regard it as the barometer of the health of the economy. They frequently stress the essentiality of the growth and spread of what has come to be called the equity culture or equity cult or risk capital for faster industrial growth. The chapter, therefore, begins with the discussion of the theory of equity culture, that is, the case for and against (the over-emphasis on) the role of equities market.
19.2
THEORY OF EQUITY CULTURE
stock market which are stressed are more from the point of view of maximising (speculative) returns for the individual investors and the market operators, and the issue of how far it helps the corporate sector in raising fresh capital is side-
LO 1 Know the case for and against the role of equities market
19.2
Financial Institutions and Markets
tracked. Recently, many articles discussing the relationship between stock market and economic growth have appeared in international journals, viz., World Bank Economic Review and World Bank Research Observer. But unfortunately, most of them have overwhelmingly emphasised the secondary market (SM) indicators and have not even mentioned primary market activity. They have assessed the role of stock markets in developing
together various arguments in favour of equity culture and then show how and why they are unconvincing.
19.2.1 The Case for Equity Culture (a)
long-term capital, but investors are often reluctant to relinquish control over their savings for long
the allocation of capital and enhances growth. Through these effects, the stock market liquidity can lead to more saving and investment also. (d) Historically, many inventions had been made much before they became innovations. Inventions became projects that required large capital injections for long periods. The industrial revolution had to wait till
through international integration can encourage a shift to higher return projects, and thereby help to promote growth. improved information improves resource allocation and accelerates growth. equity brings in improved accounting and reporting standards in its wake, and exposes domestic companies to advanced supervisory and managerial techniques.
and increases in interest rates.
Stock Market
19.3
Alternatively, if well-managed and well-established companies rely on stock markets, banks and the industrial sector. (j) The ability to effect changes in the management of quoted companies can ensure that managerial
costs of monitoring the management.
19.2.2 Examination of the Case for Equities1 (a) The liquidity advantage of the stock market has been disproportionately overplayed. Liquidity is only one of the motivating factors in savings and investment decisions; risk, return, maturity, and so on, are the other equally important and relevant considerations. The share market, as it is, is much more liquid than many other markets, and yet, the investment in shares is riskier than many other investments. Moreover, there are many other ways also to provide liquidity to the investors. Good facilities for premature retirement, and buy-back or repurchase facilities have made bank deposits and units quite liquid without their being traded on the stock market. Further, it is counter factual to say that the saving-investment process would break down or seriously suffer without liquidity. The overwhelming preference for debentures and a continued support to unquoted shares in India and elsewhere clearly suggests that the pre-occupation with stock market liquidity should be discarded. The reluctance of community is large and diverse, and to argue that all or most or majority of investors prefer short-term to long-term investments is erroneous. If investors were reluctant to invest, then long, undated or longterm bonds would not have existed. The investors in India have generally preferred long-term to shortterm claims; the maturity structure of bank deposits is a good example in this context. Finally, liquidity may encourage investor-myopia and weaken investor commitment; it may reduce investor incentive to exert corporate control and to monitor company performance, which can hurt economic growth. riskier investments in productive physical capital as companies become preoccupied with short-term
done. It can also create or accentuate the problem of volatility rather than reduce risk and uncertainty. information through price changes which tends to create a free-rider problem, that is, it reduces the incentive to exert and spend money for obtaining information. (e) The argument regarding stock markets tying up the interests of managers and owners hinges on a very equities is often incorrect because it is not related to fundamentals (future real dividends and expected 1
See also Classens, S, ‘The Emergence of Equity Investment in Developing Countries: Overview’, The World Bank Economic Review, January 1995; and Feldman, R A, and Kumar, M S, ‘Emerging Equity Markets: Growth, Benefits, and Policy Concerns’, The World Bank Research Observer, August 1995.
19.4
Financial Institutions and Markets
managers hardly have any control over market valuation, and if they try to gain such a control, other
institutions are the normal, usual sources of funds to these entities. idea. A healthy, sustained industrial activity can hardly be possible in an atmosphere where the constant threat of being swallowed or taken over by others exists. A system dependent on mergers and takeovers
(h) Another argument that the stock market attracts foreign equity and helps nations to lighten their debt servicing burden is also erroneous. The equity capital does not come free of cost. In fact, since equity investors expect a higher rate of return, it involves a higher servicing burden or a greater external drain of resources in the long run. In addition, there are problems of ownership and control which are associated with foreign equity. Its alleged advantage in terms of improved accounting, reporting, managerial and supervisory standards presumes that every equity-exporting country, be it the United States or a Middle-East country, has higher standards in this respect than every equity-receiving country. Even if one accepts such an assumption, there is no reason to believe that such standards would be applied in the case of equity capital but not in the case of debt capital. (i) The stock market has been found to be far more speculative and volatile than the bond and commodity markets in developing as well as advanced countries. The speculative bubbles have often determined liberalised and globalised economies, stock markets can easily act as conduits for spreading speculative pressures all over the world. (j) The relationship between stock market activity and economic growth is very weak indeed. The case for
market. In fact, it is the former, more than the latter, which have catalysed industrial development in most countries. It may be recalled here that technical innovations and bank credit are the two pillars of revolution and industrial revolution is symbiotic or interdependent rather than sequential as claimed by the advocates of equity culture. The stock market cannot contribute much to the growth process because not much corporate investment is
into corporate investment.
Stock Market
19.5
market, which have played an important role in industrialisation during the post-independence period in India. In Japan, the stock market remained underdeveloped even as the Japanese industry grew by leaps and bounds. In other industrialised countries such as the United States, UK, France, Canada, Germany and the growth of investment, industry and economy has not been dependent on the secondary markets. It has been found that in many countries, the underdeveloped stock market or absence of equity culture has had no adverse effect on savings and realised investment. The latest evidence also shows that the net contribution of accounted for less than 5 percent of the growth of net assets in these countries during 1980–1990.
19.3 CLASSIFICATION OF STOCK MARKETS AND SECURITIES are issued by the companies that need long-term funds. There are two types of market segments in the stock market: (i) primary market or new issue market (NIM) and (ii) secondary market (SM). While the NIM supplies fresh or
LO 2 Explain the types of market segments in the stock markets, securities traded and valuation techniques of stocks
the NIM are traded on the SM. The SM does not play any direct role in making funds available to the corporates; its role in this respect is only indirect, that is, it helps to encourage investors to invest in industrial securities by making them liquid, that is, by providing facilities for continuous, regular and ready buying and selling of those securities. NIM deals in new securities, whereas SM deals in already existing or old securities which have been listed on it. The investors acquire or buy securities directly from the companies on the NIM, while they trade securities so acquired among themselves on the SM. Business concerns raise capital through two major types of securities from the stock market. They are: (a) ordinary shares or variable dividend securities or common stock, and (b) preference shares country. They differ in their investment characteristics and as such satisfy different preferences of various investors and enjoy differing degrees of popularity.
19.3.1 Ordinary Shares Ordinary shares are ownership securities which have certain advantages in favour of the issuing companies but not illiquid. Due to the existence of a fairly active secondary market in shares, investors can turn their share holdings into cash fairly quickly. Because of the high risk which he bears, the investor can participate
it is advantageous because dividend payments on ordinary shares are not mandatory and there is no need
19.6
Financial Institutions and Markets
is quite popular with individual investors in India. The face value of ordinary shares in India varies from `1 to `1000 but the most common and popular denomination of shares is `100. The ordinary share-holders are part owners of the company, and they have voting rights. But now, the authorities have decided to issue SEs. But now, they have been permitted to buy-back their own shares to a limited extent, and either to write off/cancel them or hold them as Treasury-frozen stock.
19.3.2 Preference Shares
return (dividend) like a debenture. The holders of preference shares are entitled to income after the claims of creditors of the company have been met, but before ordinary shareholders receive any income. Because of and non-cumulative, (b) convertible and non-convertible, (c) redeemable and non-redeemable, and (d) participating and non-participating. On cumulative preference shares, if dividend is skipped in any period/ periods, it has to be paid subsequently. Convertible preference shares can be converted into ordinary shares
redeemable and non-redeemable shares are in vogue in India, but many redeemable shares are so only at the discretion of the companies. Over a period of time, there has been a trend towards increasing the proportion of redeemable shares to total preference shares. The maturity period of redeemable shares is usually between 12 and 15 years. The practice of issuing preference shares with participation and conversion rights is not common. Preference shareholders have voting rights only on those issues which vitally affect the rights attached to their shares or when dividend has not been paid for a long period of time. The rate of dividend on shares is known to vary between `1 and `1000, but the most common and popular one has been `100. In theory, a preference share offers a perfect certainty of income and, as such, is less risky. But the marketability and liquidity of preference shares are low in practice because the market for them is narrow and less active. The importance of preference share as a medium of investment for individuals has declined and now they has also declined. However, in the case of new companies, they still play a relatively greater role than in the case of older companies.
19.3.3 Private Equity Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company and make acquisitions or to strengthen a balance sheet. The majority of
Stock Market
19.7
private equity consists of institutional investors and accredited investors who can commit large sums of money for long periods of time. Private equity investments often demand long holding periods to allow for a turnaround of a distressed company or a liquidity event such as an IPO or sale to a public company. The pool funds together to take very large public companies private. There were several private equity purchases leveraged buyouts (LBOs) where large amounts of debt are issued to fund a large purchase. Private equity
19.3.4 Valuation of Ordinary Shares (Common Stocks) the present value of all future dividends. The model is as follows: P0 = Â t =1 n
Dt Dn D1 D2 = + + ºº + 1 2 t (1 + R) (1 + R) (1 + R) (1 + R) n
(19.1)
P0 = Current price Dt = The expected dividend at time t. R g P0 =
D0 (1 + g )1 D0 (1 + g ) 2 D0 (1 + g ) n + + ºº + (1 + R)1 (1 + R) 2 (1 + R) n
Taking the common term D0, we can rewrite it as follows: È (1 + g )1 (1 + g ) 2 (1 + g ) n ˘ P0 = D0 Í + + ºº + ˙ 1 (1 + R) 2 (1 + R) n ˚ Î (1 + R) 1+ R , we can have Multiply both sides in the above equation by 1+ g È (1 + g )1 (1 + g ) 2 (1 + g ) n ˘ È1 + R ˘ P0 = Í = D 1 + + + ºº + Í ˙ 0 ˙ 1 (1 + R ) 2 (1 + R) n ˚ Î1 + g ˚ Î (1 + R )
(19.2)
(19.3)
Subtract the equation (19.2) from equation (19.3) È (1 + g ) n ˘ È1 + R ˘ P0 Í - 1˙ = D0 Í1 n˙ Î1 + g ˚ Î (1 + R) ˚
(19.4)
(1 + g ) n will be closely equal to zero and the right hand side of (1 + R) n equation (19.4) will be left with D0. Hence, simplifying this equation
Assume that R > g; when n Æ
then
19.8
Financial Institutions and Markets
È1 + R - 1 - g ˘ P0 Í ˙ = D0 1+ g Î ˚ ÈR - g˘ P0 Í ˙ = D0 Î1+ g ˚ P0(R – g) = D0(1 + g) As we know it earlier that D0(1 + g) = D1 P0 =
D1 R-g
(19.5)
This model is based upon three assumptions, that is, the growth of dividend is constant, will be paid for
Example: Suppose ABC Ltd. paid a dividend of `4.00 per share for the last year. The dividends are expected to grow at the rate of 6 percent per year thereafter. If the required rate is 15 percent, then what will be the value per share? If the current price is `50, what would be the growth rate in dividends to justify this price? D0 = `4.00, G = 6%, R =15% D1 = 4.00 ¥ (1 + 0.06) = `4.24 D1 4.24 = = `47.11 R - g 0.15 - 0.06 To address the second issue, let us substitute all known value Hence, P0 =
P0 = 50 =
D0 (1 + g ) R-g
400(1 + g ) , simplifying this equation we can obtain 0.15 - g 54g = (50 ¥ 0.15) – 4 g = 0.0648 = 6.48%
19.3.5
Two Stage Growth Model
Assuming the different growth rate in two different periods, that is, the supernormal growth rate (g1) of dividend in the beginning and a stable rate (g2 equity is as follows: P0 = Â t =1 n
D0 (1 + g1 ) 1 + ¥ Pn t (1 + rcs ) (1 + rcs ) n
(19.6)
where, Pn = Dn + 1/(rcs – g2) (the terminal price), D0 = current dividend; g1 = its supernormal growth rate; n = number of years of supernormal growth; Pn = price of stock at the end of super-normal growth period which is based on the dividend growth rate of g2 from n
19.9
Stock Market
Example: The dividend per share of a company ABC Ltd. was `5.28. Its dividend has grown at 4 percent stable throughout. The required rate of return of the company is 12 percent. In the stable growth period the company paid `6.09 per share. Compute the value of the company? Answer: Dividend in the high-growth period = `5.28 Growth rate in the high-growth period = 4% (g1) Length of the high-growth period = 4 years Discount rate = 12% Stable growth rate = 3% (g2) Pn = Dn +1 /(r – g 2 ) =
6.09 ¥ (1.05) 4 (1.03) = `81.62 (0.12 - 0.03)
5.28 ¥ 1.04 [1 - (1.04) 4 /(1.12) 4 ] 81.62 + (0.12 - 0.04) (1.12) 4 = `17.61 + `51.87 = `69.48 (Answer)
Price ( P0 ) =
19.3.6
Valuation of Preferred Stock
has no maturity. Its value is simply the stated dividend (D) divided by the required rate of return on preferred stock (r). It can be represented as follows: P=
D r
(19.7)
Example: Consider a preferred stock having the par value of `100 and dividend of `10 per year. The required rate of return of this stock is 8 percent. The value of the stock will be as follows: P = `10/0.08 = `125
19.4
PRIMARY MARKET2
In the primary market, primarily, issues made by an Indian company can be right issues by a listed company and public issues involve a detailed procedure, the procedures for offering bonus issues and private placements are relatively
LO 3 Understand primary market
initial 2
SEBI, Issues by Indian Companies in India, 2013.
19.10
Financial Institutions and Markets
public offering growth. In that case, it can engage in a secondary offering by issuing additional shares of stocks to the public. follow-on public offer is already listed on an exchange, issues new shares to the investors or the existing shareholders, usually the promoters. FPO is used by companies to diversify their equity base.
Figure 19.1
issuer (i.e. record date), it is called a rights issue. The rights are offered in a particular ratio to the number of securities held as on the record date. When an issuer makes an issue of securities to its existing shareholders as on a record date, without any consideration from them, it is called a bonus issue. The shares are issued out on a record date. When an issuer makes an issue of securities to a select group of persons not exceeding 49, and which is neither a rights issue nor a public issue, it is called a private placement. Private placement of shares or convertible securities by listed issuer can be of two types: (i) Preferential allotment: When a listed issuer issues shares or convertible securities to a select group of persons in terms of provisions of Chapter XIII of SEBI (DIP) guidelines3, it is called a preferential allotment. The issuer is required to comply with various provisions which inter-alia include pricing, disclosures in the notice, lock-in and so on in addition to the (QIP): When a listed issuer of provisions of Chapter XIIIA of SEBI (DIP) guidelines, it is called a QIP.
19.4.1 Initial Public Offerings The SEBI has laid down certain entry norms for entities making a public issue. Entry norms for different routes available to an issuer for accessing the capital market are as follows: 1. An unlisted issuer making a public issue, that is, (making an IPO) is required to satisfy the following provisions:4 3 4
For details see SEBI, Disclosure and Investor Protection Guidelines, 2000. SEBI, Issues by Indian Companies in India, 2013.
Stock Market
19.11
(i)
The issuer company shall meet the following requirements: (a) net tangible assets of at least `3 crores in each of the preceding 3 full years. (b) Distributable (c) Net worth of at least `1 crore in each of the preceding 3 full years. (d) If the company has changed its name within the last 1 year, at least 50 percent revenue for the preceding 1 year should be from the activity suggested by the new name.
(ii)
(a) Issue shall be through book-building route, with at least 50 percent face value capital shall be `10 crores or there shall be a compulsory market-making for at least 2 years.
(iii) from the appraiser(s). (b) The minimum post-issue face value capital shall be `10 crores or there shall be a compulsory market-making for at least 2 years. (iv) In addition to satisfying the aforesaid entry norms, the issuer company shall also satisfy the criteria of having at least 1000 prospective allottees in its issue. 2. A listed issuer making a public issue (FPO) is required to satisfy the following requirements: (a) If the company has changed its name within the last 1 year, at least 50 percent revenue for the preceding 1 year should be from the activity suggested by the new name. (b) The issue size does year. Certain category of entities like private sector banks, public sector banks and an infrastructure
these institutions are exempted from the aforesaid entry norms. Besides the entry norms, an issuer making a public issue is required to inter-alia comply with the following provisions mentioned in the guidelines: Minimum Promoter’s contribution and lock-in: In a public issue by an unlisted issuer, the promoters shall contribute not less than 20 percent of the post-issue capital which should be locked in for a period of 3 years. period of 1 year from the date of listing. In case of public issue by a listed issuer, that is FPO, the promoters shall contribute not less than 20 percent of the post-issue capital or 20 percent of the issue size. This provision ensures that promoters of the company have some minimum stake in the company for a minimum period after the issue or after the project for which funds have been raised from the public is commenced. IPO grading is the grade assigned by a credit rating agency registered with SEBI, to the initial public offering (IPO) of equity shares or other convertible securities. The grade represents a relative
19.12
Financial Institutions and Markets
Prospectus’
Letter of Offer
price process in IPOs, allotments of shares to all investors are made on proportionate basis. In book building,
In case of Book-Building process book is built by Book Runner Lead Manager (BRLM) to know the everyday
issue, the price is mentioned after discovering it from the demand received from prospective investors. The details about the two types of issues are given in Table 19.1. The steps which are usually followed in the book-building process have been summarised as follows:5 (i) The issuer company proposing an IPO appoints a lead merchant banker as a BRLM. (ii) Initially, the issuer company consults with the BRLM in drawing up a draft prospectus (i.e. offer document) which does not mention the price of the issues, but includes other details about the size of the issue, past history of the company and a price band. The securities available to the public are
advertisement, road shows and so on. (v) The BRLM appoints a syndicate member, a SEBI-registered intermediary to underwrite the issues to (vi) The BRLM is entitled to remuneration for conducting the Book-Building process.
5
Issue type
Offer price
Demand
Payment
Reservations
Fixed Price Issues
Price at which the securities are offered and would be allotted is made known in advance to the investors.
Demand for the securities offered is known only after the closure of the issue.
In total, 100 percent advance payment is required to be made by the investors at the time of application.
A total of 50 percent of the shares offered are reserved for applications below `1 lakh and the balance for higher amount applications.
BookBuilding Issues
A 20 percent price band is offered by the issuer within which investors are allowed to bid
A 10 percent advance payment is required to be made by the QIBs along with the application, while other categories of investors have to pay 100 percent advance along with the application.
A total of 50 percent of shares offered are reserved for QIBS, 35 percent for small investors and the balance for all other investors.
Demand for the securities offered, and at various prices, is available on a realtime basis on the BSE determined by the issuer website during the only after closure of the bidding period. bidding.
See also Saha, S.K. ‘The Book Building Mechanism of IPOs’, The Chartered Accountant, August 2004.
Stock Market
19.13
(vii) The copy of the draft prospectus may be circulated by the BRLM to the institutional investors as well as to the syndicate members. (viii) The syndicate members create demand and ask each investor for the number of shares and the offer price.
(x) The prospective investors may revise their bids at any time during the bid period. (xi) The BRLM on receipts of the feedback from the syndicate members about the bid price and the quantity of shares applied has to build up an order book showing the demand for the shares of the company at various prices. The syndicate members must also maintain a record book for orders received from institutional investors for subscribing to the issue out of the placement portion. (xii) On receipts of the above information, the BRLM and the issuer company determine the issue price. This is known as the market-clearing price. (xiii) The BRLM then closes the book in consultation with the issuer company and determines the issue size of (a) placement portion and (b) public offer portion.
institutional bidder, even if he has paid full amount may be rejected without being assigned any reason as the Book-Building portion of institutional investors is left entirely at the discretion of the issuer company and the BRLM. price and receipts of acknowledgement card from SEBI. (xvi) Two different accounts for collection of application money, one for the private placement portion and the other for the public subscription should be opened by the issuer company. method. The BRLM is required to have the application forms along with the application money from the institutional buyers and the underwriters to the private placement portion. (xviii) The allotment for the private placement portion shall be made on the second day from the closure of the issue and the private placement portion is ready to be listed. existing statutory requirements. (xx) Finally, the SEBI has the right to inspect such records and books which are maintained by the BRLM and other intermediaries involved in the book-building process. Reverse Book Building The reverse book building is a mechanism provided for capturing the sell orders on online basis from the shareholders through respective book running lead managers (BRLMs) which can be used by companies intending to delist its shares through buy-back process. In the reverse book-building scenario, the acquirer/ company offers to buy-back shares from the shareholders. The reverse book building is basically a process
19.14
Financial Institutions and Markets
building is open, offers are collected from the shareholders at various prices, which are above or equal to through book building is as follows: (i) The acquirer shall appoint designated book running lead manager (BRLM) for accepting offers from the shareholders. of a symbol assigned to it by BRLM. (iii) Orders for the offer shall be placed by the shareholders only through the designated trading members, duly approved by the exchange. (iv) The designated trading members shall ensure that the security/shareholders deposit the securities offered with the trading members prior to placement of an order. n National Securities Clearing Corporation Limited.
19.5 SECONDARY EQUITY MARKET The secondary equity market is where securities are traded after being initially LO 4 offered to the public in the primary market and/or being listed on the stock Discuss secondary exchange. The stock exchanges along with a host of other intermediaries provide equity market the necessary platform for trading in the secondary market, and also for clearing and settlement. The securities are traded, cleared and settled within the regulatory framework prescribed by the exchanges and the SEBI. The secondary market operates through two mediums, namely, the over-thecounter (OTC) market and the exchange-traded market. The OTC markets are informal markets where trades are negotiated. Most of the trades in government securities take place in the OTC market. All the spot trades where securities are traded for immediate delivery and payment occur in the OTC market. The other option is to trade using the infrastructure provided by the organised stock exchanges. Each organised exchange has
member of the exchange can act as both a seller and buyer. Those members of the exchange attempting to sale of certain number of shares of a certain stock, they receive bids for that stock by other members. The sellers either accept the highest bid immediately or wait until an acceptable bid is offered. Currently, there are 20 organised stock exchanges existing in India. Among them three stock exchanges are national and others are regional stock exchanges (RSEs). Particularly, there are two prominent stock exchanges in India, that is, Bombay Stock Exchange (BSE) and National Stock Exchange of India (NSE).
Stock Market
19.15
19.5.1 Bombay Stock Exchange (BSE) groups. Over the past 137 years, BSE has facilitated the growth of the Indian corporate sector by providing
shareholder-base which includes two leading global exchanges, Deutsche Bourse and Singapore Exchange derivatives and mutual funds (MF). It also has a platform for trading in equities of small- and-medium stock market benchmark index. It is traded internationally on the EUREX as well as leading exchanges of the BRCS nations (Brazil, Russia, China and South Africa).
19.5.2 National Stock Exchange of India (NSEI) NSE was promoted by leading Financial Institutions at the behest of the Government of India and was incorporated in November 1992 as a tax-paying company unlike other stock exchanges in the country. The NSEI has a fully automated, electronic, screen-based trading system. Its objectives are (a) to provide nationsuitable communication network, (b) to provide shorter settlement cycles and book entry settlement system, (c) to bring the Indian stock market in line with international markets, and (d) to promote the secondary market in debt instruments such as government and corporate bonds. The National Stock Exchange (NSE) operates a nation-wide, electronic market, offering trading in capital market, derivatives market, and currency derivatives segments including equities, equities-based derivatives, currency futures and options, equity-based ETFs, Gold ETF and retail government securities. Today NSE network stretches to more than 1500 locations in the country and supports more than 230,000 terminals. It has two separate segments: (a) institutional participants, and which deals in PSU bonds, units, TBs, government securities, call money, CPs, CDs and so on. Everything is big in this segment; there are mega players, mega investors and mega deals in it. (b) The other is the capital market segment (CMS) which deals in equities, convertible debentures, and so on. These include securities that are traded on other stock exchanges also. WDMS started functioning from 30 June, 1994. Trading in CPs began on 16 August, 1994. CMS began trading from 3 November, 1994. The as the only conduit for interbank security deals. The NSEI is an order-driven and not a quote-driven market, shares are traded on it are divided into two categories: listed and permitted. Although there are many indexes available with NSEI, the most popular index in NSEI has been CNX Nifty.
19.5.3 Over-the-Counter Exchange of India (OTCEI) trading system. It is promoted by UTI, ICICI, IDBI, IFCI, LIC, GIC, SBI Caps, and CANBANK as a company under Section 25 of the Companies Act 1956, with headquarters at Mumbai. Its objectives are
19.16
Financial Institutions and Markets
(a) to help companies to raise capital from the market at the cheapest costs and on optimal terms; (b) to help investors to access capital market safely and conveniently; (c) to cater to the needs of the companies delayed settlements and unfair prices faced by the investors. The securities which are traded on OTCEI are divided into three categories: (a) listed, (b) permitted, and (c) initiated. These securities cannot be traded on other stock exchanges. However, they can be bought and sold at any of the OTCEI counters all over India. It has two players: members and dealers (instead of brokers) who can perform the functions of broking, trading on their own accounts and market-making. While the members can engage in sponsorship, the dealers cannot. Scheduled banks, mutual funds, banking subsidiaries, FIs, merchant bankers, venture capital funds, `3 crore can become members of OTCEI. It has an online trading-cum-depository, quote-driven and transparent system of trading. It follows T + 3 settlement system which is the fastest in the country. It provides a liquid cash market for the retail investors. The existence of market maker (MM) 6 and the modern trading and settlement system on it ensures deliveries versus payment on time. There are no problems of bad deliveries or short deliveries because the system allows the execution of trades only on the basis of electronic inventory of scrips. It encourages domestic and foreign institutional investors also to trade on it by offering them netting facilities for both intra-custodian and inter-custodian transactions. The trading on OTCEI is based on the roll-over concept which means all trading done on any day is settled on the same day itself, and the netting with the previous or subsequent week. Thus, OTCEI is a cash and retail market for small investors and small companies. With the passage of In spite of its many advantages, OTCEI has been languishing since its inception. The reasons for low activity on OTCEI are said to be (a) stringent market making norms, (b) mandatory requirement that the sponsor T + 3 settlement period not permitting speculation. Some people have criticised OTCEI for these factors and have suggested relaxation in them. In our view, these are the strengths of OTCEI and they should not be discarded merely for the sake of increasing the volume of business, because such an increase would then occur through unhealthy policies. Worried by the stagnant activity on OTCEI, the years to review its working and to suggest measures to improve its functioning. The recommendations of these committees have been in the direction of relaxing the strict norms with which OTCEI had begun operating.
19.5.4 Other Stock Exchanges in India Apart from the three SEs in Mumbai, there are 17 other national and regional exchanges located in metropolitan centres and other cities in India as on June 2014. These stock exchanges are Ahmedabad Stock Exchange 6
The market making means that a trader or a company puts forth buy and sell orders in the market and waits for someone to trade with him on either side. The MM is normally a stock exchange member who provides two-way quote for buy and sell orders with a maximum spread on a continuous basis for a minimum quantity of stocks. The ordinary investors and traders ‘take the market’, that is, they buy at the offer price and sell at the bid price. However, the MM can sell at the offer price and buy at the bid price. The system was much prevalent in Indian stock exchanges during the floor-based trading when the jobbers used to play the role of MM. But it did not work well due to lack of transparency. In an order-driven screen-based trading system, the MMs are absent.
Stock Market
19.17
Ltd., Bangalore Stock Exchange Ltd., Bhubaneswar Stock Exchange Ltd., Calcutta Stock Exchange Ltd., Cochin Stock Exchange Ltd., Delhi Stock Exchange Ltd., Guwahati Stock Exchange Ltd., Inter-Connected Stock Exchange of India Ltd., Jaipur Stock Exchange Ltd., Ludhiana Stock Exchange Ltd., MCX-Stock Exchange Ltd., Madhya Pradesh Stock Exchange Ltd., Madras Stock Exchange Ltd., Pune Stock Exchange Mumbai. The regional stock exchanges had hardly any share in the total turnover in the market.
19.6 TYPES OF INVESTOR IN THE STOCK MARKET Broadly, the investors in the stock market can be categorised into two types, such as, investors and traders on the basis of their investment horizon period and objectives. The goal of the investor is to participate in the market over a long period of time through the buying and holding of the stocks to maximise his return. Investors hold their stocks for a period of years or even decades, taking the advantage of the changes of generally more concerned with market fundamentals like price-earnings ratio, market risk, and so on. Traders on the other hand, involve frequent buying and selling of stocks with the objective of generating returns more a lower price and selling at higher price within a short period of time. Mostly the traders rely more on the technical analysis to take their investment decisions in the market. Traders are generally categorised into four types on the basis of their investment horizon period. (i) Position Trader: Positions are held from months to years, (ii) Swing Trader: Positions are held from days to weeks, (iii) Day Trader: Positions are held throughout the day and no overnight position, and (iv) Scalp Traders: Positions are taken seconds to minutes and no overnight position. individual or retail investors and institutional investors. Each retail
of a corporation. Mostly, the insurance companies, pension funds and equity mutual funds are the common purchasers of newly issued stocks in the primary market and these institutions also invest in stocks which
stocks by creating an active secondary market. Financial institutions not only participate in stock market in terms of investing funds but also issue their own stocks as a means of raising funds. For example, a pension fund may purchase the newly issued stock of an insurance company and if the pension fund someday sells hold large amount of stocks, their collective sales and purchases of stocks can affect the stock market prices
19.18
Financial Institutions and Markets
Investors Decisions and Stock Prices Investors buy the shares of a particular stock when their valuation of the stock exceeds the existing market price of the share and the investors who are holding the stocks sell their shares when their valuation has been below the existing market price. There are different valuation techniques used in the market for valuing the equity (see Chapter 2) and the differences in valuations among investors make some investors to believe that a stock is undervalued and while others believe that it is overvalued. The differences in opinions allow for market trading as there will be buyers and sellers of the same stock at a given point of time. Changes in the opinion of the investors on the basis of their valuation method shift the demand for and supply of shares and their equilibrium prices. If the demand for shares exceeds the supply of shares for sale then an upward pressure has been created on the market price, but if the supply of shares for sales exceeds the demand for shares then a downward pressure is created. Therefore, the market price of the share is determined by the participation of the investors in aggregate in the equity market.
Information and Investors Decisions
demand for share of that stock increases, which put upward pressure on the stock price. Conversely, unfavourable news about the performance of the company make the investors believe that the stock is already overvalued at its current market price, so that some investors sell their shares, which put downward pressure on the stock price. Overall, we can say that the available news or information about the company largely determine the company fundamentals and which, in turn, affect the equilibrium price of the share in the market.
Investors Sentiment and Stock Price
markets, that is, the role of cognitive biases (Kahneman and Tversky, 1979) and limited arbitrage in the Motivated from the literature of experimental psychology, the behavioural asset pricing theory assumes that investors are not completely rational but normal and systematic cognitive biases induce them to invest based on instinct and not on fundamentals (Rabin, 1998; Barberis and Thaler, 2003; Ritter, 2003; Stracca, 2004; Subrahmanyam, 2007; Byrne and Brooks, 2008). Based on the cognitive psychology literature,
Stock Market
19.19
inherent cognitive biases. At a fundamental level, the inherent cognitive biases are having two aspects, which arise either because of preferences or because of mistaken beliefs (Barberis and Thaler, 2003 p. 1063; Ritter, 2003 p. 430). Cognitive biases that arise because of preferences include mental accounting, framing, narrow framing, regret aversion and familiarity (Barberis and Thaler, 2003; Byrne and Brooks, 2008). On the other hand, cognitive biases that arise when people form beliefs include conservatism, representativeness, salience effect, disposition effect, heuristics, over and under reaction, availability bias, frame dependence, anchoring, optimism, bandwagon effect, innumeracy, extrapolation bias, illusory superiority or Dunning–Kruger effect, wishful thinking and belief perseverance (Baker and Nofsinger, ability to differentiate between opinions and information (Black, 1986), strength and weight of information signals (Hirshleifer, 2001), and instinct and rationality (Shiller, 2005). In such an environment, the herd et al., 1990) rather the fundamentals. The second fundamental argument of behavioural approach to equity pricing is the limited arbitrage hypothesis (Fama, 1970) assumes that investors are rational and value securities rationally. Following
value and any short-run over- or undervaluation in the stock prices will be corrected by the presence of et al., 1998). In contrast, literature on behavioural asset pricing suggest that, within a dynamic interplay between irrational investors or noise traders and rational arbitrageurs for the determination of security prices (Shleifer and Summers, 1990; Daniela et al., 2002), rational arbitrageurs may limit their positions in the market to avoid their loss because of the persistent noise trader risk (Black, 1986; DeLong et al., 1990), short sell constraint (Miller, 1977), interaction of the mispricing to increase before it corrects, and the arbitrageur are unable to maintain the position in the management scenario (Barberis et al asset prices and returns holds well, only if, limits to arbitrage also exist that prevent rational investors from exploiting the short-term mispricing (Barberis and Thaler, 2003; Byrne and Brooks, 2008). Considering induced irrationality called irrational sentiment that arises because of some combinations of cognitive biases, and reinforce a particular valuation error (Barberis et al., 1998; Barberies and Thaler, 2003; De Long et al., 1990). However, it has been suggested that cognitive biases and valuation errors are more commonly made by less sophisticated retail investors as compared to the informed institutional investors
19.20
Financial Institutions and Markets
19.7 STOCK MARKET INDICES AND STOCK PRICE QUOTATIONS Stock market indexes are used (i) to judge the performance of individual investor, (ii) to measure the market rates of return, and (iii) to predict the market movements. Factors affecting the construction of stock market index are as follows: (i) sample, it should be representative of total population; (ii) base year, it should be a normal year; and (iii) weighting criteria, equally weighted series, price-weighted series, market valueinto consideration only those shares issued by the company that are readily available for trading in the market. that will not come to the market for trading in the normal course. In other words, the market capitalisation Example: Stock
Quantity
Base year price
Current price
A
60,000
30
45
B
20,000
25
80
0.75
C
90,000
65
85
0.95
0.55
Solution: Equally weighted series = 1/3(45/30 + 80/25 + 85/65) = 2.0033 Price weighted series = (45 + 80 + 85))/(30 + 25 + 65) = 1.75 Market value-weighted series = (60,000 ¥ 45 + 20,000 ¥ 80 + 90,000 ¥ 85)/(60,000 ¥ 30 + 20,000 ¥ 25 + 90,000 ¥ 65) = 1.46 ¥ 45 ¥ 0.55 + 20,000 ¥ 80 ¥ 0.75 + 90,000 ¥ 85 ¥ 0.95)/ (60,000 ¥ 30 ¥ 0.55 + 20,000 ¥ 25 ¥ 0.75 + 90,000 ¥ 65 ¥ 0.95) = 1.43 If the base value of the index has been taken as 100, then in the current year the value of the index using different weighting series will be as follows: (i) equally weighted: 200.33, (ii) price-weighted: 175, Although there are many stock indices available across the world, we have reported features of some major stock indices in India and the United States (Table 19.2). Table 19.2 Features of major stock indices in India and abroad Indices
Sample
Base year
Base value
Weighting criteria
S&P BSE SENSEX
30
1978–1979
100
Value weighted from the beginning, but since 1
CNX NIFTY
50
3 November 1995
1000
Value weighted from the beginning, but since
DJIJ S&P Composite NYSE
30
1938
100
500
1941–1942
10
Value
2818
1965
50
Value
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19.7.1 Stock Price and Stock Index Quotations or exchange value to change. Investors can monitor stock price quotations and stock index quotations from
investors to compare the performance of individual stocks with general market indicators.
Symbol
Date
Open
High
Low
Closing
Traded volume
1
2
3
4
5
6
7
Value of trades (Rupees— 8
P/E
9
P/B Dividend yield 10
11
52week high
52-week low
12
13
CNX 30-06-2014 7534.05 7623.65 7531.6 7611.35 152303166 Nifty
7887.37
20.65 3.48 1.29 7700.05 5118.85
SBI
136.80
18.45 1.36 1.11 2834.90 1452.70
30-06-2014 2650.00 2706.95 2645.5 2686.25
389,993
Table 19.3 presents an example of the stock price and stock index quotations. The explanations of the concepts used in the table are explained below. Column 1: It represents the name of the company (Index). Column 2: This represents the date of transaction or trade. Column 3: trading day. Column 4 & 5: This indicates the price range at which the stock has traded at throughout the day or these are the maximum and the minimum prices that investors have paid for the stock. Column 6: The close is the last trading price recorded when the market closed on the day. Column 7: Column 8: It indicates the total value of trades happened in the day. Column 9: (Price/earnings ratio) This is calculated by dividing the current stock price by earnings per share. It indicates how much investors are willing to pay per unit of earnings. Column 10: Column 11: (Dividend yield) It is the percentage return on the dividend. It is calculated as annual dividends per share divided by price per share. Column 12 & 13: These are the highest and lowest prices at which a stock has traded over the previous 52 weeks (1 year).
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Financial Institutions and Markets
Exchange-Traded Funds (ETFs)
the underlying stocks it represents. It is essentially an index fund like mutual funds, but listed and traded on exchanges like stocks. The introduction of ETFs has opened a new window of investment opportunity for both retail as well as institutional investors. The expected return from ETF will be same as that from an index because it tracks a benchmark index. For example, if the return on investment (ROI) of CNX Nifty is expected to be 15 percent for a particular period (1 January, 2015 to 31 March, 2015), then the
and purchase as little as a share. The expense ratios of ETFs are less than that of mutual funds though they ETFs offer a number of advantages over traditional open-ended index funds as follows7: ●
offer the convenience of intra-day purchase and sale on the Exchange, to take advantage of the ●
●
They provide investors a fund that closely tracks the performance of an index throughout the day with the ability to buy/sell at any time, whereby trading opportunities that arise during a day may be better utilised. They are low cost. Unlike listed closed-ended funds, which trade at substantial premia or more frequently at discounts to create new units and redeem outstanding units directly with the fund, thereby, ensuring that ETFs
●
●
ETFs are like any other index fund, wherein, subscription/redemption of units work on the concept of exchange with underlying securities instead of cash (for large deals). Since an ETF is listed on an Exchange, cost of distribution are much lower and the reach is wider. These savings in cost are passed on to the investors in the form of lower costs. Further, the structure helps reduce collection, disbursement and other processing charges.
●
●
the fund does not incur extra transaction cost for buying/selling the index shares due to frequent subscriptions and redemptions. Tracking error generally observed to be low as compared to a normal index fund due to lower expenses and the unique in-kind creation/redemption process. The tracking error is calculated as follows: ◆
total time period required 7
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◆
day ◆
change in the TR Index for each day n) in Step
◆
◆
3. Calculate the annualised tracking error as per the formula given below Annualised tracking error = Standard deviation obtained (Step 4) ¥ sqrt (250)
●
equitising cash or for arbitraging between the cash and futures market.
19.8 STOCK MARKET LIQUIDITY A stock market is said to be liquid if traders can quickly buy or sell large numbers of shares with minimal impact on price, cost, and delay. It refers to the willingness of a market participant, a liquidity supplier, to take the opposite side in a transaction initiated by another trader, the liquidity demander. In practice, liquidity has been emerged as multidimensional and the literature has documented four dimensions of liquidity. The width, referring to the bid-ask spread for a given number of shares and commissions, and fees to be paid per share. The bid price is the price the investors are ready to pay for the stocks and the ask price is the price at which the investors sell the stocks. Second, depth is the number of shares that can be traded at given bid and asks prices. The third one, immediacy, refers to how quickly trades of a given size can be done resiliency. It characterises how fast prices revert to former levels after they different dimensions do not stand independently rather may interact with each other. For example, if a trader is patient and does not need to trade immediately, he may obtain better prices and/or be able to trade a larger amount at given prices. In this case, width and depth depend on immediacy. The liquidity of a stock depends upon the types of market and market microstructure where it is listed and systems. In a quote-driven or dealer market, a market maker posts bid and ask prices at which he wants to buy or sell and takes the opposite side of each trade. In an order-driven or limit order market, traders interact directly with each other without intermediation. Interestingly, in a limit order market liquidity is only provided
transparency is the issue of anonymity, that is, the degree to which the identity of market participants is revealed; as with transparency, informed traders prefer anonymous trading, whereas liquidity traders do not. A distinction can be made between demand and supply side anonymity. Concealing information about the identity of liquidity demanders in general increases the bid-ask spread, since suppliers can less easily make a distinction between informed and uninformed traders. It has been observed that the reduction of tick size
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Financial Institutions and Markets
decreases inside spread and depth at best bid and ask prices. Biais, Foucault and Salanie (1998) showed that Liquidity is of crucial importance to a number of agents such as traders, since it determines their cost of
on their exchange, as it is a determinant of their cost of capital and their decision about the optimal capital
19.9 MARKET MICROSTRUCTURE IN INDIAN STOCK MARKET 19.9.1 Listing of Securities8
LO 5 Listing means the formal admission of a security to the trading platform of a Explain market microstructure in Indian stock exchange. The listing of securities on the domestic stock exchanges is stock market governed by the provisions in the Companies Act, 2013, the Securities Contracts (Regulation) Act, 1956 [SC(R)A], the Securities Contracts (Regulation) Rules [SC(R)R], 1957, and the circulars/guidelines issued by the central government and SEBI as well as rules, bylaws and regulations of the particular stock exchange, and the listing agreement entered into by the issuer and the stock exchange. A number of requirements under the SC(R)R, the by-laws and the listing agreement have to be continuously complied with by the issuers in order to ensure the continuous listing of their securities. The listing agreement also stipulates the disclosures that have to be made by the companies. In addition, the corporate governance practices enumerated in the agreement have to be followed. The exchange is required to monitor compliance with the requirements. In case a company fails to comply with the requirements, penalty would be imposed as prescribed in the SC(R)A.
19.9.2
Criteria for A shares are as follows: (1) Company must have been listed for minimum period of 3 months. (2) Companies traded for minimum 98 percent of the trading days in past 3 months shall be considered eligible. (3) Companies with minimum non-promoter holding of 10 percent as per the shareholding pattern of most recent quarter shall be considered eligible. The criteria of minimum 10 percent non-promoter holding shall not be applicable to public sector undertakings (PSUs). (4) The weightage of 75 and 25 percent shall be given to ranking on 3-monthly average market capitalisation and traded turnover, respectively, to arrive
included. (b) In case, a list derived from (a) above, comprises of less than 200 companies, the companies
8
National Stock Exchange of India, Indian Securities Market–A Review, 2013.
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which have failed to comply with its listing requirements and/or have failed to resolve investor complaints and/or have not made the required arrangements with both the depositories, viz., Central Depository Services (I) Ltd. (CDSL) and National Securities Depository Ltd. (NSDL) for dematerialisation of their securities. All 9
.
which have traded at least 80 percent of the days for the previous 6 months shall constitute the Group I and percent are categorised under Group I and the scrips where the impact cost is more than 1, are categorised
of the next month. For securities that have been listed for less than 6 months, the trading frequency and the impact cost are computed using the entire trading history of the security. Categorisation of newly listed securities by NSE: a newly listed security is categorised in that group where the market capitalisation of the newly listed security exceeds or equals the market capitalisation of 80 percent of the securities in that particular group. Subsequently, after 1 month, whenever the next monthly review is carried out, the actual trading frequency and impact cost of the security is computed, to determine the liquidity categorisation of the security. In case any corporate action results in a change in ISIN, then the securities bearing the new ISIN are treated as newly listed security for group categorisation. Instances as mentioned above shall refer to all disablements during market hours in a calendar month. The penal charge of 0.07 percent per day is applicable on all disablements due to margin violation anytime during the day. Calculation of mean impact cost: The mean impact cost is calculated in the following manner: Impact cost is calculated by taking four snapshots in a day from the order book in the past 6 months. These four snapshots the percentage price movement caused by an order size of `1 lakh from the average of the best bid and offer price in the order book snapshot. The impact cost is calculated for both the buy and the sell side in each order book snapshot.10 Primarily the stocks that are listed in the stock exchanges are divided into three different categories on the decided by the authorities of the exchanges to determine which stocks will fall in which category. Large Cap Stocks listed companies in the stock exchange. Generally the companies that have a market capitalisation of more than `1000 crore are considered to be large cap companies. The stocks of these companies are categorised as 9
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10
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Financial Institutions and Markets
considered for including in the Nifty and SENSEX, that is, the prime index of the NSE and BSE. Mid Cap Stocks companies. Generally those companies that have a market capital between `200 crore and `1000 crore are considered to be mid cap companies. The stocks of these companies are categorised as the mid cap stocks. The mid cap stocks have great investment proposition as they have all the sign of rising in the market and give good return on investment. Small Cap Stocks `20 crore and `200 crore are said to be small cap companies, and stocks of these companies are considered in the small cap segment. Mostly the small cap companies are relatively new companies that have got listed at the stock market. Investing in the small cap stocks has more risk as these companies take too long to rise in the market.
19.9.3
Trading System
There are two types of market systems such as order-driven market and quote-driven market that exist in the trading of equities in the stock exchanges. The order-driven market displays all of the bids and asks, whereas the quote-driven market focuses only on the bids and asks of market makers and other designated parties. An order-driven market is one in which all of the orders of both buyers and sellers are displayed, detailing the price at which they are willing to buy or sell a security and the amount of the security that they are willing to buy or sell at that price. The biggest advantage to this system is its transparency: it clearly shows all of the market orders and what price people are willing to buy at or sell for. The drawback is that in an order-driven market, there is no guarantee of order execution whereas in the quote-driven market, there is that guarantee. In India, the stock exchanges adopt the order-driven system. There are three different markets in which the orders are executed in the market. The details about the market are given as follows: (i) Normal Market: All orders which are of regular lot size or multiples thereof are traded in the Normal Market. For shares that are traded in the compulsory dematerialised mode, the market lot of these shares is one. Normal market consists of various book types wherein orders are segregated as regular lot orders, special term orders, negotiated trade orders and stop loss orders depending on their order attributes. (ii) Odd Lot Market: All orders whose order size is less than the regular lot size are traded in the odd-lot market. An order is called an odd lot order if the order size is less than regular lot size. These orders do not have any special terms attributes attached to them. In an odd-lot market, both the price and quantity of both the orders (buy and sell) should exactly match for the trade to take place. (iii) Auction Market: In the Auction Market, auctions are initiated by the Exchange on behalf of trading members for settlement-related reasons. There are three participants in this market. Initiator—the party who initiates the auction process is called an initiator, competitor—the party who enters orders on the same side as of the initiator and. Solicitor— the party who enters orders on the opposite side as of the initiator. A trading member can enter various types of orders depending upon his/her requirements. These conditions related conditions.11 11
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(1) Time Conditions (i)
A day order, as the name suggests, is an order which is valid for the day on which it is entered. If the order is not matched during the day, the order gets cancelled automatically at the end of the trading day.
(ii)
A good till cancelled (GTC) order is an order that remains in the system until it is cancelled by the trading member. It will, therefore, be able to span trading days if it does not Exchange from time to time.
(iii)
A good till days/date (GTD) order allows the trading member to specify the days/date up to which the order should stay in the system. At the end of this period the order will get date counted are inclusive of the day/date on which the order is placed. The maximum number of days,
(iv)
An immediate or cancel (IOC) order allows a trading member to buy or sell a security as soon as the order is released into the market, failing which the order will be removed from the market. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately.
(2) Price Conditions (i) system. (ii)
It is an order to buy or sell securities at the best price obtainable at the time of entering the order.
(iii)
It is the one that allows the trading member to place an order which gets activated only when the market price of the relevant security reaches or crosses a threshold price. Until then the order does not enter the market.
A sell order in the Stop Loss book gets triggered when the last-traded price in the normal market reaches or falls below the trigger price of the order. A buy order in the Stop Loss book gets triggered when the last-traded price in the normal market reaches or exceeds the trigger price of the order. (3) Quantity Conditions (i)
An order with a DQ condition allows the trading member to disclose only a part of the order quantity to the market. For example, an order of 1000 with a disclosed quantity condition of 200 will mean that 200 is displayed to the market at a time. After this is traded, another 200 is automatically released and so on till the full order is executed. The Exchange may set a minimum disclosed quantity criteria from time to time.
19.9.4 Margin Trading When investors place an order, they may consider purchasing the share on margin. In that case, they use cash along with funds borrowed from their broker to make the purchase. For purchasing the stocks on margin,
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Financial Institutions and Markets
investors must open an account, which is called as margin account with their broker and put up some cash as collateral. The initial deposit is referred to as the initial margin. The investors are required to satisfy a maintenance margin, which is the minimum amount of the margin that they must maintain as a percentage
the broker. In this case, the investor receives a margin call from the broker, which means that the investor is required to provide more collateral (i.e. more cash or stocks) or sell the stocks. The initial margin and actual Initial margin =
Amount of money investor puts up Total value of transaction
Actual margin =
Current value of securities – Amount borrowed Current value of securities
Margin call arises when the actual margin is declining below the maintenance margin. The following example explains the process of margin call. Example: Let the current price of the stock is `100, the investor wants to buy 100 shares; the initial margin is 50 percent, and maintenance margin is 30 percent. Then total value of transaction will be `100 ¥ 100 = `10,000 and the investor must put up `5000 (50 percent of total transaction value) and borrowing of `5000 from the broker. Assume that the stock price has come down to `90, and then the actual margin will become: [(`9000 – `5000)/`9000] ¥ 100 = 44.44 percent. As the actual margin is above the maintenance margin, the investor will not get the margin call. Let further the price has again come down to `70, then the actual margin will be [(`7000 – `5000)/`7000] ¥ 100 = 28.57 percent. Now the actual margin has been lesser than the maintenance margin and the investor will get the margin call. The formula for calculating the price at which the investor will get the margin call is as follows: Margin call price =
Amount borrowed Number of shares (1 - mainmtenance margin percentage)
In the above example, the margin call price = `5000/100 (1 – 0.30) = `71.43.
19.9.5 Short Selling of the security is expected to fall and sellers believe that they could be bought back later at a lower price.
buying them back from the market and returning them to the lender. This is called covered short selling. In naked short selling securities will be later available for the seller to actually deliver to the buyer at the time of delivery. Naked short selling has been considered a way of manipulating the price of securities. As the short sellers can increase supply very fast, there is a rapid drop in the price of the security. Nervous investors then start closing
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19.29
their long positions which continues to increase supply and there is little if any demand. The short sellers are then able to easily buy-back what they short sold at a much lower price. But the chances of default in naked short-selling are also very high as the seller may not be able to buy-back the securities from the market later due to a shortage. Naked short selling is not permitted in the Indian securities market and accordingly, all investors would be required to mandatorily honour their obligation of delivering the securities at the time of settlement. All classes of investors, viz., retail and institutional investors, are permitted to short sell. The following example explains how the process of short selling works: `80 per share and will decline in the future. The goes down. at ` price valued at `8000. (iii) The sale proceeds of ` `60, 2 months later. The investor now can gain `2000 because he can buy-back 100 shares from the market for `6000 and replace the 100 shares he borrowed.
19.9.6 Settlement Cycle settlement cycles. All the securities are being traded and settled under T + 2 rolling settlement. The NSCCL T on T + 1 to NSCCL. Based on it, NSCCL nets the positions of counterparties to determine their obligations. A clearing member has to pay-in/pay-out funds and/or securities. The obligations are netted for a member pay-in/pay-out obligations are determined latest by T + 1 and are forwarded to them on the same day, so that they can settle their obligations on T + 2. The securities/funds are paid-in/paid-out on T + 2 day to the The settlement process is carried out by the Clearing Corporation with the help of clearing banks and depositories. The Clearing Corporation provides a major link between the clearing banks and the depositories. This link ensures actual movement of funds as well as securities on the prescribed pay-in and payout day. This requires members to bring in their funds/securities to the clearing corporation. The CMs make the securities available in designated accounts with the two depositories (CM pool account in the case of NSDL and designated settlement accounts in the case of CDSL). The depositories move the securities available in the pool accounts to the pool account of the clearing corporation. Likewise CMs with funds obligations make funds available in the designated accounts with clearing banks. to the extent of payment obligations. The banks process these instructions, debit accounts of CMs and credit accounts of the clearing corporation. This constitutes pay-in of funds and of securities. After processing
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Financial Institutions and Markets
through RBI clearing, the clearing corporation sends electronic instructions to the depositories/clearing banks to release pay-out of securities/funds. The depositories and clearing banks debit accounts of the Clearing Corporation and credit accounts of CMs. This constitutes pay-out of funds and securities. Settlement is deemed to be complete upon declaration and release of pay-out of funds and securities. An online facility to close out open positions of members in the capital market segment whose trading facility is withdrawn for any reason, has been provided with effect from 13 June, 2007; on disablement, the trading members will be allowed to place close-out orders through this facility. Only orders which result in reduction of existing open positions at the client level would be accepted through the close-out facility in the normal market. Members would not be allowed to create any fresh position, when in the close-out mode, to place close out orders with custodial participant code and to close out open positions of securities in trade for trade segment.
19.9.7 Index-Based Market-Wide Circuit Breaker The index-based market-wide circuit breaker system applies at three stages of the index movement, either way, viz., at 10, 15 and 20 percent. These circuit breakers when triggered bring about a coordinated trading halt in all equity and equity derivative markets nationwide. The market-wide circuit breakers are triggered by movement of either the BSE Sensex or the NSE CNX Nifty, whichever is breached earlier. The market shall of duration of the market halt and pre-open session is as follows: Trigger limit 10%
15%
20%
Trigger time Before 1:00 pm.
Market halt duration
Pre-open call auction session post market halt
45 Minutes
15 Minutes
At or after 1:00 pm up to 2.30 pm
15 Minutes
15 Minutes
At or after 2.30 pm
No halt
Not applicable
Before 1 pm
1 hour 45 minutes
15 Minutes
At or after 1:00 pm before 2:00 pm
45 Minutes
15 Minutes
On or after 2:00 pm
Remainder of the day
Not applicable
Any time during market hours
Remainder of the day
Not applicable
Exchange shall compute the Index circuit breaker limits for 10, 15 and 20 percent levels on a daily basis
19.10 MAJOR POLICY DEVELOPMENTS IN EQUITY MARKET IN INDIA This section lists the major recently adopted/mooted procedural, institutional, equities market.
LO 6 Describe major policy developments in equity market in India
Stock Market ●
19.31
The SEBI approved in February 1997 the creation of the Trade Guarantee Fund (TGF) by the BSE, which will guarantee settlement of transactions of BSE members.
● ●
An introduction of the Stock Lending Scheme (SLS) has been approved by the authorities. The SLS
●
which possess them and to deliver them to the buyer at the time of settlement against the outstanding commitments. The borrower of the securities pays the lender interest on the value of the stock borrowed. The borrowers are usually the brokers, speculators, market makers and jobbers; and the lenders are usually institutional investors, FIs, mutual funds and high net worth individuals with large inventory of shares. There is a stock lending intermediary who regulates the activities of the borrowers and lenders. The lender does not part with the ownership of the stocks; he continues to receive the dividends declared on such stocks. The SEBI has announced certain guidelines in February 1997 to make SLS operational. Depositories and custodial services have been created to facilitate and simplify securities trading. FIIs have been permitted to invest in the Indian capital market since September 1992. There is no doubt that the buying and selling of shares by FIIs have had a major impact on the movement of share prices in India; their volatility has sharply increased due to FIIs participation in securities trading. Almost all the SEs had introduced screen-based trading. The National Securities Clearing Corporation (NSCC) has started guaranteeing all trades in NSEI since July 1996. About SEs have set up clearing houses/corporations by the end of 1997.
●
● ●
● ●
NRIs and FIIs. It also abolished the dividend tax on the dividend income in the hands of the shareholders. ●
●
● ●
● ●
Non-Resident Indians (NRIs) and OCBs are allowed to buy shares and debentures with prior permission of the RBI. NRIs, OCBs and FIIs are permitted to invest up to 30 percent in equities of the Indian companies engaged in all activities except those of agriculture and plantations. New instruments such as Stock invest and many hybrid claims have been introduced in the recent past. The mandatory minimum percentage of public issues to be offered to the public has been reduced recently from 60 to 25 percent. The minimum number of shares to be applied for has been increased from 100 to 500. Companies are now required to disclose all material facts and special risk factors associated with their projects while making the public issues.
● ●
All the intermediaries, agencies, organisations concerned with the functioning of the capital market have been brought within the regulatory framework of the SEBI. Prudential norms are introduced, stock exchanges have been reconstituted. Capital adequacy norms for brokers have been introduced and guidelines for pre-issue and post-issue obligations, underwriting and capital structure have been given.
● ●
LIC, GIC, mutual funds, provident funds, pension funds and other trusts to the share market. Accordingly,
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Financial Institutions and Markets
rules regarding the investment of the incremental resources of the above-mentioned organisations in the equities have been either already liberalised or are in the process of being liberalised. For example, banks are now encouraged to involve themselves more and more in the primary and secondary markets. The ceiling on their investments in PSU bonds has been removed. They can now invest 5 percent of their incremental deposits of the previous year in equities. They can acquire shares on the secondary market; ●
The companies have been permitted from 1997 to 1998 to buy-back their own shares by using funds out for the purpose of a buy-back. There has been a growing tendency towards buy-back of their own shares by the companies, delisting of shares and conversion of public limited companies into private limited companies. The various hypotheses such as surplus cash, underpricing and capital structure hypotheses that the stock market reacts positively to share repurchase agreements or buy-back announcements.
●
underpriced, which results in the upward revision of company share price for various reasons. First, it is believed by the market that the companies initiate buy-back of their shares when they regard that their shares are underpriced in the market. Second, the shares buy-back provides the managers with an avenue to distribute excess cash or surplus capital to the shareholders, thereby, reducing the possibilities of wasteful expenditures (for purposes like perquisites, empire building and negative net present value by attempts to fend off hostile takeover threats and to avoid dilating impact of share options on per share capital structure may also encourage shares repurchases. If the management believes that the optimal leverage ratio. Fifth, the desire to increase earnings per share may also be the reason behind the buy-back ●
The SEBI has issued certain guidelines to be followed by companies if they want to buy-back their their debt obligations. This is necessary to protect debt exposure of banks, FIs and individual investors. (b) Companies are required to give 7 days prior notice to SEs for any proposal to consider buy-back at a board meeting. (c) The decision of the board has to be communicated within 15 minutes of the
●
●
as prescribed by SEBI. (e) The consent of shareholders is mandatory for buy-back. In 2003, SEBI established Central Listing Authority (CLA) to streamline the listing process. The CLS would consist of a president and not more than 10 members who would be appointed by SEBI. The authority would constitute a fund, and no exchange can consider any listing application unless it is accompanied by a letter of recommendation from the CLA. It is expected to bring about uniformity in the exercise of due diligence in scrutinising listing applications and listing agreements. In late 1990s and thereafter, we have witnessed a phenomenon of many multinational and other companies in India and abroad delisting their shares from the stock market after buying back their shares from shareholders and ceasing to be public limited companies and becoming private limited companies.
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For doing so, many companies have taken advantage of the crash in the stock market in 2000 and 2001. If this trend becomes widespread, the universe of listed stock would rapidly shrink and the investors would be left without quality stock to invest in. There are many reasons, motivations, driving forces behind this new trend. They are as follows: ◆ Certain companies no longer feel the need to raise money from the market. ◆ Their earlier listing was on account of government policy requirement. With changes in government policies, they prefer to work as private companies. If there were no government listing regulations, some of these companies would never have listed on the stock market. For example, in 1980s and 1990s, MNCs were forced to go public and reduce their stake in their Indian subsidiaries from 100 to 40 percent. In the post-liberalisation period, MNCs have been allowed to increase their stake in Indian companies up to 74 percent and even 100 percent in certain areas. ◆ A desire for freedom to operate without any interference from either the shareholders or the regulator. Some companies wish to be free from lawsuits, pressures, protests of the shareholders. ◆ When the stock market is in crisis in which the share prices of many companies are at their nadir, the companies may not see any advantage in remaining public and may, therefore, choose to delist and go private. The companies think that through delisting, they can ward off disadvantages associated with low share prices and poor liquidity which can trigger an unwanted hostile takeover bid. ◆
◆
business without being accountable to shareholders and regulators. The increasing requirements of stock exchanges in terms of disclosures, and the increasing thrust on corporate governance may motivate companies to delist and go private. Given the high cost associated with listing, the option of going private enables companies to avoid
In the depressed phase of the stock market, the promoters can buy-back their shares at low prices (i.e. at low acquisition cost) and then delist those shares. SEBI has come up with guidelines/norms for delisting of companies with a view to protect shareholders. It has issued two sets of norms: (a) SEBI (Delisting of securities) Guidelines 2003, and (b) SEBI (Central Listing Authority) Regulations 2003. These norms are in force w.e.f. mid-February 2003. These guidelines are as follows: ◆ The national and regional stock exchanges are vested with the authority to monitor the possibility of price manipulations and keep a watch on the securities that announce delisting. ◆ The guidelines make it compulsory for companies to determine the exit price for delisting of securities in compliance with the book-building process, also known as reverse book-building through an electronically linked transparent facility. ◆ The offer price would be the average of 26 week-traded price preceding the date of announcement ◆
●
◆
◆ ◆
been offered. The promoters or the acquirers of companies who wish to delist their stock should obtain prior permission of the investors through a special resolution passed at the general meeting. Delisting would be permitted only if the company is listed for a minimum period of 3 years. The shareholders would be given an exit opportunity and the exit price would also be determined in accordance with the book-building process.
19.34 ●
Financial Institutions and Markets
The organisation of the stock market is undergoing a drastic change at present; the process for such a change
being listed on other SEs. This has come to be known as demutualisation and corporatisation (DC) of the Indian SEs. The SEBI has opted for a uniform model of DC in which all SEs would be converted into
rights of the members. At present, SE members elect representatives from amongst themselves to run the SE and regulate their own activities. Under such arrangements, it has been experienced that the SEs do in the current organisational model. Under the new dispensation, the SE Companies would appoint a would be scrapped, and the members would be issued shares and would be asked to pay deposit to secure trading rights. The governing board would comprise of brokers, shareholders and investors to be represented equally. Any single equity or a group of related entities would not have more than 5 percent own, manage and use the services of the SEs. The existing members would have to give up their trading or ownership rights. ●
are as follows: In 1990s, there was an increase in the number of Regional Stock Exchanges (RESs) and there was also a creation of Interconnected Stock Exchange (ICSE) to weave these RSEs together. But this development succeeded only for a short while and by 2003, many of RSEs had zero or near-zero turnover. The causes of this need to be understood well: ◆ The RSEs have a theoretical basis in the fact that for a vast country like India, a decentralised development of stock market is supposed to be good for balanced regional development. At the same time, it is to be noted that the local, regional, semi-urban and even urban investor (as opposed to metropolitan investor) is risk-averse and he suffers from lack of expertise, knowledge, analytical skills, adequate, quick information required for investment in shares. The market size of RSEs remains small. The RSEs could not sustain when the national stock market itself became depressed. been the result of industrial recession and stock markets scams, which have destroyed the investor The BSE and NSE did not leave the space for RSEs to grow; in their anxiety to show their own growth, they occupied greater and greater space which naturally belonged to the RSEs. The BSE and NSE increased their own trading facilities in increasing number of centres, which was made possible by the spread of computerisation and information technology. RSEs could not face the competition from the BSE and NSE. ◆ The new trend of many companies delisting their shares also has adversely affected both the national SEs and RSEs. Indonext would be an exchange where all companies with paid-up capital of up to `20 crore will be traded exclusively. Such companies cannot list on the BSE and NSE, and if they are already listed on them, they will have to delist from there and list with respective RSE. RSE stock brokers will automatically ◆
●
Stock Market
●
19.35
become members of Indonext. The concept is based on Euronext Exchange which was formed in 1999 by merging the Paris, Amsterdam, Lisbon and Brussels stock exchanges. The Indonext is expected to consolidate stock exchanges in India and create a Pan-India trading system in which there would be a common order book which could be accessed by any of the stock brokers of the SEs participating in the Indonext. By 2003, all the listed scrips have been put in the list for compulsory settlement of trade in dematerialised depository system. According to one view, dematerialisation of shares is becoming popular with the
pace of transfer of securities. Many others are not so sanguine. According to them, in India, the small
●
expected to reduce risk, lower transaction costs and other higher investor protection and service for the vast majority of market participants. However, actually, the system has cheated the vast majority of market participants. The share depository service in India has not evolved as a voluntary commercial service; it has evolved as a compulsory bureaucratic requirement prescribed by SEBI for trading shares. Compulsory dematerialisation and allowing depositories to exploit their near-monopolistic position by charging very high fees have robbed investors of their money. T + 2 trading system. The Indian capital market has witnessed a radical transformation in its trading and settlement system. Earlier, there was a carry forward system in which deals could be carried forward up to as many as 90 days. Those who did not carry forward their trades could settle them at the end of same period or at the end of trading cycle which was not a rolling system and which was of 10–14 days duration. Up to June 2001, the Indian Secondary capital market was characterised by Account Period Settlement System (APS) in which trades executed within a given period, say a fortnight or a week, were netted and settled
badla
badla
T + 2 rolling system would have the following
liquidity in the market. (c) It may help to achieve true price discovery in the market. (d) It may reduce safety. (g) It may reduce market manipulations. (h) It may reduce malpractices, cheating, corruption and scams in the capital market. (i) It may help to increase transactions volumes and trading turnover in the market. (j) It may enhance the integrity of the market. (k) It may curb rampant inter-exchange arbitrage, which, among other things, was responsible for stock market scams. ●
features. They are as follows: (i) Unlike in an APS, where the settlement of trades done for a number
19.36
Financial Institutions and Markets
spread across all trading days. This reduces undue concentration of payment of monies and delivery of infrastructure and system capacity. (iii) In rolling settlements, the time lag between the trade execution and settlement is substantially reduced which results in lowering of the outstanding market positions. Consequently, the risk of the Exchange on member-brokers for the outstanding positions gets substantially reduced. Similarly, the risk of the clients on the member-brokers and vice versa also gets substantially
●
key element of compensation package for the employees or as a means to retain their able employees. ESOPs are primarily a commitment made by a company to its employees for offering a limited number
decline in the stock market during 1990s saw fortunes of investors dwindling. However, employees new stock options at the existing market price in place of ESOPs whose strike price had fallen below the market price. The repricing is generally done by means of cancelling the existing ESOPs, and issuing
●
●
●
existing price. In order to provide an additional route for raising funds in the domestic market, SEBI permitted listed The Investor Protection Fund (IPF) has also been set up by the stock exchanges to protect the interests of investors. The exchanges maintain an IPF to take care of investor claims, which may arise out of non-settlement of obligations by the trading member, who has been declared a defaulter, in respect of trades executed on the exchange. Measures of investor protection that have been put in place over
The index is the average of the disclosure index, director liability index and shareholder suits index. The index ranges from 1 to 10, with higher values indicating better investor protection. Based on this index, India fares better than a large number of economies, including even some of the developed ones such as France and Germany. Corporate governance has emerged as an important tool for protection of shareholders. The corporate governance framework in India has evolved over a period of time since the setting up of the Kumar Mangalam Birla Committee by SEBI. According to the Economic Intelligence Unit Survey of 2003, in terms of corporate governance across the countries, India was rated the third best country to have good corporate governance code after Singapore and Hong Kong. To improve the availability of quarterly basis. To enhance the level of continuous disclosure by the listed companies, SEBI amended
Stock Market
●
●
●
●
19.37
and takeovers of companies have also been put in place. These are aimed at making the takeover process more transparent and to protect the interests of minority shareholders. Security Exchange Board of India (SEBI) introduced e-IPO concept into the Indian primary market on 4 October, 2012. The objective to this event was to simplify the process of issuing IPOs, lower their costs and increase their level of penetration among retail investors. On 4 January, 2013, the SEBI introduced the facility for intermediaries to be able to verify the permanent account number (PAN) of their clients online on the Income Tax website without insisting on the original PAN card, provided the client has presented a document other than the PAN card for proof of identity. Security Exchange Board of India (SEBI) introduced Rajiv Gandhi equity saving scheme on 6 December,
shares only in the top 100 stocks traded on Bombay Stock exchange and National Stock Exchange. The SEBI has allowed mutual fund (MF) distributors on 4 October, 2013 to use the infrastructure of the stock exchanges for the purchase and redemption of mutual fund units directly from AMCs on behalf of their clients. Prior to this, the facility was available only for stockbrokers and clearing members.
●
19.11 CRITICAL APPRAISAL OF THE MEASURES TO DEVELOP EQUITY MARKET The foregoing array of measures constitutes an impressive and powerful policy package indeed. Although some of these measures are welcome, the of weaknesses, drawbacks and malpractices, and its depressed state during the
LO 7 Review the measures to develop equity market 12
(1) Limited Growth of Equity Market in India: There are a number of important and sensible reasons why the growth of equity market ought to remain limited in India. First, there are clear limits to the growth of the corporate sector, as of the whole economy. The call for an ever-increasing mobilisation of funds on the capital market for an ever-increasing investment expenditure for an ever-increasing rates of corporate growth can result only in over-investment, overheating and business cycles in the economy. Second, compared to other
stability due to its being excessively speculative and volatile nature. Due to the entry of FIIs, NRIs and due the channelisation of more and more savings through the equity market would mean a progressive decline in the direct scope and coverage of monetary policy, and, therefore, a decline in its effectiveness. Fourth, in the Indian economy, small, village, cottage, home industry, agriculture, and the activities in the informal, 12
For elaboration, see Bhole, L M, Financing of the Private Corporate Sector: Trends, Issues, and Policies, Himalaya Publishing House, Mumbai, 2000.
19.38
Financial Institutions and Markets
unorganised, small sector have a crucial role to play, but they cannot access the equity market. The sectoral inter alia, on only a limited growth of the equity market. (2) Role of Banks and NBFIs in the Equity Market: (against) shares may soon pose problems for the authorities. Not long ago (in April 1995), banks were advised to desist from acquiring shares and debentures on the secondary market because they were not permitted to trade there. This policy was reversed in October 1996 when the banks were allowed to trade on the secondary revive the SENSEX. The ambivalence, the dithering approach and the pre-occupation with the SENSEX
involvement of banks in the equity market, therefore, is a nostrum for destabilising the system. The policy of maintaining a distance between them for more than 100 years has stood the test of time. At this very juncture, when the authorities are struggling to rebuild a viable banking system, its undue involvement with the equity market may best be avoided. The corporate demand for channelising more institutional resources into equities is guided purely by self-interest. As the institutional investments are bound to be block investments, the corporates want the voting or controlling powers of institutions to be limited. Already there is a widespread practice of promoters and managements controlling companies and enjoying vast economic power without encouraged to invest in corporate shares but are not allowed to participate in the governance of companies.
in equities from the created money, or the budgetary and RBI support, or the funds mobilised from sources
market strictly as the long-term investment, but they should not invest much in trading on the secondary
stability and security. Many experts there have strongly argued that more than a marginal involvement of B (3) Objections to the Policy of Developing Equity Market with Fiscal Concession: The policy of argument that the equity investment deserves special tax treatment because it is more risky is not really convincing. The higher and regular reward for the greater risk-bearing must come from the good, improved To build a tax-incentives-disincentives regime which seeks to frown upon the long-term, natural preferences of the savers in a given society (debt instruments in India), and to create preferences for certain other claims
Stock Market
19.39
tends to reduce tax coverage and aggravate the problems of low tax revenue, larger public debt and higher
The argument that the investment in shares suffers from double taxation also cannot stand scrutiny. The taxation of company income and dividend income separately is unavoidable because companies and shareholders are Companies and shareholders should be treated either as different for all purposes or one in all respects. If we treat them as one for all purposes, there would not be a need for their separate taxation, but then there partnership business. To achieve neutrality among different forms of business organisation selectively would be a wrong public policy. Further, the serious implications of the integration of taxation of the shareholders and companies in the case of closely held companies also ought to be kept in mind before such a policy is implemented. Does the so-called double taxation of dividends lead to a greater retention of net earnings by the companies as has been argued by some people? There is no empirical evidence to support this position in and promoted which meet the preferences of the investors. Given the fact that an overwhelmingly large body of investors in India generally prefers debt instruments, it would be wrong to favour equities and disfavour (4) Interest Rate Policy for Promoting Equity Investment: It follows that the interest rates policy which has been designed partly to promote equity investment needs to be changed. For long, interest rates on bank deposits have been kept at a relatively low level to obviate the need for raising the lending rates too
There is also a need to raise interest rates on debentures suitably. In this context, the 1997–1998 budgetary provision to abolish dividend tax without providing a corresponding concessions along with the policy of low interest rates favour the rich and disfavour the low- and middleforeigners, directors and top 50 individual holders. Among the individuals who hold the remaining 30 percent also, the majority belongs to the upper-, middle- and rich-income groups. It has been found in the United States also that although the percentage of American population that owns common stock directly or indirectly has quintupled between 1952 and 1990, the richest 0.5 percent of the American population owns 31 percent of the total US stock; the richest 10 percent owns 89 percent and the poorest 90 percent owns 11 percent of the shares. There is no doubt that to favour equities is to favour the very rich. (5) Role of Secondary Market Activities in the Economy: It is imperative to develop a balanced perspective on the place of the secondary securities markets in the economy. In theory, they are required to facilitate, support, enable the healthy growth and functioning of primary markets, as the very words, primary and secondary, convey. The current focus of thinking on the CFS, SENSEX, market capitalisation, and so on,
19.40
Financial Institutions and Markets
secondary markets may reduce the volume of activity not only on the new issue market but also in the banks, curve, that is the inevitability of the need for making a choice, is quite relevant in respect of the expansion of
19.12 OVERVIEW OF EQUITY MARKET IN INDIA The equity market size in terms of market capitalisation, in India has expanded mostly because of change
throughout the period (Table 19.4). The turnover ratio (TOR), which equals the total value of shares traded activity or liquidity in the stock markets. The turnover ratio measures trading relative to the size of the
domestic exchanges as a share of GDP. This ratio measures trading relative to the size of the economy. Both
liquidity ratios by boosting the value of stock transactions even without a rise in the number of transactions or a fall in transaction costs. Further, liquidity may be concentrated among larger stocks (Table 19.4). Table 19.4 Select stock market indicators of India Year
No. of domestic listed companies
Market capitalisation Total cash segment turnover Turnover ratio as percentage of GDP as percentage of GDP
1991
—
19.4
—
32.7 167
Value-traded ratio 6.3
2000
—
46.8
—
2005
4763
54.3
54.3
2006
4796
84.7
66.76
78.9
66.9
2007
—
86.5
70.02
81.8
89.4
97.7
78.1 53.1
2008
—
55.7
109.32
85.2
85.8
2009
4996
85.6
69.10
116.3
79.8
2010
4987
93.6
89
75.6
61.9
2011
5112
54.2
60.1
56.3
39.4
2012
5191
68.6
38.8
54.6
33.5
2013
5211
67.6
32.2
43.4
29.4
2014
5336
74.0
29.5
38.6
28.5
2015
5624
94.1
41.5
43.6
41.0
2016
5911
86.6
36.7
32.4
28.0
Source: RBI, RCF, SEBI-Handbook 2013, 2014, 2016 Securities Market in India: Overview.
19.41
Stock Market
Year
Public issues
Right issues
No.
No.
2001–2002
20
6501.81
15
1041.26
2002–2003
14
3638.68
12
431.61
2003–2004
35
22,265
22
1007
2004–2005
34
24,640
26
3616
2005–2006
103
23,294
36
4088
2006–2007
85
29,797
39
3711
2007–2008
92
54,511
32
32,518
2008–2009
21
2082
25
12,637
2009–2010
44
46,736
29
8319
2010–2011
58
48,654
23
9503
2011–2012
35
10,482
16
2375
2012–2013
33
6528
17
8945
2013–2014
40
8692
15
4576
Source: SEBI Annual Reports. Notes: (1) No. refers to the number of issues of the instrument. (2) Amount refers to the issues amount of the instrument in rupees (crore).
From the Table 19.5, it is evident that the resource mobilisation through public and right issues has increased
the growth of the two major stock exchanges BSE and NSE in India in terms of listed companies, market capitalisation ratio, turnover ratio and traded value ratio. During the period 1995–2013, the number of listed Table 19.6
Selected indicators of BSE and NSE
Year
Market capitalisation/ BSE
NSE
BSE
1995
4702
135
1996
5603
422
2000
5815
2001
Turnover ratio
NSE
BSE
46.3
—
47.5
33.8
720
47.1
5869
785
2002
5782
2003 2004
Traded value ratio
NSE
BSE
NSE
14.5
—
6.7
—
8.9
16.5
4.2
5.7
52.7
75.2
82.2
35.4
43.3
27.4
31.5
175.0
203.6
47.9
64.1
793
26.9
28.0
50.2
80.6
13.5
22.6
5650
818
23.3
21.9
54.9
115.1
12.7
25.1
5528
909
43.4
40.6
41.9
98.1
18.2
39.8 (Contd.)
19.42
Financial Institutions and Markets
2005
4731
970
52.4
48.9
30.5
71.9
16.0
35.2
2006
4781
1,069
81.8
76.2
27.0
55.8
22.1
42.5
2007
4821
1,228
82.6
78.4
27.0
57.8
22.3
45.3
2008
4887
1,381
103.0
97.4
30.7
73.1
31.7
71.2
2009
4929
1,432
55.3
51.9
35.6
95.0
19.7
49.3
2010
4975
1470
94.1
91.7
22.4
68.9
21.0
63.2
2011
5067
1574
94.1
92.2
16.2
53.4
15.2
49.2
2012
5133
1646
110.4
108.3
10.7
46.1
8.0
33.6
2013
5211
1666
73.2
71.5
5.9
29.2
4.3
20.9
Source: SEBI-Hand book of Statistics 2005, 2013 and 2014. Notes: Turnover Ratio = (Turnover/Market Capitalisation) and Traded Value Ratio = (Turnover/GDP)
companies has increased from 4702 to 5211 in the case of BSE and for NSE it has increased from 135 to 1666. Market capitalisation to GDP ratio has increased continuously during 1995–2008 and after that it has the government in the context of India. The turnover ratio and traded value ratio were highest in the year 2001 and after that both the ratios have declined continuously in both the stock exchanges. This implies that there is the problem of liquidity in the stock market for a reasonable period of time, which has also larger implications on the growth process of the economic growth. Table 19.7 presents the certain characteristics of two major stock market indexes in India. The volatility
opportunity existing in the market. The stock markets worldwide have grown in size as well as depth over for about 43 percent of worldwide turnover in 2012. Despite having a large number of companies listed on its exchanges, India accounted for a meager 1.3 percent in total world turnover in 2012. The market Table 19.7 Stock market index, volatility and P/E ratio Year
CNX-NIFTY Volatility
P/E ratio
P/B Ratio
SENSEX Dividend yield
Volatility
P/E ratio
P/B Ratio
Dividend yield
2000
1.98
24.7
4.48
1.06
1.72
19.72
2.82
1.56
2001
2.0
17.05
3.72
1.14
2.2
17.55
2.57
1.85
2002
1.4
18.25
2.93
1.33
1.5
13.74
2.14
2.28
2003
1.0
13.44
2.16
2.91
1.0
18.55
3.5
1.81
2004
1.4
21.27
3.59
1.72
1.4
16.05
3.82
1.69
2005
1.6
14.84
3.88
1.94
1.5
20.05
4.92
1.29
2006
1.0
20.68
5.26
1.3
1.0
19.84
4.95
1.28
2007
1.8
17.49
4.63
1.31
1.8
20.18
5.19
1.07
19.43
Stock Market 2008
2.0
20.66
5.09
1.06
1.9
12.68
2.47
1.92
2009
2.7
14.49
2.53
1.83
2.8
21.05
3.85
1.12
2010
1.9
22.52
3.73
0.93
1.9
20.04
3.46
1.13
2011
1.1
22.11
3.7
1.07
1.1
17.85
3.46
1.47
2012
1.3
18.79
3.02
1.5
1.3
17.19
2.95
1.57
2013
0.9
17.51
3.01
1.46
0.8
17.87
2.65
1.39
2014
1.1
18.8
3.42
1.31
1.1
18.3
2.70
1.50
2015
0.9
22.7
3.70
1.27
0.9
19.2
3.10
1.29
2016
—
21.1
3.26
1.45
—
20.18
2.85
1.39
Source: SEBI-Handbook of Statistics 2013, 2008; ISMR-2012, 2013, 2016. Note: Volatility is calculated as standard deviation of the natural log of returns of indices for the respective period
Country/ region
No. of listed companies
Year
2010
2011
2012
Developed market
27,107
27,497
Australia
Market capitalisation ratio
Turnover ratio
2010
2011
2012
2010
2011
2012
26,839
—
—
—
130.49
151.39
97.30
1913
1922
1959
157.28
87.34
84.60
84.01
104.03
81.75
France
901
893
862
72.71
56.57
69.78
76.15
93.98
61.79
Germany
571
670
665
42.72
33.17
43.72
98.27
148.44
82.45
Japan
3553
3961
3470
80.90
60.35
61.76
104.41
117.51
97.95
Korea
1781
1792
1767
130.83
89.08
104.50
149.34
204.45
128.24 37.78
Singapore
461
462
472
203.09
128.63
150.75
76.24
82.31
UK
2056
2001
2179
142.88
119.39
123.99
96.77
102.37
82.42
USA
4279
4171
4102
120.22
103.62
119.02
177.69
196.61
114.50
21,924
20,681
—
—
—
92.32
116.91
81.92
Emerging Market
21,673
China
2063
2342
2494
95.55
68.42
44.24
168.60
226.35
157.58
India
4987
5112
5191
123.33
63.81
68.60
65.40
72.90
49.27
Russia
345
327
276
81.62
46.37
43.41
79.61
143.95
83.72
Brazil
373
366
353
98.32
47.13
54.60
58.30
78.22
67.86
Indonesia
420
440
459
66.70
21.04
45.18
35.95
35.79
23.11
Malaysia
957
941
921
214.27
91.85
156.94
21.97
32.63
26.14
Mexico
130
128
131
51.93
29.48
44.57
23.89
27.40
22.50
49,421
47,520
—
—
—
—
—
—
World Total
48,780
USA as % of World
8.77
8.44
8.63
—
—
—
43.0
—
—
India as % World
10.22
10.34
10.92
—
—
—
1.3
—
—
Source: ISMR-2013, SEBI Handbook of Statistics-2013. Notes: Market capitalisation ratio = Market capitalisation/GDP, Turnover Ratio = (Turnover/Market Capitalisation)
19.44
Financial Institutions and Markets
capitalisation ratio of all listed companies for most of the developed countries has come down from the year 2010 to 2011, but it has shown an increasing trend in the year 2012. In the case of emerging economies also market capitalisation ratio has declined during the same period. For India, it has drastically come down from 123 to 64 percent.
19.13 DO FUNDAMENTALS AFFECT STOCK RETURNS IN INDIA? The movement of stock indices is highly sensitive to the changes in fundamentals of the economy and to fundamentals which may be formed either rationally or adaptively on economic fundamentals, as well as economic fundamentals play determining role in the performance of stock market. Chen, Roll and Ross
returns. Friedman (1988) suggests wealth effect and substitution effect as the possible channels through which stock prices might directly affect money demands in the economy. Friedman (1988) expected that the wealth effect will dominate and thus the demand for money and stock prices to be positively related. The theoretical basis to examine the link between stock prices and the real variables are well established in economic literature, for example, in Baumol (1965) and Bosworth (1975). The relationship between stock prices and real consumption expenditures, for instance, is based on the life cycle theory, developed by Ando and Modigliani (1963), which states that individuals base their consumption decision on their expected life time wealth. Part of their wealth may be held in the form of stocks linking stock price changes to changes in consumption expenditure. Similarly, the relationship between stock prices and investment spending is based on the q theory of James Tobin (1969), where q capital stock at current prices.
cost of its funds as many companies borrow in foreign currencies to fund their operations and, hence, its stock price. An alternative explanation for the relation between exchange rates and stock prices can be provided through portfolio balance approaches that stress the role of capital account transaction. Like all commodities, exchange rates are determined by market mechanism, that is, the demand and supply condition. A blooming
try to sell their stocks to avoid further losses and would convert their money into foreign currency to move out of the country. There would be demand for foreign currency in exchange of local currency and it would lead to depreciation of local currency. As a result, rising (declining) stock prices would lead to an appreciation (depreciation) in exchange rates. Moreover, foreign investment in domestic equities could increase over time
Stock Market
19.45
demand could depend on the performance of the stock market. Bodie (1976), Fama (1981), Geske and Roll (1983), and Pearce and Roley (1983), Pearce (1985) document positive effects will outweigh the negative effects and stock prices will eventually rise due to growth of money supply (e.g. Mukherjee and Naka (1995)). They argue that a change in the money supply provides information on money demand, which is caused by future output expectations. If the money supply increases, it means that money demand is increasing, which, in effect, signals an increase in economic activity. Higher argue that the price of a stock is a function of its monetary value and the perceived risk in holding the stock. A stock is attractive if the monetary value it bears is high. On the other hand, a stock is unattractive, if the perceived risk is high. The authors argue that the money supply affects the stock market through its effect on both the monetary value and the perceived risk. Money supply affects the monetary value of a stock through its effect on the interest rate. The authors believe that tightening the money supply raises the real interest rate. An increase in the interest rate would, in turn, raise the discount rate, which would decrease the value of the stock as argued by the real activity theorists. Mukherjee and Naka (1995) reveal that there has been a positive relationship was found between the Japanese industrial production and stock return. However, Cutler, Poterba and Summers (1989) found that Industrial not in the 1946–1985 sub-period. In Indian context, Bhattacharya and Mukherjee (2002) studied the nature of the causal relationship between stock prices and macro aggregates for the period 1992–1993 to 2000–2001. Their results show that there is no causal relationship between stock price and macro-economic variables such as money supply, national income and interest rate but there exists a two way causation between stock
2001–2002 to 2014–15. The monthly data of NSE Nifty, BSE Sensex, growth rate of industrial production, the empirical investigation. The sources of data are the Hand book of statistics on Indian economy published by RBI.
and NSE Nifty returns during the period 2001–2002 to 2014–2015. Growth rate of industrial production (the
have the positive impact on stock returns in India. These results conclude that fundamental do affect the investments are the major determinants of stock returns.
19.46
Financial Institutions and Markets
Variables
Intercept
BSE SENSEX
NSE NIFTY
t-Statistic
p-Values
t-Statistic
p-Values
3.15
8.57
0.0001
4.59
9.29
0.00001
–0.04
–1.35
0.0241
0.89
1.065
0.0356
IIP
0.09
0.45
0.88
0.25
1.89
0.91
FII
0.125
3.15
0.0568
0.15
0.023
IR
–0.0069
–0.136
0.045
–0.085
–0.259
0.055
EX
–0.235
–2.05
0.056
–0.013
–1.71
0.066
R Square F-Statistics D-W Statistics
.0015
0.78
0.72
F(5150) = 9.56 (0.0001)
F(5150) = 8.92 (0.0001)
1.21
1.95
19.14 DRAWBACKS OF INDIAN STOCK MARKETS The discussion of the working of stock markets cannot be complete unless we point out their major weaknesses. This is really an important subject which deserves to be discussed at full length. However, for lack of space, we have to 13 ●
LO 8 Show the drawbacks of the Indian stock markets
The working of stock markets in India is characterised by unethical practices of diverse forms on the part of existing companies, new companies and entrepreneurs, brokers and other operators on the markets. The mergers and acquisitions through malpractices, entering into presenting an excessively rosy picture about new ventures, insider trading, misinformation, stealing of shares, trading in fake shares and circular trading are some of the examples of the utterly reprehensible practices on the stock markets. As a result, an almost complete lack of protection to the interests of the genuine and small investors is the worst part of the functioning of these markets. The majority of investors in corporate securities have serious grievances and the SEBI has not been able to help much in
●
13
The standards of service and information provided to investors by companies and stock brokers are very poor indeed. The trading on Indian stock markets is extremely thin and restricted. The number of listed stocks in which there is active and daily trading is extremely small; the number of hours during which trading normally takes place is very limited and restricted. This already small number of hours is quite often further curtailed and the market often remains closed on many days in a week. As a result, the liquidity of scrips in reality is quite low. About 64 percent of listed scrips were not traded at all on BSE during 1995–1997.
For a detailed discussion of these weaknesses, see Bhole, L M, ‘The Indian Capital Market at Crossroads’, Vikalpa, April-June, 1995, and Bhole, L M, ‘The State of Indian Stock Market Under Liberalisation, Finance India, March 2002.
Stock Market ●
●
●
19.47
The whole activity on the stock market and share prices are determined by excessive speculation; they have little correspondence with the fundamentals or the real performance of the economy. The industrial both the directions. The speculators in India (stock exchange members, property dealers, bullion and commodity merchants, business tycoons, company insiders, fund managers, and so on) have reduced speculation to a degenerate activity. In theory, there is a positive relationship between share price movements and the volume of new issues. However, our study has shown that in practice, there is no positive relation between these variables in India. The market has often experienced sharp payment crises arising out of brokers entertaining speculative business well beyond their manageable resources. The authorities virtually failed to monitor and curb these excesses. The payments crises have been so acute that a number of stock exchange members have been declared defaulters and a few others have been directed not to carry on their business. The hardships to many investors. Instead of providing liquidity to share investments, the stock market has become the cause of restricting the marketability of shares on account of delays in settlements. The stock exchanges do not have uniform settlement periods and dates. The bad deliveries have been crippling the market.
●
●
drawbacks mentioned above. There is structural and organisational imbalance in the growth of the stock markets. As said earlier, only four exchanges account for the major part of the total business. The stock markets even today are almost entirely urban-oriented with little relation with vast rural economy.
●
●
●
trading is high in volume. Small and individual investors, small market players and small companies have always suffered from many disabilities on the capital market, but things have worsened for them with the passage of time. The stock market activity is becoming more centralised, concentrated and non-competitive, serving the of equities by individuals and households as a percentage of total equity capital is declining, and public issues are increasingly becoming less for the public. The market is increasingly being dominated by institutional investors. They, along with FIIs, are currently picking up en bloc about 75 percent of new issues which account for about 60 percent of the market turnover. The volatility of the Indian stock market has tended to increase over the years due to the (a) adoption of internationalisation and integration of the Indian market with the world markets, (d) introduction of new,
●
Contrary to share prices, the secular trend in the average gross dividend yield on equities has been one of sharp decline. The high total rate of return on equities indicates that the equities have emerged as the gainful medium of investment primarily for the speculative investors. Thus, as somebody has put it, the of return on their investments.
19.48 ●
●
Financial Institutions and Markets
Although the amount of capital raised on NIM has increased in the recent past, it has been found that in many cases, funds have been raised for frivolous purposes, or that the proceeds of issues have been diverted to stock exchanges and property markets. As said above, the stock market has become a veritable cesspool of innumerable and wide varieties of unscrupulous, illegal practices, murky deals, and frauds. To enable the common citizen to gauge the depth of the malaise, a few examples may be given here: ◆ Taking advantage of the craze among the nouveau riche or parvenus, and the middle class aspirants
which exist only on paper. This is done in collusion with merchant bankers, underwriters, advertisers,
◆
huge interest which really belongs to the investors. Although legal and allowed (approved) by the authorities, India is perhaps the only country in the world where there is a practice of prior, privileged, preferential, reserved allotments of a substantial part (25–30 percent) of new issues, often at a heavy (as high as 90 percent) discount, to promoters and their nominees, companies, NRIs, foreign collaborators, FIIs, foreign banks, mutual funds, and so on. This has enabled almost all foreign companies to hike their equity stake in their Indian branches at ridiculously low prices. The executives of companies, mutual funds, and other private and public organisations or for themselves.
◆
the authorised signatory were available at various places in Mumbai at 10–20 percent of their market value. These shares were being used mainly as instruments for pledging purposes to borrow money ◆
◆
●
In another racket which came to light recently, a large number of brokers and sub-brokers were caught tampering with public issue application forms and pocketing brokerages on applications actually submitted by other brokers. In yet another racket discovered in November 1993, it was found that shares worth crore of rupees which were supposed to be in the safe custody of Stock Holding Corporation of India Ltd. (SHCIL) were used for raising funds illicitly. As a practice, the shares of reputed blue chip companies bought
pledge or exchange and to make considerable amount of money which, in turn, was used to play in share markets or to lend as badla safe custody were sold by some people. Contrary to the general belief that stock exchanges are archetypal examples of the perfectly competitive market, the Indian stock exchanges are oligopolistic in nature because their membership is restricted. Their functioning is marked by the operation of multiple cards by many members. The brokers and jobbers habitually stop entertaining fresh business from their clients and force them to square up positions after pushing down prices on the day before the end of the settlement because they speculate in shares without possessing them. They force weak clients to pay badla which is a violation of trading
Stock Market
19.49
norm. They often trade on their own accounts, credit gains to their own books and debit losses to their
for themselves.
SUMMARY ◆
◆
◆
◆
◆ ◆
◆
There are two types of market segments in the stock market (i) primary or new issue market, and (ii) secondary market. The major instruments available in these two segments are ordinary shares, preference shares, right issues, bonus issues, initial public offerings, follow on public offerings, and so on. In the primary market the price of initial public offerings is determined through the book-building The secondary market operates through the over-the-counter market and exchange-traded market. The over-the-counter market operates primarily over the telephone and computer network and the organised time period in each day. The major stock exchanges in India are Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). The demand and supply of shares and the interaction among the traders in the market set the prices in the secondary market on a day-to-day basis. The securities are grouped into various categories on the basis of their size, liquidity and impact cost. There are two types of market systems such as order-driven and quote-driven markets that exist in the trading of equities in the stock exchanges. In response to the different policy measures taken, although, both primary and secondary segments of market have grown in terms of size and volume, still they are not at par with the developed stock markets as Indian stock market has accounted for only 1.3 percent of total world turnover in the year foreign institutional investment, call money rate and exchange rate.
KEY TERMS Equity culture Primary market Secondary market Ordinary share Preference share Private equity Initial public offerings
Follow on public offerings Right issue Bonus issue Private placement Book building Reverse book building Stock market indices
Price earnings ratio Dividend yield Price to book ratio Exchange-traded fund Bid ask spread Order-driven market Quote-driven market
19.50
Financial Institutions and Markets
Initial margin Maintenance margin Margin call Short selling
Settlement cycle Turnover ratio
Index-based market-wide circuit breaker Tracking error
QUESTIONS 1. Critically examine the relationship between stock market development and economic growth. 2. What do you mean by primary stock market and explain the entry norms for routes available to an issuer for accessing the capital market in India? 3. What are the different steps followed in the book-building process? 4. What are the different methods of issuing fresh capital in Indian stock market? 5. Does investor sentiment affect the stock prices? If yes, then provide the theoretical basis for this. 6. What do you mean by stock market liquidity and how it is measured? 7. Provide a synoptic view of the market microstructure in the Indian stock market. 8. What are the various measures taken by the different authorities in India to develop the equity culture?
10. Point out major weaknesses of the Indian stock market 11. Do fundamentals determine stock returns? Explain. 12. Explain with a suitable example how and when an investor gains through short selling?
market value-weighted series. Stock
Open price
High
Low
Close
Base price
52 Week
P/E
Traded quantity
Traded value
Outstanding shares
A
78
79.25
75.05
75.45
44.95
35.20/ 85.10
15.1
86945
6560000
14331028
B
18.2
18.85
17.95
18.30
9.36
11.60/52.95
8.6
4056072
74226118
191986549
C
3730
3790
3730
3764
2936
3134/ 4900
62.89
576
2167863
11265070
D
130
132.7
126.4
128.6
106
118/169
11.63
267078
34346231
74177694
E
1400
1421.8
1336
1347
1298
1279/ 1489
49.83
66747
89908209
14843230
14. Assume that an initial margin requirement of 50 percent and a maintenance margin of 30 percent. An investor buys 100 shares of stock on margin at `60 per share. The price of the stock subsequently drops
Stock Market
19.51
to `50. Is there a margin call? On the basis of your result justify your answer. If your answer is no, then at what maximum price the investor will get the margin call? 15. Write short notes on the following: (a) Private equity (b) Over-the-counter exchange of India (c) Information and investor decisions (d) Exchange-traded funds (e) Order-driven market (f) Quote-driven market (g) Short selling
Derivatives Market
20
CHAPTER Learning Objectives LO 1 LO 2 LO 3 LO 4 LO 5 LO 6
20.1 INTRODUCTION
Derivatives
long position short position commodity derivative
organized exchanges or in an over the counter market
20.2
Financial Institutions and Markets
20.2 SERVICES PROVIDED BY DERIVATIVES ●
●
● ●
Derivatives Market
20.3
●
●
●
20.3
TYPES OF DERIVATIVES
20.3.1 Forwards
20.3.2 Futures
LO 1 Know various types of financial derivatives and the important concepts used in derivatives market
20.4
Financial Institutions and Markets
Forwards versus Futures
20.5
Derivatives Market
20.3.3 Options
call options put options
exercise date expiry date American options
European options exercise
(strike or striking) price in the money out of the money
covered option
naked option
Types of Options
stock index options
interest options
20.6
Financial Institutions and Markets
or currency options
range forward RF forward RRF
swaptions
ratio range
Derivatives Market
Futures versus Options
20.3.4 Swap
20.7
20.8
Financial Institutions and Markets
Types of Swaps
coupon swap
basis swap,
bond swap
substitution swap inter-market spread swap
tax swap
Swaps with timing mismatches Swaps with option such as payoffs
vice versa
Derivatives Market
Debt–Equity Swap
20.3.5 Warrants and Convertibles
20.9
20.10
Financial Institutions and Markets
20.3.6 Credit Derivatives
20.3.7 Weather Derivatives
Derivatives Market
20.3.8 Freight Derivatives
20.3.9 Property Derivatives
20.4 SOME IMPORTANT CONCEPTS USED IN DERIVATIVES MARKET
20.11
20.12
Financial Institutions and Markets
vice versa
Basis
Derivatives Market
20.13
Moneyness in the money out of the money
at the money
Table 20.1 Explanation of the concept of moneyness for call option and put option Call Option
Put Option
In-the-money
Spot price of underlying asset > strike price (S > X) Spot price of underlying asset < strike price (S < X)
At-the-money
Spot price of underlying asset = strike price (S = X) Spot price of underlying asset = strike price (S = X)
Out-of-themoney
Spot price of underlying asset < strike price (S < X) Spot price of underlying asset < strike price (S < X)
*When the market price is very near to the strike price, the option is called near-the-money option.
20.5
VALUATION OR PRICING OF DERIVATIVES LO 2 Identify different models used for the valuation of derivatives
20.5.1 Pricing of Forward Contracts (Financial Assets)
20.14
Financial Institutions and Markets
S F T r I y
F
S erT `
S
r
T F
`
S If F
S
I
r
¥
F S
I
T
I
T
y
`
rT
`
¥
F
`
rT
F
S
S er
F
`
S
rT
I
r
yT
F
¥
` K K
F
f
S
f
Ke
rT
f
F
K
f
K F
rT rT
K
Derivatives Market
20.15
I f
S
I
Ke
rT
y f
yT
Se
Ke
rT
20.5.2 Pricing of Future Contracts (Commodities)
C F
S +C
rT
c F Se
r+c T
c
C F eiT
S +C
rT
c iT
F e
Se
r+c T
i
or F
Se
i
r+c i T
cost of carry r r y i
y c
r i+c
20.16
Financial Institutions and Markets
20.5.3 Binomial Option Pricing Models
The one-step Binomial Model S
f
T
Su
Sd
u d
option is fu
Su
fd
Sd
S 0u fu S0 f S 0d fd
S dD S uD
D
fd
fu
S uD
fu
S dD
fd
fu - f d S0u - S0 d
D r S uD fu e SD
f
SD
f
rT
S uD
fu e
rT
u
d
T
Derivatives Market
D fu (1 - de - rT ) + f d (ue - rT - 1) u-d
f or f
e
rT
[Pfu +
P fd
e rT - d u-d
P
` `
`
` `
S u
`
`
T d
fu
S
u
`
`
fd
`
S
(0) = ` 33 ( ) = `1
(0) = ` 30 = 0.6111 (0) = ` 27 ( ) = `0
P e0.10 ¥ 0.25 - 0.9 1.1 - 0.9
P
P f
e
¥
¥
¥
d
`
20.17
20.18
Financial Institutions and Markets
Two-step Binomial Model
S 0u 2 f uu S 0u fu S 0 ud f ud
S0 f S 0d fd
S 0d 2 f dd
S d
S
f
e
rDt
e r Dt - d u-d
fu
e
rDt
e
f
e
P fdd
f
[Pfud +
rDt
P fud
fd e
[Pfuu
rDt
S
P fd
[Pfu
P
u Dt
r
P fd
[Pfu
rDt
[P fuu
P
P fud
P fdd P
P
P
P `
is `
u
d
S
`
Dt
r
`
Derivatives Market
e0.05 ¥ 1 - 0.8 1.2 - 0.8
P
`
`
` `
f
e
¥
20.19
¥
¥
¥
`
`
¥
¥
`
20.5.4 Black–Scholes Model (BSM)
Weiner Process
x dx
adt + bdz adt
of a
x b
a
dz represents
b
Ito process dx a x t dt + b x t dz G of x
t dG
2
Ê ∂G ∂G ∂G 1 ∂ 2 G 2 ˆ bdz a b ˜ dt + + + ÁË 2 ¯ ∂x ∂x ∂t 2 ∂x
Ê ∂G ˆ 2 ÁË ˜ b ∂x ¯
Ê ∂G ∂G 1 ∂ 2 G 2 ˆ a + + b ˜ ÁË ∂x ∂t 2 ∂x 2 ¯
20.20
Financial Institutions and Markets
Stock Price Model t
S
Dt
DS
Dt
mSDt
Dt Æ dS
mSdt
dS
mSdt + sSdz
dS S
mdt + sdz
dG
Ê ∂G ∂G ∂G 1 ∂ 2 G 2 2 ˆ sSdz mS + s S ˜ dt + + ÁË 2 ¯ ∂S ∂S ∂t 2 ∂s
G
S
t m
s
dz The Lognormal Property of an Underlying Asset S S
G
S ∂G 1 ∂ 2 G 1 ∂G = ; = - 2 and = 0 as G ∂S S ∂s 2 ∂t s
dG
1 1 1 2 2ˆ Ê1 s S ˜ dt + sSdz ÁË mS + 0 2 ¯ s 2s s dG
1 2ˆ Ê ÁË m - s ˜¯ dt + sdz 2
T 1 2ˆ Ê ÁË m - s ˜¯ T 2
1 2ˆ Ê ÁË m - s ˜¯ 2 S
sT ST
ÈÊ ˘ 1 ˆ S ~ Δ ÍÁ m - s2 ˜ T , s2T ˙ Ë ¯ 2 Î ˚
È ˘ 1 ˆ Ê ST ~ Δ Íln S0 + Á m - s2 ˜ T , s2T ˙ Ë ¯ 2 Î ˚
s
Derivatives Market
ST
T
S
1 ˆ Ê ST is S + Á m - s2 ˜ T Ë 2 ¯ is s T Derivation of Black–Scholes–Merton Differential Equation
● ● ● ● ● ●
dS
mSdt + sSdz
f
S
df
Ê ∂f ∂f ∂f 1 ∂ 2 f 2 2 ˆ sSdz S m s S ˜ dt + + + ÁË 2 ¯ ∂S ∂S ∂t 2 ∂S
DS
mSDt + sSDz
Df
Ê ∂f ∂f ∂f 1 ∂ 2 f 2 2 ˆ sS Dz mS + s S ˜ Dt + + ÁË 2 ¯ S ∂ ∂S ∂t 2 ∂S Dz ∂f ∂S
P=- f +
∂f S ∂S
Dt DP
Df +
∂f DS ∂S
t
20.21
20.22
Financial Institutions and Markets
Df DP
DS
Ê ∂f 1 12 f 2 2 ˆ s S ˜ Dt ÁË ¯ ∂t 2 ∂S 2
Dt DP
rPDt DP
P
Ê ∂f 1 ∂ f 2 2 ˆ ∂f ˆ Ê S ˜ Dt s S ˜ Dt = r ÁË f + ÁË 2 ¯ ∂S ¯ ∂t 2 ∂S 2
∂f ∂f 1 ∂ 2 f 2 2 + rS + s S = rf ∂t ∂S 2 ∂S 2
f
S K
t
T
f
K
t
T
S
Dt Black–Scholes Option Pricing Formula
c
SNd
p
rT
d d
Ke
Ke
N d
rT
Nd
SN d
ln( S0 / K ) + (r + s2 /2)T s T d s T
Derivatives Market
C K r S T Nd
Nd
d
d
s
` ` S
`
d
ln(52/50) + (0.1 + 0.22 /2)0.5 0.2 0.5
K
`
r
s
d Nd Nd ¥
c p p
Ke e
rT –
e N d ¥
¥
¥
SN d ¥
¥
T
20.23
20.24
Financial Institutions and Markets
Merits of BSM
vice versa
Limitations of BSM
20.6 DERIVATIVES MARKET IN INDIA: PROSPECTS AND POLICY Badla
Badla
badla
LO 3 Understand the prospects and policy of derivatives market in India
badla badla badla badla
badla
Derivatives Market
20.6.1 Major Policy Developments
20.25
20.26
Financial Institutions and Markets
RBI Guidelines Permitting Banks to Offer Hedge Instruments
●
● ●
●
●
●
●
●
●
1
SEBI, Report of the Committee to Develop Appropriate Regulatory Framework for Derivatives Trading in India, September 1997.
Derivatives Market ●
●
●
●
●
●
●
20.27
20.28
Financial Institutions and Markets
recommendations of Sharma committee ●
●
●
●
● ●
mutatis mutandis ●
●
●
●
Derivatives Market
●
●
●
20.29
20.30
Financial Institutions and Markets
●
●
viz.
20.31
Derivatives Market
. .
20.7 MARKET DESIGN FOR FINANCIAL DERIVATIVES TRADING IN INDIA equity linked derivatives currency derivatives
interest rate derivatives
LO 4 Illustrate the market design for financial derivatives trading in India
20.32
Financial Institutions and Markets
` `
` ` `
20.8 CONTRACTS SPECIFICATIONS2
Equity Derivatives Parameter
Underlying
Index futures Index options
Futures on Options on Mini index individual individual futures securities securities
CNX Nifty CNX IT Bank Nifty Nifty Midcap 50 CNX PSE CNX Infra
135 Securities
Mini index options
CNX Nifty CNX Nifty
Long-term index options CNX Nifty
(Contd.) 2
Indian Securities Market—A Review, ISMR-2013, 2012.
20.33
Derivatives Market Security Descriptor Instruments
FUTIDX
OPTIDX
Option type
-
Call European(CE)/ put European (PE)
Trading cycle
Three-months trading cycle-the near month(1), the next month(2), and the far month (3) Three quarterly expiries (March, June, September, and December cycle)
Expiry day
Last Thursday of the expiry month. If the last Thursday is a trading holiday, then the expiry is the previous trading day.
Strike price intervals
—
Permitted lot Underlying size Price steps Price bands
` Operating range of 10% of the base price
FUTSTK
OPTSTK
FUTIDX
OPTIDX
OPTIDX
CE/PE
-
CE/PE
CE/PE
Depending on underlying price
—
Depending on underlying volatility
—
Underlying
Underlying
Underlying
20
` A contract price range based on its delta value is computed and updated on daily basis
` Operating range of 10% of the base price
` A contractprice range based on its delta value computed and updated on daily basis
Futures Ticker symbol Contract size Notional value
Tick size Trading hours Expiry date Option type
Daily settlement price
` Operating range of 10% of the base price
Depending on underlying price 20
Depending on underlying price
Underlying
`
`
A contract-
A contract-
price range based on its delta value computed and updated on daily basis
range based on its delta value computed and updated on a daily basis.
Options
S&P 500 250 units — ¥ ` 0.25 0.25 As in the equity derivative segment Third Friday of the respective contract month. In case the third Friday is a holiday in the United States or in India, the contract shall expire on the preceding business day. — The options contracts is European-styled, which can be exercised only on the expiration date. Last half hour’s weighted average price
Daily premium settlement (Contd.)
20.34
Financial Institutions and Markets
Final settlement price
All open positions at close of last day of the trading shall be settled to the special opening quotation (SOQ) of the S&P 5000 index on the date of expiry.
Final settlement procedure
Final settlement will be cash settled in INR Final settlement will be cash settled in INR of in-the-money contracts shall be assigned to open short positions in option contracts.
Final settlement day
All open positions on expiry date shall be settled on the next working day of the expiry date (T + 1)
Position limits
The trading member/mutual funds position limits and the disclosure requirements for clients are the same as those applicable in the case of domestic stock index derivatives.
Symbol Market type Option type Premium Unit of trading Underlying/order quotation Tick size Trading hours Contract trading cycle Strike price Strike price intervals Price operating range Quantity freeze Base price Expiry/last trading day Exercise at expiry
Final settlement day Position limits
Initial margin Extreme loss margin Settlement premium Settlement Mode of settlement Final settlement price (FSP)
USD–INR Normal Premium-style European call and put options Premium quoted in Indian Rupees One contract unit denotes USD 1000 The exchange rate in Indian Rupees for RS Dollars 0.25 paise (i.e. `0.0025) Monday to Friday, 9.00 a.m. to 5.00 p.m. Three serial monthly contracts followed by one quarterly contract of the cycle March-JuneSeptember-December 12 in-the-money, 12 out-of-the-money, and 1 near-the money (25 CE and 25 PE) `0.25 10,001 or greater price) of the contract Two working days prior to the last business day of the expiry month at 12 noon price and assigned in a random basis to the open short positions of the same strike and series. Last working day (excluding Saturdays) of the expiry month. The last working day will be the same as that for interbank settlements in Mumbai. The gross open position across all contracts (both futures and options) shall not exceed the following: Client: Lower of 6% of total open interest or USD 10 million Trading Members: Higher 15% of the total open interest or USD 50 million Banks: Lower 15% of the total open interest or USD 100 million SPAN-based margin 1.5% of the notional value of open short position Premium to be paid by the buyer in cash on T+1 day Daily settlement: T+1 Final settlement: T+2 Cash settled in Indian Rupees RBI reference rate on the date of expiry of the contract
Derivatives Market
20.35
GOI security, 7 percent annual compounding) Symbol
10YGS7
Market type
Normal
Instrument type
FUTIRD
Unit of trading Underlying
` 10-year notion coupon-bearing Government of India (GOI) security (notional coupon: 7% with semi-annual compounding)
Tick size
`0.0025
Trading hours
Monday to Friday, 9:00 a.m. to 5:00 p.m.
Contract trading cycle December) Last trading day
Two business days prior to the last working day of the delivery/expiry month.
Quantity freeze
1251 lots or greater
Base price Price operating range
±5% of the base price
Position limits
Clients: 6% of the total open interest or `300 crore, whichever is higher Trading Members: 15% of the total open interest or `1000 crore, whichever is higher.
Initial margin
SPAN-based margin
Extreme loss margin
0.3% of the value of the gross open positions of the futures contract
Settlement
Daily settlement MTM: T + 1 in cash Delivery settlement: Last business day of the expiry month.
Daily settlement price
Closing price or theoretical price
Delivery settlement Mode of settlement
Daily settlement in cash
Deliverable grade securities
GOI securities
Conversion factor
The conversion factor would be equal to the price of the deliverable security (Per Indian annual compounding.
Invoice price
Daily settlement price times a conversion factor + accrued interest
Delivery day
Last business day of the expiry month
Intent to deliver
Two business days prior to the delivery settlement day.
20.9 DEVELOPMENT OF FINANCIAL DERIVATIVES MARKET LO 5 Explain the financial derivatives market
10 (1.62) 39 (6.31) 14 ((2.27) 38 (6.15) 500 (44.72) 400 (80.00) 100 (20.00)
(iii) Currency futures
(iv) Currency options
(v) Equity index futures
(vi) Equity index options
2. 2. OTC instrument (total)
(i) Interest rate swaps
(ii) Currency swaps
1118
60444
7997 (17.19)
2253 (4.84)
36262 (77.96)
46512 (76.95)
917 (6.58)
291 (2.09)
49 (0.35)
32 (0.23)
4623 (33.18)
8020 (57.56)
13932 (23.05)
1998
121226
13746 (14.11)
4509 (4.63)
79161 (81.62)
97416 (80.36)
1700 (7.14)
325 (1.36)
26 (0.11)
47 (0.19)
11759 (49.39)
9951 (41.79)
23810 (19.64)
2002
431873
67106 (19.11)
12291 (3.49)
271853 (77.39)
351250 (81.37)
8103 (10.51)
1134 (1.41)
133 (0.16)
159 (0.19)
44308 (54.95)
26787 (33.22)
80623 (18.66)
2007
55822 (13.24)
16509 (3.92)
349288 (82.44)
421619 (85.21)
4806.8 (6.57)
964.9 (1.32)
147.3 (0.20)
181.1 (0.25)
46428.7 (63.46)
20627.7 (28.20)
73156.5 (14.79)
2009
58331 (13.20)
19271 (4.36)
364377 (82.44)
441979 (86.46)
4560.3 (6.59)
1128.4 (1.63)
144.2 (0.21)
170.2 (0.25)
40930 (59.11)
22312 (32.22)
69245.1 (13.54)
2010
59154 (12.21)
22791 (4.70)
402611 (83.09)
484556 (94.03)
3398.9 (11.04)
984 (3.20)
87.2 (0.28)
221.2 (0.72)
3159.6 (10.27)
22924.4 (74.49)
30775.3 (5.97)
2011
56786 (12.56)
25420 (5.62)
369999 (81.82)
452205 (89.32)
3940.6 (7.29)
1249.4 (2.31)
105.3 (0.19)
230.3 (0.43)
25909.7 (47.93)
22620.6 (41.58)
54055.9 (10.68)
2012
476982.3 494775.5 511224.1 515331.3 506260.9
63149 (15.06)
14941 (3.56)
341148 (81.37)
419238 (87.89)
4129.1 (7.15)
650.5 (1.13)
129.3 (0.22)
124.3 (0.22)
33978.8 (58.84)
18732.3 (32.44)
57744.3 (12.11)
2008
4710511
54238 (1.17)
25448 (0.55)
4566725 (98.28)
4646411 (98.64)
5381.4 (8.40)
1380.7 (2.15)
142.6 (0.22)
243.9 (0.38)
32786.2 (51.15)
24165.1 (37.70)
64099.9 (1.36)
2013
Notes: Figures in brackets are percentages to respective totals. Other swap-related derivatives includes credit default swap, swaptions, forex swaps and so on. Sources: Quarterly reviews of Bank for International Settlement.
3. Grand Total
—
146 (23.62)
(ii) Interest rate options
(iii) Other swap-related derivatives
370 (59.87)
618 (55.28)
1. Exchange traded instruments (Total)
(i) Interest rate futures
1986
Derivatives types
20.36 Financial Institutions and Markets
20.37
Derivatives Market
`
`
Table 20.7 Turnover in equity derivatives market in India (in percentage and ` in crore) Year
Index futures
Stock futures
Index options
Stock options
Total (turnover)
BSE
NSE
BSE
NSE
BSE
NSE
BSE
NSE
BSE
NSE
2001–2002
1.23
20.69
0.44
49.61
0.08
3.63
0.11
24.23
1926 (1.85)
101925 (98.15)
2002–2003
0.41
9.94
0.15
64.78
0.00
2.09
0.00
22.64
2478 (0.56)
439866 (99.44)
2003–2004
0.31
25.88
0.24
60.95
0.00
2.47
0.02
10.14
12074 (0.56)
2130447 (99.44)
2004–2005
0.53
30.13
0.01
57.90
0.09
4.76
0.00
6.59
16112 (0.63)
2547053 (99.37)
2005–2006
0.00
31.38
0.00
57.87
0.00
7.02
0.00
3.74
9 (0.00)
4824251 (100)
2006–2007
0.75
34.25
0.05
51.66
0.00
10.68
0.00
2.61
59006 (0.80)
7356270 (99.20)
2007–2008
1.76
28.66
0.06
56.62
0.00
10.22
0.00
2.69
242308 (1.82)
13090477 (98.18) (Contd.)
20.38
Financial Institutions and Markets
2008–2009
0.11
32.39
0.00
31.57
0.00
33.85
0.00
2.08
11775 (0.11)
11010482 (99.89)
2009–2010
0.00
22.27
0.00
29.41
0.00
45.45
0.00
2.86
234 (0.00)
17663665 (100)
2010–2011
0.00
14.90
0.00
18.79
0.00
62.79
0.00
3.52
154 (0.00)
29248221 (100)
2011–2012
0.55
11.13
0.03
12.67
1.92
70.65
0.00
3.04
808476 (2.51)
31349732 (97.49)
2012–2013
0.32
6.53
0.01
10.92
18.16
58.87
0.03
5.17
7163519 (18.51)
31533004 (81.49)
2013–2014
0.13
6.50
0.11
10.43
19.09
58.54
0.10
5.08
9219434 (19.44)
38211408 (80.56)
2014–2015
0.06
5.41
0.01
10.91
26.50
52.55
0.23
4.32
20362741 (26.80)
55606443 (73.20)
Source: SEBI Handbook of Statistics in Indian Security Market, 2015, 2013, 2010, 2008. Note: Notional Turnover = (Strike Price + Premium) ¥ Quantity. And the turnover value (total) of BSE and NSE are reported in crores.
` in crore) Year
BSE
NSE
Total
2004–2005
169 (1.15)
14649 (98.85)
14818
2005–2006
0 (0.00)
28522 (100)
28522
2006–2007
0 (0.00)
66494 (100)
66494
2007–2008
431 (0.27)
156519 (99.73)
156950
2008–2009
113 (0.12)
91840 (99.88)
91953
2009–2010
0 (0.00)
76943 (100)
76943
2010–2011
1 (0.001)
83701 (99.99)
83702
2011–2012
192 (0.27)
72296 (99.74)
72488
2012–2013
32596 (36.47)
56759 (63.53)
89355
2013–2014
17960 (23.29)
59131 (76.71)
77091
2014–2015
37268 (28.03)
95654 (71.97)
132922
Source: SEBI Handbook of Statistics, 2015. Note: Values in the parenthesis are in percentage to total.
Derivatives Market
Table 20.9
20.39
Trends/business growth in interest rate derivative segment
Year
NSE trading value (` crore)
BSE trading value (` crore)
Total trading value (` crore)
2003–2004
20.3 (100)
—
20.3
2010–2011
62 (100)
—
62
2011–2012
3959 (100)
—
3959
2012–2013
0.22 (100)
—
0.22
2013–2014
30172 (92.13)
2579 (7.87)
32751
2014–2015
421559 (90.96)
41912 (9.04)
463471
Source: SEBI Handbook of Statistics, 2015, 2005. Note: (1) Interest rate futures trading started in April 2003. (2) NSE re-introduced interest rate futures contracts on 10 year G-Sec w.e.f. 31 August, 2009. (3) NSE re-introduced interest rate futures contracts on 91-day GOI T-Bill wef 4 July 2011. (4) IRF on 91-day GoI T-bill started at NSE on 4 July, 2011. (5) Trading at BSE started in November 13 while it started in January 14.
Table 20.10 Trends/business growth in currency derivative segment Year
NSE (turnover in crore)
BSE (turnover in crores)
Grand total
Currency futures
Currency options
Total
Currency futures
Currency options
Total
2008–2009
162272
—
162272 (100)
—
—
—
162272
2009–2010
1782608
—
1782608 (100)
—
—
—
1782608
2010–2011
3279002
170786
3449788 (100)
—
—
—
3449788
2011–2012
3378489
1296501
4674990 (100)
—
—
—
4674990
2012–2013
3765105
1509359
5274465 (100)
—
—
—
5274465 (Contd.)
20.40
Financial Institutions and Markets
2013–2014 2014–2015
2940886 2247992
1071628 775915
4045009 (94.26)
211816
3625374 (61.30)
1307077
244312 (5.74)
4256825
32496
1908543 (38.70)
4932451
601466
Note: (1) The currency future was introduced on 29 August, 2008 at NSE. (2) The currency option was introduced on 29 October, 2010 at NSE. (3) Trading on currency derivative ton BSE was launched on Thursday, 28 November, 2013. For the year 2013–2014, we have considered data span from 29 November 2013 to 31 March, 2014.
20.10 DEVELOPMENT OF COMMODITY DERIVATIVES MARKET IN INDIA LO 6 Discuss the development of commodity derivatives market in India
Derivatives Market
Table 20.11 Turnover of commodity derivatives in various exchanges
20.41
(` in crore)
Year
MCX
NCDEX
NMCE
Others
Total
2003–2004
2456 (1.9)
1490 (1.15)
23842 (18.43)
101576 (78.52)
129364
2004–2005
165147 (28.88)
266338 (46.58)
13988 (2.45)
126286 (22.09)
571759
2005–2006
961633 (44.62)
1066686 (49.5)
18385 (0.85)
108418 (5.03)
2155122
2010–2011
9841502 (85.76)
1410602 (12.29)
218411 (1.9)
5643 (0.05)
11476158
2011–2012
15591095 (88.21)
1810204 (10.24)
268351 (1.52)
5221 (0.03)
17680871
2012–2013
14881057 (89.30)
1598426 (9.59)
177134 (1.06)
7697 (0.05)
16664314
2013–2014
8611449 (88.76)
1146328 (11.55)
152819 (1.54)
15174 (0.15)
9925770
2014–2015
5183707 (84.49)
904063 (14.73)
36040 (0.59)
11684 (0.19)
6135494
Source: SEBI Handbook of statistics, 2015
20.42
Financial Institutions and Markets
Table 20.12 Product Segment-wise percentage share in turnover at commodity exchanges Year
MCX Agl.
NCDEX
Metals Bullion Energy
Agl.
NMCE
Metals Bullion Energy
Agl.
Metals Bullion
2010–2011
1.2
25.5
52.5
20.8
78.7
2.6
5.0
13.7
59.0
33.0
8.0
2011–2012
1.3
17.4
63.9
17.5
91.9
1.7
1.6
4.8
50.0
41.0
9.0
2012–2013
1.8
21.1
52.5
24.6
97.4
0.5
0.1
2.0
60.0
36.0
3.0
2013–2014
2.0
20.0
49.5
28.5
99.3
0.0
0.5
0.1
87.0
9.0
4.0
2014–2015
2.1
24.6
41.5
31.7
96.3
0.0
3.6
0.1
100.0
0.0
0.0
Source: SEBI Handbook of statistics, 2015
20.11 CRITIQUE OF DERIVATIVES
20.11.1 Speculative Nature
3
For this and the next section, see also Bhole, L M, ‘Futures, Options, and Other Financial Innovations in India’, Productivity, July– September 1994.
Derivatives Market
20.11.2 Increase in Risk
20.11.3 Instability of the Financial System
20.43
20.44
20.11.4
Financial Institutions and Markets
Price Instability
Derivatives Market
20.11.5 Displacement Effect
20.11.6 Increased Regulatory Burden
20.11.7
●
Adverse Empirical Evidences
20.45
20.46
Financial Institutions and Markets
●
● ●
●
20.12 CRITIQUE OF INTRODUCTION OF DERIVATIVES IN INDIA
Derivatives Market
4
SEBI, Report of the Committee to Review the System of Carry Forward Transactions, Bombay, March 1995.
20.47
20.48
Financial Institutions and Markets
SUMMARY ◆
◆
◆
◆
◆ ◆
◆
◆
◆
◆
◆ ◆ ◆
Derivatives Market
KEY TERMS Derivatives Interest rate swap
Badla European option
QUESTIONS
20.49
20.50
Financial Institutions and Markets
` `
`
`
` ` ` `
`
`
` ` `
`
Part 6 International Dimensions of Financial Markets
market. Further, a detailed analysis on the uses, components, trends, determinants and
CHAPTERS 21. Foreign Exchange Market 22. Foreign Capital Flows
Foreign Exchange Market
21
CHAPTER Learning Objectives LO 1 LO 2 LO 3 LO 4 LO 5
Know the structure of foreign exchange market and its prominent players in India Recognise various trading platforms and the risk involved in the FEM Understand different types of exchange rates and exchange rate system Explain global and Indian foreign exchange market activity and trends in exchange rates Describe the issues in foreign exchange market
21.1 INTRODUCTION
increased consistently over the years. The open economy reality introduces two in place of one—kinds of monetary units in transactions or exchange mechanism, namely, the domestic monetary unit and the foreign monetary unit. The latter is called foreign exchange. In addition to coins, notes and bank deposits denominated in foreign monetary units, foreign exchange generally includes a variety of highly liquid claims denominated in foreign monetary units. The liquid claims denominated in foreign monetary units can increase through international trade and investments, but these would not be possible without the arrangements or mechanism for buying and selling foreign currencies because the rupee is not the international means of exchange. In this context, the importance of foreign exchange market increases which allows currencies to be exchanged in The market in which national monetary units or claims are exchanged for the foreign monetary units is foreign exchange market (FEM). It is cleared at a conversion price, that is, at the exchange rate, in one currency to another. International companies rely on the foreign exchange market to exchange their home currency for a foreign currency that they need to purchase imports or use for foreign investments. They also need the foreign exchange market to exchange a foreign currency that they receive into their home currency. In the Indian context, according to the Foreign Exchange Regulation Act (FERA), 1973, foreign
21.4 exchange means foreign currency and it includes (a) all deposits, credits and balances payable in any foreign currency, and any drafts, traveller’s cheques, letters of credit and bills of exchange expressed or drawn in Indian currency but payable in any foreign currency, and (b) any instrument payable, at the option of the drawee or holder thereof or any other party thereto, either in Indian currency or in foreign currency or partly in one and partly in the other. The global FEM is said to be the oldest, biggest, most extensive or geographically spread, most active and quick, fastest growing and most liquid market in the world. The FEM is not a physical place; it is an informal, electronically linked network of big banks, foreign exchange brokers and dealers whose function is to bring buyers and sellers together. leading ones being in London, New York, Paris, Zurich, Tokyo, Milan, and Frankfurt. The trading in FEM is usually done 24 hours a day by telephones, display monitors, telex and fax machines, and the satellite communications network called the Society for Worldwide International Financial Telecommunications (SWIFT), which is a computer-based communication system. Each participating bank has a separate ‘foreign exchange-trading room’, and most transactions are based on oral communications to begin with; the written documents follow only later. There exists an informal code of moral conduct which has given a status of a bond to the word given by exchange dealers. The FEM operates on very narrow spreads between buying and selling prices; they can be smaller than a tenth of a percent of the value of the currency traded, and they
chapter discusses various dimensions of foreign exchange market, exchange rates and foreign exchange
21.2 FOREIGN EXCHANGE MARKET STRUCTURE Most foreign exchange markets in developing countries are either pure dealer markets or a combination of dealer and auction markets. In the dealer markets, some dealers become market makers and play a central role in the determination way exchange rates at which they are willing to deal with other dealers. The
LO 1 Know the structure of foreign exchange market and its prominent players in india
among market makers. In most of the EMEs, a code of conduct establishes the principles that guide the operations of the dealers in the foreign exchange markets. It is the central bank, or professional dealers association, which normally issues the code of conduct (Canales-Kriljenko, 2004). In auction markets, an auctioneer or auction mechanism allocates foreign exchange by matching supply and demand orders. In pure auction markets, order imbalances are cleared only by exchange rate adjustments. Pure auction market structures are, however, now rare and they generally prevail in combination with dealer markets. The Indian foreign exchange market is a decentralised multiple dealership market comprising two segments— the spot and the derivatives market. In the spot market, currencies are traded at the prevailing rates and the settlement or value date is 2 business days ahead. The 2-day period gives adequate time for the parties to
21.5 send instructions to debit and credit the appropriate bank accounts at home and abroad. The major sources of supply of foreign exchange in the Indian foreign exchange market are receipts on account of exports and portfolio investment, external commercial borrowings (ECB) and non-resident deposits. On the other hand, the demand for foreign exchange emanates from imports and invisible payments in the current account, amortisation of ECB (including short-term trade credits) and external aid, redemption of NRI deposits and account, and thus the external aid received by the government comes directly to the reserves and the Reserve Bank releases the required rupee funds. Hence, this particular source of supply of foreign exchange is not routed through the market and as such does not impact the exchange rate. The derivatives market encompasses forwards, swaps and options. Though forward contracts exist for maturities up to 1 year, majority of forward contracts are for 1 month, 3 months or 6 months. Forward contracts for longer periods are not as common because of the uncertainties involved and related pricing issues. A swap transaction in the foreign exchange market is a combination of a spot and a forward in the markets can be grouped into three broad segments, viz., forwards, options (foreign currency rupee options and cross-currency options) and currency swaps (foreign currency rupee swaps and cross-currency swaps). The detailed discussion on these derivative instruments is given in the Chapter 22. As in the case of other EMEs, the spot market is the dominant segment of the Indian foreign exchange market. Like other markets, the spot segment of the foreign exchange market has two parts: wholesale and retail.
21.2.1 Retail Market The exchange of bank notes, bank drafts, currency, ordinary and traveller’s cheques between private customers, tourists and banks takes place in the retail market. The RBI has granted two types of money
both purchase and sale transactions with the public, ‘restricted money changers’ can only purchase foreign currency from the foreign tourists.
21.2.2 Wholesale Market The wholesale market is primarily an interbank market in which major banks trade in currencies held in different currency-dominated bank accounts, that is, they transfer bank deposits from seller’s to buyer’s the major commercial banks are the market makers (entities which deal with assets on their own accounts) deal directly in the interbank market. They usually have a credit line with large banks or with their head other countries, major banks have ready access to foreign currencies. As indicated earlier, interbank foreign currency transactions usually do not involve a physical transfer of currency, they simply involve bookkeeping entries among banks. There is no central location for this market and trading in it is continuous. Banks do
21.6 buying and selling rates. The interbank market can thus be said to have two parts: direct and indirect. In the direct market, banks quote buying and selling prices directly to each other and all participating banks are market makers. It has been sometimes characterised as a ‘decentralised, continuous, open-bid, doubleauction’ market. In the indirect market, the banks put orders with brokers who put them on ‘books’, and try to match purchases and sales orders for different currencies. They charge commission to both the buyers and sellers. This market is characterised as ‘quasi-centralised, continuous, limit-book, single-auction’ market.
21.3
PLAYERS IN THE FOREIGN EXCHANGE MARKET IN INDIA
Players in the Indian market include (a) ADs, mostly banks who are authorised to deal in foreign exchange, (b) foreign exchange brokers who act as intermediaries and (c) customers—individuals and corporates, who need foreign exchange for their transactions. Though customers are major players in the foreign exchange market, for all practical purposes they depend upon ADs and brokers. In the spot foreign exchange market, foreign exchange transactions were earlier dominated by brokers. Nevertheless, the situation has changed with the evolving market conditions, as now the transactions are dominated by ADs. Brokers continue to dominate the derivatives market. ADs have been divided into different categories. The licences for ADs are issued to banks and other institutions, on their request, under Section 10(1) of the Foreign Exchange Management Act, 1999. All scheduled commercial banks, which include public sector banks, private sector changers (FFMCs) and select regional rural banks (RRBs) and co-operative banks belong to category II of 86 (Category I) ADs operating in India out of which 5 are co-operative banks. All merchant transactions in the foreign exchange market have to be necessarily undertaken directly through ADs. However, to provide depth and liquidity to the interbank segment, ADs have been permitted to utilise the services of brokers for better price discovery in their interbank transactions. is generally felt that more ADs should be encouraged to participate in the market making. The customer segment of the foreign exchange market comprises major public sector units, corporates and business entities with foreign exchange exposure. It is generally dominated by select large public sector units such as Indian Oil Corporation, ONGC, BHEL, SAIL, Maruti Udyog, and also the Government of India (for defence and civil debt service) as also big private sector corporates such as Reliance Group, Tata Group, and Larsen and Toubro, among others. In recent years, foreign institutional investors (FIIs) have emerged as major players in the foreign exchange market. The Reserve Bank intervenes in the market essentially to ensure orderly market conditions. The Reserve Bank undertakes sales/purchases of foreign currency in periods of excess demand/supply in the market. Foreign Exchange Dealers’ Association of India (FEDAI) plays a special role in the foreign exchange market for ensuring smooth and speedy growth of the foreign exchange market in all its aspects. All ADs are required to become members of the FEDAI and execute an undertaking to the effect that they would abide by the terms and conditions stipulated by the FEDAI for transacting foreign exchange business. The FEDAI is also the accrediting authority for the foreign exchange brokers in the interbank foreign exchange market.
21.7
21.4 FOREIGN EXCHANGE MARKET TRADING The currencies are traded on ‘spot’ or ‘cash’ basis, that is, for immediate delivery and on ‘forward’ basis, that is, for delivery at sometime in future at the price
LO 2 Recognise various trading platforms and the risk involved in the FEM
are exchanged instantaneously over-the-counter, in the interbank spot market funds are not generally received until 2 business days after the intimation of transactions. Forward contracts are normally available for 1–12 month delivery. Forward trading generally occurs in two different ways: outright and swap. The former is a contract for an exchange of currencies at some future value date. The latter, on the other hand, is a combination of two simultaneous trades: an outright forward contract and an opposing spot deal. A variety of trading platforms are used by dealers in the EMEs for communicating and trading with one or telex. Some dealers also trade on electronic trading platforms that allow for bilateral conversations and dealing such as the Reuters Dealing 2000–2001 and Dealing 3000 Spot systems. Bilateral conversations may also take place over networks provided by central banks and over private sector networks. Reuters’ Dealing System has been the most popular trading platform in EMEs. In the Indian foreign exchange market, spot trading takes place on four platforms, viz a foreign exchange-trading platform launched by IBS Forex (P) Ltd. in 2002 in collaboration with Financial Technologies (India) Ltd.; and two other platforms by the Reuters—D2 platform and the Reuters market data
system enables real-time matching of currency pairs for immediate and auto execution in both the spot and forward segments. In the negotiated dealing system, on the other hand, participant is free to choose and underlying currency as well as the terms of trade. These trading platforms cover the US dollar–Indian Rupee (USDINR) transactions and transactions in major cross-currencies (EURIUSD, USDIJPY, GBPIUSD and so on), though USD–INR constitutes most of the foreign exchange transactions in terms of value. It is the given to members free of cost. The main advantage of this platform is its offer of straight-through processing (STP) capabilities as it is linked to CCIL’s settlement platform. In the forward segment of the Indian foreign exchange market, trading takes place both over-the-counter (OTC) and in an exchange-traded market with
21.5 RISK MANAGEMENT IN THE FEM The foreign exchange market is characterised by constant changes and rapid innovations in trading methods pose various kinds of risks such as settlement risk, market risk, credit risk and operational risk to the market. The foreign exchange settlement risk arises because the delivery of the two currencies involved in a trade usually occurs in two different countries, which, in many cases are located in different time zones. Most
21.8 of the banks in the EMEs use some form of methodology for measuring the foreign exchange settlement exposure. Many of these banks use the single day method, in which the exposure is measured as being equal to all foreign exchange receipts that are due on the day. Some institutions use a multiple day approach for measuring risk. Several emerging markets in recent years have implemented domestic real-time gross settlement (RTGS) systems for the settlement of high value and time critical payments to settle the domestic leg of foreign exchange transactions. Recognising the systemic impact of foreign exchange settlement risk in pursuance of the recommendations of the Sodhani Committee, the Reserve Bank had set up the commenced settlement of foreign exchange operations for interbank USD–INR spot and forward trades from 8 November, 2002 and for interbank USD–INR cash and tom trades from 5 February, 2004. The CCIL undertakes settlement of foreign exchange trades on a multilateral net basis through a process of novation and all spot, cash and tom transactions are guaranteed for settlement from the trade date. Every eligible foreign exchange contract entered between members gets novated or replaced by two new contracts—between the CCIL and each of the two parties, respectively. Following the multilateral netting procedure, the net amount payable to, or receivable from, the CCIL in each currency is arrived at, member-wise. The Rupee leg is settled through the members’ current accounts with the Reserve Bank and the USD leg through CCIL’s account with the settlement bank at New York. The CCIL sets limits for each member bank on the basis of certain parameters such as member’s credit rating, net worth, asset value and management quality. Apart from managing the foreign exchange settlement risk, participants also need to manage market risk, by the Reserve Bank for banks to manage risk in the interbank foreign exchange dealings and exposure in derivative markets as market makers, the boards of directors of ADs (category-I) are required to frame an open exchange position and the aggregate gap limits need to be approved by the Reserve Bank. The open position is generally measured separately for each foreign currency consisting of the net spot position, the net forward position and the net options position. Various limits for exposure, viz., overnight, daylight, stop loss,
In the case of market risk, most banks use a combination of measurement techniques including VaR models. The credit risk is generally measured and managed by most banks on an aggregate counter-party basis so as to include all exposures in the underlying spot and derivative markets. Some banks also monitor country risk through cross-border country risk exposure limits. Liquidity risk is generally estimated by monitoring buckets. Banks also track balances to be maintained on a daily basis in Nostro accounts, remittances and committed foreign currency term loans while monitoring liquidity risk.
21.6 EFFICIENCY OF THE FOREIGN EXCHANGE MARKET
21.9 phone bills, cable charges, bookkeeping expenses and trader salaries among others. In the spot segment, it may also include the risks involved in holding the foreign exchange. These costs/bid-ask spreads are expected basic sources of bid-ask spreads: (a) order processing costs, (b) inventory holding costs, and (c) information 1999). The low and stable bid-ask spread in the foreign exchange market, therefore, indicates that market is The spread in the Indian foreign exchange market has declined overtime and is very low at present. In India, the normal spot market quote has a spread of 0.25 of a paisa to 1 paise, whereas swap quotes are available at 1–2 paise spread. A look at the bid-ask spread in the rupee–US dollar spot market reveals that during the initial phase of market development (i.e. till the mid-1990s), the spread was high and volatile due to a thin market with unidirectional behaviour of market participants. In the subsequent period, with relatively deep gains. It was empirically observed that expected volatility of the rupee–dollar exchange rates could impact the spread which increases with the increase in volatility (RBI, RCF, 2005–2006). However, the trading volume has negligible impact on the exchange rate spread. The intercept of the estimated equation is highly can be attributed to lower volatility in the foreign exchange market.
21.7 EXCHANGE RATES The exchange rate (ER) is the price of one country’s currency (money) in terms of another country’s currency (money).
21.7.1 Types of Exchange Rates
LO 3 Understand different types of exchange rates and exchange rate system
It has been implicitly assumed so far that a single price clears the FEM, that is, we have the exchange rate in the FEM. This, however, is an unrealistic assumption because actually a complex variety of exchange rates exists at the same time between the same two currencies. There are different ERs for bank notes, bank drafts, cheques, buying and selling, respectively. The rates at which spot and forward transactions take place are known as ‘spot rate (SR)’ and ‘forward rate (FR)’, respectively. There are retail spot rates and interbank spot rates; the former is based on the latter. Then there are ‘cross rates’ which are exchange rates between two currencies neither of which is the US dollar, and which are calculated by using the dollar rates for both the currencies. The economists make a distinction between the actual or ‘nominal exchange rate’ (NER) and the ‘real exchange rate’ (RER). The latter indicates the real purchasing power of one currency relative to another currency; it is the NER adjusted for changes in the relative purchasing power of each currency since some base period. Formally, REER r = NEER t ¥ where INFa and INFh
(1 ¥ INFa )t (1 + INFh )t t is
21.10 The ERs discussed above are the bilateral rates, that is, they are the rates between any two individual currencies. The ER vis-a-vis different currencies does not change uniformly in terms of direction and magnitude. In order to obtain a summary measure of changes in the ER of a currency vis-a-vis all the other (major) currencies, that is, in order to obtain a measure of the multilateral ER, economists have developed the concepts and measures of the ‘nominal effective exchange rate’ (NEER) and the ‘real effective exchange rate’ (REER). The term,
for computing NEER and REER; for example, bilateral exports-based (or trade, i.e. exports plus importsthat exists between the home country and other countries in the third country markets.1 Certain conventions exist in the world FEMs with regard to the way spot rates are quoted. Interbank trades in dollars are quoted either in ‘American terms’ (number of US$ per unit of foreign currency) or ‘European terms’ (number of foreign currency units per US$). There is a practice of giving either ‘direct quotation’ (number of home currency units, say rupees, per unit of foreign currency, say pound sterling) or ‘indirect quotation’ (the number of units of foreign currency, say pound sterling per unit of home currency, say a rupee) when banks deal with non-bank customers. The Indian FEM was following the system of ‘indirect quotes’ until August 1993; since then it has switched over to ‘direct quotes’. The spreads (difference between the buying and selling rates) on smaller transactions is much wider than the Banks charge their retail customers slightly more than the going interbank ‘selling rate’ or ‘ask rate’, and pay slightly less than the interbank ‘buying rate’ or ‘bid rate’; the extent of the makeup or markdown depends on the size of the retail transaction. In the forward market, commercial customers are quoted the ‘outright rate’, that is, the actual price, whereas in the interbank market, the forward rate (FR) is quoted only as a discount from or a premium on the spot rate (SR). This forward differential is known as the ‘swap rate’. The foreign currency is said to be at ‘forward discount’ if FR < SR; at ‘forward premium discount or premium rate (FDR or FPR) can be calculated by using the following formula: 12 Ê Forward rate – Spot rate ˆ FDR or FPR = Á ¥ ˜ Spot rate Ë ¯ Forward Contract marturity in months In a free and competitive FEM, spot and forward rates move in the same direction. They are linked by the interest rates differential between the two countries, and the current market expectations about the future spot rates (events). Generally, forward rates predict future spot rates. Theoretically, the forward rates should equal the expected future spot rates. The forward discount or premium is closely related to the interest differential between the two currencies. The currency of the country with lower interest rates should be at a forward premium in terms of the currency of the country with higher rates. In the absence of transactions costs, the the forward rate is said to be at interest parity. 1
For further understanding, see Jadhav, Narendra, ‘Effective Exchange Rate Indices: A New Methodology for Incorporating the Third Country Competition’, in National Institute of Bank Management, International Monetary, Banking, and Trade Systems and Economic Development, Pune, 1992.
21.11
21.7.2 Devaluation and Depreciation of Exchange Rate It is useful to understand the meaning and measures of exchange rate changes at this juncture. There is a convention to distinguish devaluation (revaluation) from depreciation (appreciation) of the currencies or exchange rates. The devaluation (revaluation) of a currency refers to a policy-determined decrease (increase) Depreciation (appreciation) refers to a decline (increase) in the price or exchange rate of a given currency relative to a foreign currency depreciation essentially mean the same thing, both have the same effects, and the way of measuring both of them is the same. The percentage change in the direct exchange rate between the rupee and dollar (i.e. the percentage change in the rupee value of dollar) can be calculated as follows: È E1 - E0 ˘ Í E ˙ ¥ 100 0 Î ˚ È E0 - E1 ˘ Í E ˙ ¥ 100 Î 1 ˚ where E1
E0
It may be noted that the two rates would not be equal because the base of which the change is calculated differs in two cases; the value of one currency is the inverse of the value of another currency.
21.7.3 Exchange Rate Systems Different kinds of exchange rate systems have been tried by different countries in the world. Of them, the two
Fixed Exchange Rate System
or an agreed upon percentage, say, 1 percent on either side of the par value. The CB intervenes in the FEM to The ER is not used as a tool for correcting imbalances in the balance of payments (BOP). Intermediate Exchange Rate Systems the wider band system. This is also known as a target zone system. Under the crawling peg, the par value is automatically revised; the CB intervenes whenever the ER approaches a ‘support point’ and revises the viz., those on capital viz., those on current account. This is also known as the
21.12
without resisting the fundamental market forces; or to lean against the wind, that is, to moderate or prevent
21.7.4 Appropriate Exchange Rate Regime combination of (a) full capital account convertibility (FCAC), (b) domestic monetary policy independence, and (c) a stable currency. If a country has capital account convertibility (CAC), it has to give up either (b) or
21.7.5 Changes in the Indian ER Regime In India, there have been far reaching changes in the ER regime over the years. The rupee was linked with rupee link was severed de jure sometime in 1947, and the par value of the rupee came to be expressed in terms of gold. However, the exchange value of the rupee in terms of the pound sterling was not disturbed de facto. India informed the IMF that the par value of rupee would be 4.145142857 grains (0.268601 gram) ` the pound sterling was devalued in September 1949 as the rupee also was devalued to an identical extent in 1949. However, the devaluation of the rupee in September 1949 and June 1966 in terms of gold resulted in 0.118489 gram later.
of the US dollar. The exchange rate of rupee was pegged to the US dollar, while the pound sterling continued to be the intervention currency. This arrangement had a very short life span; it existed only during August– December 1971. In December 1971, the pegging of the exchange rate of the rupee to the US dollar was discontinued and a central rate for the rupee equivalent to the average of the RBI buying and selling rates for the pound sterling came to be adopted. This arrangement lasted till 24 September, 1975 when the rupee was delinked from the pound sterling. daily exchange rate movements of a selected number of currencies which were the major trading partners of India. In other words, since that day, the rupee came to be linked with a basket of currencies. The selection
21.13 of the currency units and weights to be assigned to them was left to the discretion of the RBI subject to the approval of the government. In order to discourage speculation in the foreign exchange markets on the likely changes in the rupee–sterling rate and other foreign currency rates, the actual composition of the basket was not disclosed. Under this arrangement also, the pound sterling continued to be the currency of intervention. Under the system of basket-pegging, the value of the domestic currency with respect to the numerair (intervention) currency was changed in line with the movements in the weighted average of the value of the trading partners’ currencies vis-a-vis the numerair currency. The choice of basket peg instead of a single-currency-peg was made with a view to imparting stability to the exchange rate of rupee. A single-currency peg faces the danger of greater volatility in the exchange rate of however, doubtful whether the exchange value of the rupee in reality remained stable as a result of the system of the basket-peg. The number of adjustments in the rupee–sterling rate had increased from 3 in 1975 to 13 in 1979, 34 in 1980, 71 in 1981, 94 in 1982, 124 in 1983, 142 in 1984, 154 in 1985, 200 in 1988 and 252 in 1989–1990. During 1975–1992, the ER regime in India was characterised by daily announcements by the RBI of its buying and selling rates to authorised dealers for merchant transactions. The basket-peg system was replaced by the system of ‘Liberalised Exchange Rate Management’ (LERM) or the dual exchange rates in March 1992, which lasted till February 1993. In March 1992, the dollar replaced
the remaining 60 percent could be traded at the market rate. The former used to be lower than the latter. This system in February 1993. Important ERs which exist under this system are the FEDAI indicative rate (which is the average of the middles of highs and lows of the FEDAI buying and selling rates), the RBI buying and selling, that is, intervention rates and the RBI reference rate. The RBI rates are arrived at on the basis of market (FEDIAI) rates. As a part of UERS, trade account convertibility of the rupee was introduced on 2 March, 1993. Over the next 18 months, restrictions on a number of other current account transactions were relaxed, and the rupee was made convertible for many current account transactions from 20 August 1994. India now stands on the threshold of introducing capital account convertibility. Similarly, the FERA, 1973 has now been replaced by the Foreign Exchange Management Act (FEMA). As in many other industrialised and newly emerging countries, India has now adopted an ER regime
smooth, and the RBI tries to ensure that market operations and ER movements should be transactions-oriented and not purely speculative in nature. India has set up its own clearing house for dollar–rupee transactions with regime in India has worked well and there is really no need for adopting some alternative ER system such as allowing rupee to appreciate freely, that is, non-intervention by the RBI, or the aggressive reduction by the RBI in the degree of appreciation of the rupee, or RBI should intervene to bring about calculated volatility in ER.
21.14
21.7.6 Determinants of Exchange Rate
exchange rate system, the equilibrium spot exchange rate, like any other market price, is determined by the equality of market demand for and supply of currencies generated on trade, investments (assets), hedging, approach. Under the former, the demand for and supply of foreign exchange are determined by exports and known as the balance of payments (BOP) accounts of the country. All the credit items (viz., exports of goods in BOP give rise to the demand for (supply of) its (foreign) currency, and all the debit items (viz., imports of
imports which are invoiced in foreign currency, the country’s residents must sell domestic currency to obtain the needed foreign currency. Similarly, when imports are invoiced in domestic currency, its foreign recipients must sell it to obtain foreign currency.
about the future values of these variables, and (j) the expected exchange rate. It is very important to realise that only the relative changes in these factors at home vis-a-vis foreign countries affect the ER. Let us elaborate. The law of one price and parity conditions is the basis of nominal ER determination. The former states that in the absence of market imperfections and transactions costs, the exchange-rate-adjusted prices of identical arbitrage in markets. Following this law, the Purchasing Power Parity Theory (PPPT) posits that the exchange in the price levels in the two countries. The exchange rate change during a given period should equal the India than in the United States would lead to a depreciation of the rupee and an appreciation of the dollar. If would rise (dollar would appreciate) by 5 percent. Although the ER generally behaves in accordance with the PPPT in the long run, deviations from the PPPT next section). If changes in the nominal exchange rate are fully offset by the changes in relative prices in two countries, the real exchange rate remains unchanged. A rise in either or both of them in, say, India in relation to either or both of them in, say, the United States will induce Indian as well as American investors to switch from dollar-denominated to rupee-denominated securities and investments, which will result in the appreciation of the rupee and the depreciation of the dollar.
21.15 Similarly, if the excess of money supply over money demand in, say, India is greater than a similar excess in, say, the United States, the rupee would tend to depreciate and dollar would tend to appreciate. Further, an improvement in the terms of trade (prices of a country’s exports relative to those of its imports) of a given country would shift the demand curve for its currency to the right, which would lead to the appreciation of its currency. Finally, the currencies of the countries with lower (higher) political and economic risk (stability) would have higher values than those of the countries with higher (lower) risk (stability). Apart from the current
Some authors have stressed the role of stocks of relevant macro-variables in determining the ER. Their approaches are known as the monetary approach and the portfolio balance approach. The monetary approach emphasises the links between the monetary aggregate, GNP, price level and exchange rate. For example, it posits that the higher rate of growth of real GNP would lead to an appreciation of the currency of the country experiencing such a growth. The portfolio balance approach states that the bonds in different countries are not perfect substitutes for each other. Therefore, the changes in preferences for bonds of one country over another, or different changes in bond supplies in different countries, would affect the exchange rate. At
short run, temporary imbalances in supply and demand and the extent of intervention by the central bank
21.7.7 Objectives of Exchange Rate Policy in India (ii) To reduce excess volatility in exchange rates, and to ensure that the market correction of overvalued or undervalued exchange rate is orderly and calibrated. (iii) To help maintain an adequate level of foreign exchange reserves. (iv) To help eliminate market constraints in the way of development of a healthy FEM. In the early phase of liberalisation, the rupee was devalued against major currencies by about 17–19 percent in two stages in July 1991 in order to tackle the BOP crisis. Some people have argued that this policy led to an improvement in the BOP, increase in foreign exchange reserves (FERs) and the stabilisation of the ER. Others think that this is not true because the ER remained stable only during March 1993 to October 1995, after which the rupee became volatile. There have been frequent turmoils in the FEM and bouts of depreciation and appreciation in different periods requiring heavy RBI intervention, which has been discussed further in
markets. The surplus on the capital account and the increase in FERs after 1993 are not good indicators of the of other types of foreign capital rather than through the positive trade balance. The adverse consequences of
21.16
21.8 GLOBAL AND INDIAN FOREIGN EXCHANGE MARKET ACTIVITY AND TRENDS IN EXCHANGE RATES activity to $5.3 trillion per day in 2013, up from $3.3 trillion in 2010 (Table exchange rates, the 2013 survey results continue the trend of strong turnover exchange rates grew roughly by the same magnitude. The growth in global
LO 4 Explain global and Indian foreign exchange market activity and trends in exchange rates
2007 to 2010 reported in the prior survey, but falls short of the record 72 percent increase (at current exchange rates) between 2004 and 2007. Table 21.1 Global foreign exchange market turnover (Daily average in April, in billions of US dollars)
1998
2001
2004
2007
2010
2013
1527
1239
1934
3324
3971
5345
Spot transaction
568
386
631
1005
1488
2046
Outright forward
128
130
209
362
475
680
Foreign exchange swaps
734
656
954
1714
1759
2228
Currency swaps
10
7
21
31
43
54
Options and other products
87
60
119
212
207
337
1718
1500
2036
3376
3969
5345
11
12
26
80
155
160
Foreign exchange instruments
Memo: Total on April 2013 exchange rates Exchange-traded derivatives
Source: BIS Quarterly review, various issues, BIS Triennial Central Bank Survey Foreign Exchange Turnover in April 2013.
accounted for 24 percent, institutional investors such as pension funds and insurance companies accounted (BIS, 2013)2. Foreign exchange trading has become more locally concentrated since 2010, reversing the trend percent in 2010 to 58 percent in 2013—the lowest level since the 2001 survey. The decrease in the share of cross-border deals is also evident in other OTC markets, such as the market for interest rate derivatives, but does not necessarily mean that trading activity has become less international. The increasing concentration place between counterparties located in these centres, although they could be headquartered elsewhere. From 2
BIS Triennial Central Bank Survey, Foreign Exchange Turnover in April 2013.
21.17 Table 21.2 Foreign exchange market turnover by counterparty (Daily average percentage share)
Items With reporting dealers
1998
2001
2004
2007
2010
2013
63.0
58.1
52.6
41.9
38.9
38.7
19.6
27.9
32.8
40.3
47.7
52.6
17.4
14.0
14.3
17.8
13.4
8.7
Local
45.7
42.4
38.4
38.3
35.1
42.3
Cross border
54.2
57.5
61.2
61.7
64.9
57.7
Source: BIS Quarterly review, various issues and BIS Triennial Central Bank Survey Foreign exchange turnover in April 2013.
the Table 21.3, it is evident that the foreign market is highly dominated by US dollar followed by euro, Japanese yen and pound sterling. Indian rupee has accounted for only 1 percent in the year 2013, which has increased from 0.2 percent in the year 2001. The Japanese yen stood out as the major currency that saw the most substantial jump in trading activity, whereas the role of the euro as an international currency declined among major emerging market currencies. Table 21.3
Foreign exchange turnover by currency (Percentage to total)
Currency
2001
2004
2007
2010
2013
US dollar
90.4
88.7
86.3
84.9
87.0
Euro
37.7
37.2
37.0
39.1
33.4
Japanese yen
22.7
20.3
16.5
19.0
23.0
Pound sterling
13.3
16.9
15.0
12.9
11.8
Australian dollar
4.2
5.5
6.7
7.6
8.6
Canadian dollar
4.5
4.2
4.2
5.3
4.6
Mexico peso
0.8
1.1
1.3
1.3
2.5
Singapore dollar
0.9
1.0
1.2
1.4
1.4
Korean won
0.7
1.2
1.1
1.5
1.2
Russian rouble
0.4
0.7
0.8
0.9
1.6
Indian rupee
0.2
0.3
0.7
1.0
1.0
Chinese renminbi
0.0
0.1
0.5
0.9
2.2
Brazilian real
0.4
0.2
0.4
0.7
1.1
Source: BIS Quarterly review, various issues and BIS Triennial Central Bank Survey Foreign Exchange turnover in April 2013.
21.4). The majority of global foreign exchange trading in 2013 has occurred via the intermediation of dealers’
21.18 Table 21.4
Percentage share of daily averages of global foreign exchange market turnover by countries
Country
1998
2001
2004
2007
2010
2013
Australia
2.3
3.2
4.1
4.1
3.8
2.7
Brazil
0.2
0.3
0.1
0.1
0.3
0.3
Canada
1.8
2.6
2.3
1.5
1.2
1.0
–
–
0.0
0.2
0.4
0.7
Denmark
1.3
1.4
1.6
2.1
2.4
1.5
France
3.7
2.9
2.6
3.0
3.0
2.8
Germany
4.7
5.4
4.6
2.4
2.2
1.7
Hong Kong SAR
3.8
4.0
4.1
4.2
4.7
4.1
India
0.1
0.2
0.3
0.9
0.5
0.5
Japan
7.0
9.0
8.0
5.8
6.2
5.6
Netherlands
2.0
1.8
2.0
0.6
0.4
1.7
China
Singapore
6.9
6.1
5.1
5.6
5.3
5.7
Switzerland
4.4
4.5
3.3
5.9
4.9
3.2
The United Kingdom
32.6
31.8
32.0
34.6
36.8
40.9
The United States
18.3
16.0
19.1
17.4
17.9
18.9
Source: BIS Quarterly review, various issues and BIS Triennial Central Bank Survey Foreign Exchange turnover in April 2013
United States and Singapore expanded their share the most, with turnover growth of 47, 40 and 44 percent, trading activity fell by 13 percent in Switzerland and by 5 percent in Australia. Foreign exchange market activity in India has been only 0.5 percent of the total share, which has come down from 0.9 percent in the year 2007. Tables 21.5 and 21.6 reveal that the rupee’s performance over the years also has been equally sad. Like its internal value, the external value of the rupee also declined continuously and drastically since independence. A look at the entire period since 1993 when India moved towards market-determined exchange rates reveals that the Indian rupee has generally depreciated against the dollar during the last 22 years, except during the years 2003–2004, 2005–2006 and 2007–2008 when rupee appreciated on account of general dollar weakness against major currencies. For the period as a whole, 1993–1994 to 2013–2014, the Indian rupee depreciated against dollar by about 15.5 percent on an annual average basis. Rupee has depreciated against
slightly in comparison to the previous year.
21.19 Table 21.5
Changes in rupee exchange rates (annual averages)
Year
SDR
September 1949
— —
June 1966
US dollar
Pound sterling
Deutsche mark
Yen
3.31
—
—
—
4.76
—
—
—
—
4.76
13.33
—
—
—
7.58
21.0
—
—
1970–1971
7.5
7.57
18.0
1975–1976
10.17
8.38
18.61
3.40
—
2.8
—
1980–1981
10.10
8.04
18.42
4.02
3.8
1985–1986
12.92
12.23
16.85
4.56
5.6
28 June 1991
27.85
21.04
34.36
11.74
15.2
1 July 1991
30.34
23.12
37.48
12.77
16.8
2 July 1991
33.89
25.95
41.59
14.16
18.7
1991–1992
33.43
24.47
42.51
14.62
18.5
1992–1993
37.14
30.65
51.69
19.59
24.6
2001–2002
60.21
47.69
68.32
42.18
38.2
2002–2003
64.13
48.40
74.82
48.09
39.7
2003–2004
65.68
45.95
77.73
53.98
41.67
2004–2005
66.92
44.93
82.86
56.51
40.81
2005–2006
64.48
44.27
79.04
53.91
38.01
2006–2007
66.67
45.28
85.72
58.11
37.03
2007–2008
63.27
41.34
82.72
56.60
35.13
2008–2009
68.64
43.50
80.13
63.74
42.30
2009–2010
74.58
48.40
75.72
67.39
51.81
2010–2011
69.75
45.72
70.69
60.66
52.16
2011–2012
73.64
46.67
74.77
64.87
58.62
2012–2013
81.78
53.43
84.69
68.67
67.02
2013–2014
89.06
58.59
91.77
77.89
60.07
Source: Handbook of Statistics on Indian Economy
Table 21.6 Movements of Indian rupee–US dollar exchange rate 1993–1994 to 2014–2015 Year
Range (` per US$)
Average exchange rate (` per US$)
Appreciation/ Depreciation (%)
Standard deviation
1993–1994
31.21–31.49
31.37
0.10
1999–2000
42.44–43.42
43.33
3.00
0.9
2003–2004
43.45–47.46
45.95
5.06
0.72
2004–2005
43.36–46.46
44.93
2.22
1.03
2005–2006
43.30–46.33
44.28
1.45
1.79
—
(Contd.)
21.20 2006–2007
43.30–46.97
45.28
2.26
0.89
2007–2008
39.27–43.15
40.24
11.12
0.84
2008–2009
39.89–52.06
45.91
14.09
3.57
2009–2010
44.94–50.53
47.42
3.27
1.34
2010–2011
44.03–47.57
45.59
3.85
0.89
2011–2012
43.95–54.24
47.95
5.17
3.04
2012–2013
50.56–57.22
54.45
13.57
1.25
2013–2014
53.74–68.36
60.49
11.10
3.08
2014–2015
58.43–63.75
61.15
1.08
1.19
Source: Handbook of Statistics on Indian Economy, RBI (2015)
The changes in the effective exchange rates as given in Table 21.7 also show that the NEER has declined sharply and the REER has not remained stable during 1975–1976 to 1995–1996. In spite of a secular decline In terms of real effective exchange rates (REER), the REER appreciated by about 2 percent, during 2005– 2006 and it has depreciated during the period 2006–2007 to 2013–2014 except in the year 2010–2011. It appears that exchange rate changes, on the whole, are not much effective in correcting the BOP disequilibria. The historical evidence from abroad also shows that massive exchange rate variations (nominal and real) become relatively stronger and depreciating countries relatively weaker.3 Table 21.7 Indices of REER and NEER of the Indian rupee (Annual Average: 2004–2005 = 100)
Year
Export-based weight REER
1975–1976
109.17
1976–1977
% Change
NEER
Trade-based weights % Change
113.43
REER
% Change
106.17
64.51
40.91
67.02
40.92
1980–1981
63.80
1.09
71.16
1985–1986
58.81
7.83
65.84
NEER
% Change
112.19
62.73
40.91
66.28
40.92
6.18
61.67
1.69
70.01
5.63
7.47
58.01
5.95
66.67
4.78
1990–1991
44.08
25.05
44.24
32.81
44.62
23.08
45.48
31.78
1993–1994
101.73
130.79
113.11
155.69
99.91
123.91
114.53
151.83
1994–1995
106.69
4.88
111.05
1.82
104.23
4.32
113.29
1.09
1995–1996
101.83
4.56
102.86
7.37
98.10
5.88
104.84
7.45
1996–1997
100.66
1.15
100.70
2.10
96.74
1.39
102.24
2.48
1997–1998
104.85
4.16
104.03
3.30
100.68
4.07
105.42
3.10
1998–1999
95.97
8.47
102.18
1.77
92.96
7.67
101.99
3.25
1999–2000
96.93
1.00
102.27
0.09
95.90
3.17
104.25
2.21
2000–2001
100.38
3.56
101.93
0.33
100.90
5.21
105.53
1.23 (Contd.)
3
Thirwall, A P, ‘What is Wrong with Balance of Payments Adjustments Theory?’, The Royal Bank of Scotland Review, March 1988, pp 3–8.
21.21 2001–2002
100.30
0.08
100.76
1.15
100.77
0.13
104.89
0.61
2002–2003
97.65
2.64
98.42
–2.32
98.09
2.66
102.07
2.69
2003–2004
100.78
3.21
99.41
1.01
99.47
1.41
99.81
2.22
2004–2005
100.00
0.78
100.00
0.59
100.00
0.53
100.00
0.20
2005–2006
102.28
2.28
103.12
3.12
102.26
2.26
102.91
2.91
2006–2007
99.02
3.18
98.93
4.07
98.34
3.83
98.37
4.41
2007–2008
109.77
10.85
118.07
19.36
107.95
9.77
118.81
20.77
2008–2009
103.75
5.48
110.18
6.69
101.67
5.82
110.50
6.99
2009–2010
103.53
0.22
102.43
7.03
101.06
0.60
103.34
6.48
2010–2011
115.73
11.78
107.23
4.68
111.63
10.46
107.40
3.92
2011–2012
116.45
0.62
103.03
3.91
111.51
0.11
102.41
4.65
2012–2013
110.58
5.04
92.21
10.51
105.55
5.35
91.38
10.77
2013–2014
108.88
1.54
85.43
7.35
104.41
1.08
84.92
7.07
Source: Handbook of Statistics on Indian Economy, Various issues.
21.9 ISSUES IN FOREIGN EXCHANGE MARKET 21.9.1 Central Bank Intervention in FEM used frequently to maintain the exchange rate within the prescribed margins.
LO 5 Describe the issues in foreign exchange market
discontinued pegging their currencies to the US dollar, bringing in an era of banks. The central banks have, however, often intervened for a variety of reasons: ●
●
to be different from actual values to maintain export competitiveness;
● ●
to protect the currency from speculative attack and crisis
In this context, Jalan (2003) has pointed out that intervention by most central banks in foreign exchange exchange rate movements as against trade balances and economic growth, which were important in the earlier days. In recent times, there has been a large increase in international capital movements. In emerging
categorised into sterilised and non-sterilised. Sterilised intervention occurs when the purchase or sale of foreign currency is offset by a corresponding sale or purchase of domestic government debt to eliminate the effects on domestic money supply. Non-sterilised intervention occurs when the authorities purchase or sell
21.22 foreign exchange, normally against their own currency, without such offsetting actions. Sterilisation might There are differing effects of sterilised and non-sterilised intervention on the net foreign assets (NFA) and net domestic assets (NDA) of the central bank and on money supply (M) (Table 21.8). Table 21.8 Effects of foreign exchange intervention Intervention
Effects on NFA
Effects on NDA
Effects on M
+
0
+
+
–
0
–
0
–
–
+
0
Non-sterilised foreign exchange Intervention (Purchase) Sterilised foreign exchange Intervention (Purchase) Non-sterilised foreign exchange Intervention (Sale) Sterilised foreign exchange Intervention (Sale)
Note: +: positive impact, –: negative impact, 0: no impact, NFA: net foreign assets, NDA: net domestic assets, M: money supply
monetary channel. Any purchase of foreign exchange (i.e., intervention) if left unsterilised will impact the monetary base (rises), which, in turn, induces changes in the broader monetary aggregates, interest rates, real demand for goods and assets and ultimately the exchange rate (depreciates). In so far as sterilised intervention is concerned, the proponents of monetary approach claim that it is ineffective. The literature, (a) portfolio balance channel under which domestic and foreign bonds are assumed to be imperfect substitutes, and intervention, even though sterilised, impacts exchange rate by changing the relative supplies of bonds; (b) signalling channel where sterilised purchase of foreign currency will lead to a depreciation of the exchange rate if the foreign currency purchase is assumed to signal a more expansionary domestic monetary policy and vice versa; and (c) more recently, the noise-trading channel, according to which a central bank can use sterilised interventions to induce noise traders to buy or sell currency (Kortian, 1995). Even if an intervention has only a temporary effect, it can still lead to noise traders assuming that the trend has been broken and induce investors to take positions in line with the central bank’s intentions. central bank intervention have attempted to examine whether sterilised intervention has had a quantitatively been observed that while empirical evidence on the effectiveness of central bank intervention is available developing countries including India is weak. Empirical evidence in the Indian case, however, suggests that
(Pattanaik and Sahoo, 2001). There is some evidence of co-movement in demand–supply mismatch proxied by the difference between the purchase and sale transactions in the merchant segment of the spot market and
21.23 intervention by the Reserve Bank. A positive correlation of 0.7 is also found in the case of demand–supply mismatch and net RBI purchases (RBI, RCF, 2005–2006). The Reserve Bank of India (RBI) very often intervenes in the foreign exchange market to stabilise the value of rupee against foreign currencies. The intervention by the RBI in the foreign exchange market could be either passive (whereby it engages off-market deals) or active (whereby it purchases and sells dollars).The RBI has the authority to enter into foreign exchange transactions both on its own account and on behalf of the government. However, it does not deal in foreign exchange directly with the public; it does so through the authorised dealers. Intervention is the sale and purchase of foreign currencies in the foreign exchange market. The authorised dealers were expected to buy from or sell currencies to the RBI only after exhausting all avenues for meeting their needs and unloading currencies on the domestic market. The exporters were required to surrender the foreign exchange that they could not unload on the domestic market to the RBI, and they could not use foreign currencies for dealings on the international markets, except insofar as such dealings were required to cover their currency position arising out of genuine merchant transactions. The forward purchases or sales of foreign currencies against rupees with foreign banks were prohibited. The guiding principles of the foreign exchange market were as follows: (a) all the foreign exchange transactions with the RBI and among the dealers must be against genuine trade transactions, (b) foreign exchange transactions must not lead to speculation, (c) the market must meet its own needs before approaching the RBI, and (d) currency positions should be either square or near square at the end of each day. Before the introduction of new economic policy under the Foreign Exchange Control System (FECS), the government had assumed a monopoly of exchange transactions, that is, all foreign exchange required for payment to foreigners was to be bought from the government; it also regulated the transfer of monetary and other assets owned or acquired by its residents in foreign countries. The government dictated the price at which it bought and sold foreign exchange, as well as, the amount of, and the purposes for which foreign exchange was made available. India had used Exchange Control to utilise limited foreign exchange resources according September 1939 which was later placed on a statutory basis by enacting Foreign Exchange Regulation Act (FERA), 1947. This Act was replaced by a more comprehensive, amended and expanded legislation, namely, FERA, 1973 which came into force on 1 January, 1974. Since the inception of the Exchange Control, the RBI was empowered to prescribe the rates at which the authorised dealers could undertake foreign exchange business. The Bank exercised this power indirectly through the Exchange Banks’ Association till 1958 and exchange rates in pound sterling in consultation with the bank for the banks’ transactions. The RBI stipulated that banks must follow these rates. The banks were free to quote their own rates for other currencies as long as they were worked out on the basis of market conditions within the framework of guidelines which were issued by the FEDAI from time to time. Earlier the RBI used to establish the day’s buying and selling rate of the rupee in terms of pound sterling at the beginning of the day. In order to maintain the ruling exchange value of the rupee, the bank was obliged to buy
buying and selling rate for many years in any other foreign currency than the pound sterling because the latter was an intervention currency. The dollar purchases were started by RBI from 9 October, 1972 and dollar
21.24 sales from 2 February, 1987. Deutsche mark purchases were started from 4 March, 1974 and Japanese yen rupee was made market-determined. During the period of liberalisation and in the era of market-determined exchange rate system RBI intervenes in the foreign exchange market time to time to stabilise the exchange rate and to save the foreign exchange market from various problems raised in the international market. Most of the time, the monetary authorities in many countries use interest rate as a policy instrument to contain the excess volatility and to maintain the exchange rate at its desirable level. A depreciation of exchange rate calls for an increase in interest rate and appreciation of exchange rate calls for a decrease in interest rates. The bank Rate, repo (repurchase agreement) rate and reverse repo rate have also been used by the monetary authorities to contain the excessive volatility in the foreign exchange market. For example, the external value of the rupee in terms of dollar was found to be under pressure in a few episodes during the second half of the 1990s which can be attributable to a number of factors like East Asian and Russian currency crises (contagion rate policy was followed to contain excess volatility in the foreign exchange market. The call money rate was allowed to increase to 34.83 percent in November 1995, 28.75 percent in March 1996 and again 28.75 percent in January 1998. After restoration of normal condition in the foreign exchange market, the call rate was brought back to its normal level. It has been found that the call money rate and net intervention were RBI has taken many policy measures to stabilise the foreign exchange market in India. Table 21.9 shows that the volume of sales and purchases of foreign currencies by the RBI has been much resulted in greater upward and downward pressures on the value of the rupee, and consequently, a greater need for CB intervention. The RBI intervention has been both for preventing depreciation or devaluation (when sales have been greater than purchases) and appreciation (when purchases have been greater than sales) of the rupee. The Reserve Bank undertook intervention in both spot and forward segment and liquidated its forward Table 21.9 Reserve Bank’s intervention in the foreign exchange market
(US$ bIllion)
US dollar Year
Purchase
Sale
Net
Outstanding forward sales /purchase
1975–1976
0.71
—
—
—
1980–1981
0.71
—
—
—
1991–1992
12.81
7.7
4.48
—
1992–1993
40.67
41.07
0.4
—
2000–2001
28.2
25.8
2.4
1.3
2005–2006
15.2
7.1
8.1
0
2010–2011
2.45
0.76
1.69
1.97
2011–2012
16.65
22.00
5.35
8.99
2012–2013
12.64
16.22
3.58
147.49
2013–2014
52.39
43.00
9.39
216.12
Source: Reserve Bank of India, Handbook of Statistics of the Indian Economy.
21.25
Bank to release rupees for buying dollars. An analysis of the movement of exchange rate and net purchases rupee. Empirical analysis, however, reveals that while FII investments have contributed towards increasing volatility, intervention by the Reserve Bank has been effective in reducing volatility in the Indian foreign exchange market. Intervention by the Reserve Bank to neutralise the impact of excess foreign exchange effect of increase in FCA on monetary base, the Reserve Bank has been continuously mopping up the excess liquidity from the system through open market operations. The CB intervention in India has often been of a sterilisation nature. It has also been impinging on the domestic liquidity quite sharply. The net sales of foreign exchange by the RBI have sometimes led to the withdrawal of liquidity from the money market and the shooting up of call rates. The net purchases have had the opposite effect. Thus, the RBI intervention volatility in the former to the latter.
21.9.2 Forward Premia and Foreign Exchange Rate The forward exchange market in India is active up to 1-year with concentration up to 6 months. The link of the capital account, the forward premia is getting aligned with the interest rate differential. Free movements yield curve are necessary for the development of forward market in foreign exchange. The forward exchange future. The forward contracts are on 1 month, 3 months, 6 months, 9 months, and 1 year basis. There are three types of participants in the forward exchange market. They are hedgers, arbitragers and speculators. Hedgers are those who enter the forward exchange market to protect themselves against the exchange rate risk. But whether hedging the exchange rate risk due to forward contract is favourable or not depends on the because of the discrepancies between interest rate differentials and forward premium or discount. Speculators market because they believe that the future actual spot rate corresponding to the data of the quoted forward exchange rate will be different from the quoted forward rate. In this way, they equalise the expected change in exchange rate to the forward premium or discount on foreign currency. For example, if the expected rate of depreciation is greater than the forward premium, the speculators will buy the foreign currency, which will force the forward rate to go up until it equals with expected rate of depreciation. The opposite process will work if the expected exchange rate depreciation is less than forward premium. Thus, risk-neutral speculator will ensure that expected change in depreciation is equal to the forward premium. A currency is said to be at forward premium, if the forward exchange rate for that currency represents an appreciation for that currency compared with the spot exchange rate. On the other hand, a currency is said to be at a forward discount, if the forward exchange rate for that currency represents depreciation for that currency compared with the spot exchange rate. To illustrate, let us assume that the spot exchange rate is
21.26 ` `45, then we can say that there is a premium on dollar. On the other hand, if the forward rate is less than `45, then there is a discount on dollar. The forward premium or discount is explained as a percentage of spot exchange rate, that is, Et + 1 – St)/St where Et + 1
t+1
St
t
The Reserve Bank of India has been publishing data on forward premia for three maturities namely,1 month, 3 month and 6 month since 1993. The forward exchange rate can be calculated with the help of spot exchange rate and forward premium/discount. For instance, the forward exchange rate in time period t can be calculated as follows: FERt
t
+ [SERt ¥ FP/100] t t
The denominator of the component FP/100 depends on the maturity of the forward premium. It would be 100, 200, 400 and 1200 for 1 year, 6 months, 3 months and 1 month, respectively. The calculated annual average forward exchange rates for 1 month, 3 months and 6 months maturities during 1996–2014 have been presented in Table 21.10. Table 21.10
Forward premia, forward exchange rate, spot exchange rate in India (Annual average)
Year
Forward premia 1 month 2.01
Spot rate
3 months
6 months
Calculated forward exchange rate 1 month
3 months
6 months
1996
12.14
12.41
12.59
35.42
35.78
36.52
37.65
2000
3.76
3.69
3.64
44.94
45.08
45.35
45.76
2005
1.60
1.41
1.25
44.27
44.33
44.43
44.55
2006
2.01
1.81
1.64
45.28
45.36
45.48
45.65
2007
3.31
3.06
2.85
41.34
41.45
41.66
41.93
2008
4.01
3.00
2.40
43.50
43.65
43.83
44.02
2009
3.27
3.01
2.74
48.40
48.53
48.76
49.06
2010
5.02
4.77
4.32
45.72
45.91
46.27
46.71
2011
6.75
6.13
5.79
46.67
46.93
47.39
48.02
2012
8.02
7.28
6.62
53.43
53.79
54.40
55.20
2013
8.50
8.03
7.59
58.59
59.01
59.77
60.81
2014
8.55
8.36
8.22
61.14
61.58
62.42
63.65
Source: Handbook of Statistics on Indian Economy, Various issues.
21.27
21.9.3 Co-movement of Domestic and Foreign Interest Rates and the Exchange Rate The RBI and banks and others participate in both the spot and forward markets. The market is characterised sometimes by the excess demand for foreign exchange in merchant and interbank segments which hardens the forward premia and it also makes the RBI to sell the currency in the forward market. It is natural that the RBI intervention is in the opposite direction to the excess demand or supply in the market, and then only it is assessed is to study the co-movement of domestic and foreign interest rates and the exchange rate. Two theories or conditions which we used for this purpose are Covered Interest Parity (CIP) condition, and the Uncovered Interest Parity (UIP) condition. The CIP states that the forward premium or forward discount, that
mentioned above. The CIP and UIP imply that forward premia or discounts are an unbiased predictor of the future spot exchange rate. Several channels have resulted in growing integration of money and forex markets—importers and exporters
pre/post-shipment credit in forex and switch between rupee and foreign currency credit has also helped to increase integration between money and forex markets. Further, when banks are allowed to grant foreign currency loans out of FCNR liabilities, integration is enhanced. Similarly, when banks swap/unswap FCNR deposits, greater integration is achieved. The introduction of rupee interest rates derivatives also will help invest funds in overseas money market also has induced integration. Further, the step taken by the RBI to helped integration. As a result of this step, companies as well as exporters can substitute rupee credit for forex credit depending on the cost and exchange risk. If liquidity is considerable and call rates are easy, banks may deploy funds either in forex or government or money or repo market which may affect forward premia. The integration between the domestic and overseas markets works through the forward market. On the whole, due to developments just mentioned, the government securities market, capital market, money market, and forex market have become relatively more integrated in the sense that new participants in these markets move (relatively more freely and to a relatively extent) from one market to another. The integration of forex and domestic markets depend upon the foreign currency liabilities and assets banks can maintain and the extent or degree to which they are swapped into rupees and vice versa.
21.9.4 Currency Convertibility (CC) The convertibility of the Indian rupee has been a subject of great interest and excited discussions in recent years. The submission of the Report4 of the Committee on Capital Account Convertibility (CCAC), at the end of May 1997 has given a fresh impetus to them. At the time of submission of the said report, the situation in India was mixed in the sense that there was no full current account convertibility (CURAC) and there was capital account convertibility (CAC) in certain respects. ADs could supply, without clearance from the RBI, foreign exchange for current account transactions only up to a limit, but there were virtually no restrictions 4
RBI, Report of the Committee on Capital Account Convertibility (Tarapore Committee), Mumbai, 1997.
21.28 a move towards CAC, and it recommended that the implementation of CAC be spread over a 3-year period,
pre-conditions for CAC in India. Following the recommendations of the Tarapore Committee, the whole host of capital account transactions have been liberalised or deregulated in the recent past. It has been argued that for most transactions which are required for business and personal convenience, the rupee is practically fully ceiling, the permission is generally given quite easily. And, the authorities have declared that they would discussion on the meaning, prerequisites and possible dangers of CC in general should help to impart clarity to public thinking on this subject. Meaning and General Features of CC The CC does not have just one meaning. Its meaning has undergone changes over the years. In the nineteenth
currency balances of non-residents into the currency demanded by them, at the parity to be maintained within wishing to buy foreign goods and services … can freely sell domestic for foreign currency … at a single but possibly variable foreign exchange rate covering all current transactions inclusive of normal trade credit, whereas foreigners (non-residents) with balances in domestic currency arising from current transactions can sell them at the same foreign exchange rate or purchase domestic goods freely at prevailing domestic currency prices’.5 As per the IMF’s Article VIII, a currency is convertible if it is convertible for current account transactions alone. It may be noted that according to R I Mackinnon and IMF, to acquire a status vice versa at market-determined rates of embodies the creation and liquidation of claims on, or by, the rest of the world’.6 The Tarapore Committee and vice versa at market-determined rates of exchange’. In other words, CAC implies complete mobility of not only equalises the rates of return of capital across the countries but also increases the level of output and equitable distribution of level of income.
follows: CC means instituting exchange arrangements whereby residents, non-residents and foreigners can exchange (transform) freely (without limit) domestic currency for (into) any foreign currency or gold and vice versa countries introduce CC, the concept of anyone or two currencies being the reserve currencies vanishes; in theory, all convertible currencies are reserves currencies or the international means of payments. 5
Mackinnon, R I, Money in International Exchange, Oxford University Press, Oxford, 1979, p. 6. 6RBI, Report of the Committee on Capital Account Convertibility (Tarapore Committee), Mumbai, 1997, P. 4.
21.29 Making a given currency convertible involves removing most of the exchange and trade controls, and (a) freeing the ER regime; (b) eliminating import licensing, custom duties, import taxes and tariffs, advance import deposits, export incentives, and multiple exchange rates; (c) removing restrictions on international services transactions, earning, availability, use, retention and holding of foreign exchange at home and abroad, and on international capital movements as well as buying and selling of foreign exchange, and The case for CC is the same as the case for free competition or free trade. It is said to (a) stimulate economy through effective international competition, (b) align domestic and world prices better, (c) offer greater capital, and (d) make more foreign capital available to the countries. In the past, for attaining the status of convertibility, the currency had to be convertible into gold. The dollar used to be called a convertible currency because it could be converted so. Such a condition no longer exists now. Similarly, unlike in the system is not a must for CC; it does not require and is independent of any particular ER system. A view that
that the CC implies progress towards free trade, it has often existed with trade and exchange restrictions.
restrictions.
Convertibility: Full or Partial Convertibility can be ‘full’ or ‘partial’. sell currency is only limited in amount; or it is only on any one or two BOP accounts; or it is only for the foreigners. According to some people, full convertibility means removing trade and exchange
make it really or effectively so, unless it comes to enjoy wide and easy acceptability as a means of payment view that the adequacy of reserves is one of the pre-conditions for making a currency convertible. The CCAC also has held such a view. In theory, any convertible currency itself is a reserves currency, and the country of that currency should not need other reserves currencies if the convertibility is effective or real. The convertibility is essentially widening the general acceptability of the currency from domestic to international economy of the country in question. More than 45 out of 128 IMF member countries, some of them quite wealthy, have made their currencies convertible formally, but many of them are still de facto non-convertible. Pre-requisites For introducing convertibility and for making it effective, the following pre-conditions need to be met:
21.30 (iii) Foreign exchange reserves should be large in practice. (iv) The trading partners should open up their trade and payments systems. (v) Debt levels, particularly, external debt level, should be low. (vi) Fiscal and Labour market reforms, including unemployment insurance, job retraining, and wage discipline should be achieved. Dangers of CC A considerable amount of empirical evidence from a large number of countries shows that the theoretical consequences, particularly, during the transition period. They are as follows: (i) It increases the risk of capital real in practice due to the fact that 90 percent of transactions in FEMs are not related to trade. (ii) It tends to
imports, particularly non-essential ones. (v) It increases the misuse of foreign exchange not only for luxury and leisure industry but also for smuggling of goods, drugs, arms and for other nefarious activities. (vi) Unlimited access to short-term external borrowings and giving unrestricted freedom to domestic residents to convert their domestic bank deposits and idle assets in response to market developments or exchange rate taught us. It should be realised that free mobility of capital has adversely affected many countries such as Mexico, East Asia, Russia, and so on. However strong might be the economic, fundamentals of developing countries, free in exchange rate appreciation and, thereby, affect the competitiveness of the host country in the international intervention in order to avoid these adverse effects causes the problems in the management of these reserves and affects the independent monetary policy operation. FCAC may encourage arbitrage operation. It is so from the capital surplus country at a cheaper cost which not only increases the external debt burden of the
provides wrong signal to the international investors about the host country’s economic fundamentals. Since investment, they mobilise their funds for higher returns which may result in moral hazard and adverse It must also not be forgotten that the CC has remained largely non-existent in most of the countries, indicating wars, which are quite unpredictable, make the CC unsustainable. As mentioned earlier, only about 50 percent of the IMF member countries have introduced CC so far, and in many of them it exists only de jure and not de facto. The dollar problem which had developed some years back illustrates that free convertibility of the rupee is not a feasible proposition indeed. The convertibility of the dollar had appeared to be advantageous in Among the countries which have made their currencies convertible, only the United States and Germany have
21.31 granted convertibility to non-residents on both current and capital accounts, others practise convertibility liberal and complacent view of the experiences of other countries, and thereby introducing CAC immediately would harm the country. A relevant question which also can be legitimately asked is when the kind of free market mechanism expected under the CC is not available in domestic markets, how can it be expected to be
Full Capital Account Convertibility in India as percentage of GDP from 4.5 in 1997–1998 to 4.0 in 1998–1999 and further to 3.5 in 1999–2000, fully deregulated interest rate structure by 1997–1998 and reduction of NPAs as percentage of total advances to 12 percent by 1997–1998, 9 percent by 1998–1999 and 5 percent by 1999–2000 for full The performance of these indicators has not been satisfactory in recent years also. For example, gross
banks as a percentage to total advance has not declined to the expectation level. Interest rates have not been deregulated completely. Bank deposit rates, provident fund rate, and all long-term interest rates are still administered by the government. But the issue of full capital account convertibility (FCAC) once again has become a matter of active discussion in India due to the accretion of large FERs discussed in the previous subsection. Following recommendations are given for full capital account convertibility in India in 2006. 1. The spot and forward markets should be liberalised and extended to all participants, removing the constraint on past performance/underlying exposures. 2. Bank margins on foreign exchange transactions of smaller customers need to be reduced by separating foreign exchange business from lending transactions and introducing an electronic trading platform. 3. The Reserve Bank’s intervention in the foreign exchange market should be through the anonymous order-matching system.
5. 6. 7. 8.
borrow and lend overseas both on short-term and long-term, depending upon the strength of their balance sheet. Currency futures may be introduced subject to risks being contained through proper trading mechanism, structure of contracts, and regulatory environment. The existing guaranteed settlement platform of CCIL needs to be extended to the forwards market. The banking sector should be allowed to hedge currency swaps by buying and selling without any monetary limits. A monitoring exchange rate band of ± 5.0 percent around the neutral real effective exchange rate (REER) may be considered and the REER should incorporate services to the extent possible. rate policy should be reviewed.
21.32
21.9.5 Forex Reserve Management The main objectives in managing a stock of reserves for any developing country, including India, are preserving their long-term value in terms of purchasing power over goods and services, and minimising risk and volatility in returns. After the East Asian crises of 1997, India has followed a policy to build higher levels arising from unanticipated capital movements. Accordingly, the primary objectives of maintaining FER in India are safety and liquidity; maximising returns is considered secondary. In India, reserves are held for foreign obligation can always be met. In any emerging economy, the desirable size of reserves can be explained mainly by four factors: (i) the and (iv) opportunity cost. In recent years, some additional factors have emerged for developing economies
abundant international liquidity in the global economy resulting from easing of monetary policy in developed countries, especially the United States. Therefore, this could be a short-term phenomenon, which might reverse swiftly with a rise in interest rates in the developed countries. The foreign exchange reserves (FERs) have increased substantially in the recent past and they are now among one of the largest in the world. The economic theory regards the volume of a country’s FERs as an indicator of its health, and it holds that ‘foreign exchange barrier’ is a crucial impediment to the growth of developing countries. From this point of view, the increase in FERs to an unprecedentedly high level in the recent past should be regarded as a desirable development. However, the observers are not agreed on this point. As per
ability to absorb the shocks and uncertainties in the world economy and her ability to cope up with crisis and
The other view points out the likely adverse implications of very high level of FERs. First, the maintenance or holding of excessive FERs is costly. The cost of holding FERs is the opportunity cost of investing them in productive activities. Second, the accumulation of FERs augments the domestic money supply, and, in order to avoid excessive growth in money supply, the RBI has to conduct sterilisation operations by selling the government securities. Third, high FERs have increased the interest burden of the economy, because a
FERs represent arbitrage funds from the NRIs in America, Europe, and Gulf countries. Sixth, the increase in FER has been due to push rather than pull factor, that is, it is not so much due to the strength of the Indian economy as the disappointing state of the world economy. Seventh, the reserves have not been built up due to favourable balance of trade or surplus on the current account. Eighth, a part of increase in FERs has been due to the revaluation of reserves on account of depreciation of US dollar against other major currencies.
21.33
as FDI, portfolio investments and remittances, and the rates of interest paid on NRI deposits and multilateral loans have been lower than international interest rates. Similarly, it has been argued that the arbitrage per se foreign entities. This is so because there is a minimum period of 1 year for holding deposits in India by the NRIs, and the rate of interest on such deposits is subject to a ceiling rate of 2.5 percent over LIBOR. Finally, FII investments in debt funds are subject to an overall ceiling of $1 billion in the aggregate. Tables 21.11–21.14 give useful information on the level and composition of FERs in India, and also certain indicators in the form of ratios which tell us whether FERs are excessive or not. Three types of assets—SDRs, gold and foreign currency—comprise FERs. Among these, foreign currency accounts for almost more than 90 percent of FERs. Table 21.11 shows a phenomenal increase in FERs. India’s foreign exchange reserves `114.16 billion at end-March 1991 increased gradually to `21,376.47 billion. It may be mentioned that forex reserves data prior to 2002–2003 do not include Reserve Tranche Position India as a creditor in February 2003 with a contribution of SDR 5 million. Tables 21.11 and 21.12 detail the major sources of accretion to foreign exchange reserves during the period from March 1991 to March 2015. The increase in foreign exchange reserves in the recent period has been on account of capital and external commercial borrowings, (b) foreign investment, and (c) short-term credit. The accretion of foreign exchange reserves needs to be seen in the light of total external liabilities of the country. India’s international liabilities, is available as of December 2014 (Table 21.13). Table 21.11 Level and composition of foreign Exchange reserves in India (` in Billion)
Year
SDR
Gold
Foreign currency assets
Reserve tranche position
Total
1950–1951
—
1.18
9.11
—
10.29
1960–1961
—
1.18
1.86
—
3.04
1969–1970
0.92
1.83
5.46
—
8.21
1970–1971
1.12
1.83
4.38
—
7.33
1980–1981
4.97
2.26
48.22
—
55.45
1990–1991
2.00
68.28
43.88
—
114.16
1995–1996
2.80
156.58
584.46
—
743.84
2000–2001
0.11
127.11
1844.82
—
1972.04
2001–2002
0.50
148.68
2491.18
—
2640.36
2002–2003
0.19
167.85
3414.76
31.90
3614.70
2003–2004
0.10
182.16
4662.15
56.88
4901.29
2004–2005
0.20
196.86
5931.21
62.89
6191.16
2005–2006
0.12
256.74
6473.27
33.74
6763.87 (Contd.)
21.34 2006–2007
0.08
295.73
8365.97
20.44
8682.22
2007–2008
0.74
2008–2009
0.06
401.24
11960.23
17.44
12379.65
487.93
12300.66
50.00
2009–2010
12838.65
225.96
811.88
11496.50
62.31
12596.65
2010–2011
204.01
1025.72
12248.83
131.58
13610.13
2011–2012
228.60
1382.50
13305.11
145.11
15061.30
2012–2013
240.20
1397.40
14126.30
125.10
15884.20
2013–2014
268.30
1301.67
16609.10
110.20
18283.80
2014–2015
249.44
1191.60
19854.58
80.85
21376.47
Source: Handbook of Statistics on Indian Economy, Various Issues.
Table 22.12
Sources of accretion to foreign exchange reserves since 1991 (US$ billion)
Itemits
2007–2008 2008–2009 2009–2010 2010–2011 2011–2012 2012–2013 2013–2014
Foreign investment
90.36
320.88
30.3
29.1
17.1
18.6
7.8
NRI deposits
10.73
28.64
2.9
2.2
3.9
9.4
13.7
External assistance
8.69
5.71
1.0
3.0
0.6
0.0
0.1
External commercial borrowing
33.41
7.45
0.7
6.0
8.4
1.7
2.5
Other items in capital accounts
14.13
56.92
10.2
10.7
9.7
5.4
6.2
Valuation change
208.88
197.60
19.8
6.8
0.9
0.1
4.1
Total
233.87
292.93
29.3
13.8
6.6
0.4
14.8
Source: RBI various publications.
Table 21.13
International investment position in India (US$ million)
Item
December 2014
A.
Assets
1.
Direct investment abroad
2.
Portfolio investment
3.
Other investments
4.
Foreign Exchange Reserves
320,649 490,456
129,578 1430 38,799
5.
Total foreign assets
B.
Liabilities
1.
Direct investment in India
252,331
2.
Portfolio investment
211,772
3.
Other investments
382,857
4.
Total foreign liabilities
846,961
5.
Net foreign Liabilities
356,505
Source: RBI Bulletin, Various Issues.
21.35 Table 21.14 Indicators of adequacy of foreign exchange reserves (FER) in India` Year
Import cover of Reserves (Months)
FER to Reserve Money
FER to Broad Money
FER to External Debt
FER to Shortterm Debt
FER to GDP
1990–1991
2.5
13.0
4.3
7.0
68.3
—
1995–1996
6.0
38.3
12.4
23.1
430.8
6.3
2000–2001
8.6
65.0
15.0
41.8
1165.4
11.5
2005–2006
11.6
118.03
24.78
119.8
1743.76
18.96
2006–2007
12.4
122
26.22
1663.64
128.46
24.36
2007–2008
15
133.34
30.89
698.68
139.35
31.77
2008–2009
10.3
129.94
26.95
510.24
109.77
30.87
2009–2010
11.2
108.99
22.49
531.88
106.74
27.89
2010–2011
9.6
98.84
20.94
469.07
99.62
27.66
2011–2012
7.1
105.53
20.46
376.56
81.67
28.70
2012–2013
7.0
104.85
18.93
302.02
71.38
28.97
2013–2014
7.8
105.91
19.21
331.84
68.15
31.84
2014–2015
8.9
110.85
20.27
403.28
71.76
—
Source: RBI, Various Publications.
Are Foreign Exchange Reserves Adequate? Adequacy of reserves has emerged as an important parameter in gauging its ability to absorb external shocks. of import cover has been broadened to include a number of parameters which take into account the size, which the economy is vulnerable. The high level committee on balance of payments, which was chaired by Dr. C. Rangarajan, erstwhile Governor of Reserve Bank of India, had suggested that, while determining the adequacy of reserves, due attention should be paid to payment obligations, in addition to the traditional measure of import cover of 3–4 months. In 1997, the report of committee on capital account convertibility under the chairmanship of Shri S S Tarapore suggested four alternative measures of adequacy of reserves which, in addition to trade-based indicators, also included money-based and debt-based indicators. Similar views have been held by the committee on fuller capital account convertibility (Chairman: Shri S S Tarapore, July 2006). One such measure requires that the usable foreign exchange reserves should exceed scheduled amortisation of foreign currency debts (assuming no rollovers) during the following year. The other one is based on a ‘liquidity at risk’ rule that takes into account the foreseeable risks that a country could face. This approach requires that a country’s foreign exchange liquidity position could be calculated under a range of possible so on. Reserve Bank of India has done exercises based on intuition and risk models in order to estimate ‘liquidity at risk (LAR)’ of the reserves.
21.36 The traditional trade-based indicator of reserve adequacy, viz., import cover of reserves, which increased from 2.5 months of imports to 12.4 months of imports in the year 2006–2007 declined to 8.9 months of imports at end-March 2015. The ratio of foreign exchange reserves to short-term debt increased from 68.3 percent at end-March 1991 to 1743.76 percent at end-March 2006 and again declined to 71.76 percent in the year 2014–2015. The other ratios such as FER to reserve money, FER to broad money, FER to total external debt and FER to GDP have increased slightly in the year 2013–2014 as compared to the year 2014–2015 (Table 21.14).
How are the Foreign Exchange Reserves Managed in India? The Reserve Bank of India (RBI), in consultation with the Government of India, currently manages FER. As the objectives of reserve management are liquidity and safety, attention is paid to the currency notice. The essential framework for investment is conservative and is provided by the RBI Act, 1934, which requires that investments be made in foreign government securities (with maturity not exceeding 10 years), and that deposits be placed with other central banks, international commercial banks and the Bank for International Settlement following a multi-currency and multi-market approach. The conservative strategy adopted in the management of FER has implications for the rate of return interest rates prevailing in the international markets. However, the low returns on foreign investment
rating agencies. According to the High Level Committee on BOP, which was appointed by the government with C Rangarajan as its Chairman, the level of reserves should be able to buy imports of 3 months. If so, present level of FERs is excessive. Even if we accept the other norm for optimum reserves, namely, 6 months of imports as suggested by some economists, the present FER in India can be regarded to be excessive. The third type of norm is based on the thinking that FER should meet not only imports requirements but also should take into account the volume of short-term debt, servicing of medium-term debt, interest and requirements of 1 year is good or desirable. This is known as ‘Guidotti rule’. India’s FER at present are excessive even in terms of this very liberal norm. As it will be discussed in greater details in the next chapter, the foreign capital in very large magnitude is neither necessary nor desirable for India. It is so because the voluntary savings in India generated
The cumulative net impact of the real rate of interest on investment is positive because its effect operating in interest rates affects both savings and investments adversely. The proper utilisation of domestic savings
21.37
this, co-ordination among economic agents, such as, households, corporates, banks, and the government, contrast to Arrow–Debrew’s model of co-ordination success in a competitive environment, co-ordination failure is very much prevalent in the present uncertain milieu.
21.9.6 Euro and South Asian Currency Italy, Spain, Portugal, The Netherlands, Belgium, Finland, Luxemburg, Ireland, Greece and Austria, which, along with three other countries (Britain, Denmark and Sweden) have formed European Economic and Monetary Union (EMU). It may be noted that the three countries just mentioned are part of EMU but not euro. It was formally introduced on 1 January, 1999. During the period between 1 January, 1999 and 31 December, 2001, the respective national currencies of the above-mentioned 12 countries continued to be legal tender, but their governments issued debt only in euro. On 1 January, 2002, euro notes and coins were introduced and a changeover to euro at retail level began. The respective national currencies of the 12 countries ceased to exist and euro became the sole legal tender in those countries from 1 July, 2002. The euro symbol is €. The conversion rates between euro and the respective national currencies of member countries equals (1) 1.958583 German marks, (2) 6.55957 French francs, (3) 1936.27 Italian lira, (4) 166.386 Spanish pesetas, (5) 200.482 Portuguese escudos, (6) 5.94573 Finnish markka, (7) 0.787564 Irish punts, (8) 40.3399 Belgian/Luxembourg francs, (9) 2.20371 Dutch guilders, (10) 13.7603 Austrian schillings, and (11) 340.750 Greek drachmas. The European Central Bank (ECB) was inaugurated on 30 June, 1998, which replaced European Monetary Institute. Its headquarter is in Frankfurt. There is also a 15-nation European Parliament. the second most important international currency after the US dollar, but far ahead of the Japanese yen. Euro is expected to emerge as a rival currency to US dollar. An idea has recently been mooted to introduce a common South Asian Currency for the SAARC region (India, Sri Lanka, Bhutan, Nepal, Maldives, Bangladesh and Pakistan) also on line with euro. It will take considerable amount of efforts and time to implement this idea.
SUMMARY ◆
The market in which national monetary units or claims are exchanged for the foreign monetary units
◆
electronically linked network of big banks, foreign exchange brokers and dealers whose function is to bring buyers and sellers together. The trading in FEM is usually done 24 hours a day by telephones, display monitors, telex and fax
21.38 ◆
◆
◆
◆
◆
◆
◆ ◆
◆
◆
Most foreign exchange markets in developing countries are either pure dealer markets or a combination of dealer and auction markets. In the dealer markets, some dealers become market makers and play a an auctioneer or auction mechanism allocates foreign exchange by matching supply and demand orders. The Indian foreign exchange market is a decentralised multiple dealership market comprising two segments—the spot and the derivatives market. In the direct interbank market, banks quote buying and selling prices directly to each other and all participating banks are market makers. It has been sometimes characterised as a ‘decentralised, continuous, open-bid, double-auction’ market. In the indirect market, the banks put orders with brokers who put them on ‘books’, and try to match purchases and sales orders for different currencies. They charge commission to both the buyers and sellers. This market is characterised as ‘quasi-centralised, continuous, limit-book, single-auction’ market. Players in the Indian market include (a) ADs, mostly banks who are authorised to deal in foreign exchange, (b) foreign exchange brokers who act as intermediaries, and (c) customers—individuals and corporates, who need foreign exchange for their transactions. In the Indian foreign exchange market, spot trading takes place on four platforms, viz Forex (P) Ltd. in 2002 in collaboration with Financial Technologies (India) Ltd., and two other platforms by the Reuters—D2 platform and the Reuters market data system (RMDS) trading platform that have a minimum trading amount limit of US$ 1 million. Various kinds of risks faced by the foreign exchange market are settlement risk, market risk, credit risk and operational risk. The bid-ask spread in the Indian foreign exchange market has declined overtime. The exchange rate (ER) is the price of one country’s currency (money) in terms of another country’s currency (money). In order to obtain a summary measure of changes in the ER of a currency vis-a-vis all the other (major) currencies, economists have developed the concepts and measures of the ‘Nominal Effective Exchange Rate’ (NEER) and the ‘Real Effective Exchange Rate’ (REER). The devaluation (revaluation) of a currency refers to a policy-determined decrease (increase) in its
◆
systems. ◆
◆
◆
about the future values of these variables, and (j) the expected exchange rate. The majority of global foreign exchange trading in 2013 has occurred via the intermediation of dealers’
Sterilised intervention occurs when the purchase or sale of foreign currency is offset by a corresponding sale or purchase of domestic government debt to eliminate the effects on domestic money supply. Nonsterilised intervention occurs when the authorities purchase or sell foreign exchange, normally against their own currency, without such offsetting actions
21.39 ◆
A currency is said to be at forward premium if the forward exchange rate for that currency represents an appreciation for that currency compared with the spot exchange rate. On the other hand, a currency is said to be at a forward discount if the forward exchange rate for that currency represents depreciation for that currency compared with the spot exchange rate.
KEY TERMS Bid-ask spread Exchange rate Forward rate Nominal effective Exchange rate Real effective
Exchange rate Forward premium Currency depreciation Currency devaluation Currency appreciation Fixed exchange rate system Floating exchange rate system
Managed or dirty exchange rate system Purchasing power parity Sterilised intervention Non-sterilised intervention Forward premia Currency convertibility
QUESTIONS 2. Highlight the different types of risks the foreign exchange market face and how they are managed.
6. Analyse the trends in exchange rate during the period of liberalisation in India. 7. Explain the impact of foreign exchange intervention on the money supply of the economy. 9. Explain the concept of adequacy of foreign exchange reserves. (a) Devaluation (b) Exchange rate system (d) Foreign exchange trading (e) Currency convertibility
Foreign Capital Flows
22
CHAPTER Learning Objectives LO 1 LO 2 LO 3 LO 4 LO 5 LO 6 LO 7 LO 8
Identify the uses and determinants of foreign capital
Describe the components of foreign capital in India Review FDI in the retail sector in India Show the drawbacks of foreign capital
22.1 INTRODUCTION Perceptions and policies with regard to the role of foreign (international) capital (savings) in the process 15–20 years were marked by caution in welcoming the foreign capital. A restrictive and selective approach
capital enthusiasm and optimism; some micro units have now begun to view it as a substitute rather than as a measure. The government has recently introduced a number of policy measures to attract foreign investment; and corporate—that India is a good investment risk or a good market place; and that they would be provided all
22.2
Financial Institutions and Markets
to India.
22.2 USES AND DETERMINANTS OF FOREIGN CAPITAL LO 1 Identify the uses and determinants of foreign capital
●
The imbalances between saving and investment lead to current account gaps. Massive increases in the
●
interest rates in the United States and some other countries. Empirical evidence has established that with the interest rates in the United States.1 ●
●
The legal and institutional structure which is transparent and easily understood.
● ●
● ● ● 1
exchange rates. The relative terms of trade of different countries. The absorption capacity of the receiving countries. The business cycle phases or the growth (economic) prospects in different countries.
Ferandez Arias, E; and Montiel P J, ‘The Surge in Capital Inflows to Developing Countries: An Analytical Overview’, The World Bank Economic Review, January 1996.
Foreign Capital Flows
inter alia
● ●
22.3
The requests and the negotiation skills of different countries.
●
● ●
The extent of the innovativeness of the markets in respect of designing and supplying a whole range of
●
Advances in the computer and telecommunication technologies leading to a revolution in the availability
●
speculative bubbles.
22.3 MULTILATERAL FINANCIAL INSTITUTIONS
are (a) the International Bank for Reconstruction and Development (IBRD)
LO 2 Know multilateral financial institutions
Development Bank (ADB); (c) the International Monetary Fund (IMF); and (d) the Bank for International
capital for development to the BRICS countries. World Bank member countries by promoting investment in high quality projects and for productive purposes; (b) promote private foreign investment by providing guarantees or by participating in loans and other investments made by
International Financial Corporation (IFC); and (c) Multilateral Investment Guarantee Agency (MIGA).
22.4
Financial Institutions and Markets
IDA:
International Development Association or Agency (IDA) was
could not meet the terms of WB loans. Its loans have a maturity up to 50 years and are provided free of cost wealthy countries contribute to the resources of the IDA. IFC:
International Finance Corporation (IFC). It was set up in 1956 with
the shares of both individual companies and funds that invest in those securities. It does not supply funds to countries. MIGA: Multilateral Investment Guarantee Agency (MIGA) was set up in 1988. It guarantees or provides insurance protection to foreign investors up to 90 percent of an investment
policy and advisory services to the developing countries for creating an attractive investment climate. ADB: The Asian Development Bank (ADB) provides or guarantees direct loans to private ventures in Asian private enterprises. IMF: International Monetary Fund (IMF) was established in 1944 to help countries to abstain from changing
of multilateral payments and to create a reserve base. Although the nations are supposed to borrow from the
(introduced in 1952) enable countries to obtain funds ahead of the need so as to lessen the risk of attack on
the proceeds for special development loans. The Supplementary Financing or Witteveen Facility gives stand grants loans to countries to purchase crucial inventories. BIS:
Foreign Capital Flows
New Development Bank (NDB): Bank
22.5
BRICS Development
22.4 INTERNATIONAL FINANCIAL INSTRUMENTS viz loans; (b) euro deposits or euro currency or euro money; (c) foreign bonds; (d) euro bonds; (e) Fixed Rate Notes (FRNs); (f) Note Issuing Facility (NIF); (g)
LO 3 List international financial instruments
International Depository Receipts (IDRs). Euro Issues:
because the restrictions such as the ceiling on interest rates and higher CRR imposed by the US authorities on domestic banks had led many US banks to accept dollar deposits at their foreign branches in Europe and Petroleum Exporting Countries (OPEC) had accumulated massive BOP surpluses which they also preferred
have leapt beyond their traditional boundaries so that it is possible to write cheques in French francs against
22.6
Financial Institutions and Markets
currency deposits and credits; and the markets for them are called euro currency markets. Spearheading the
country in which it is issued (the country of issue) and the location of the issuing entity (the nationality of the issuer). Let us try to understand further the terminology involved in this context by studying the meaning and nature of some of the instruments mentioned earlier.
subsidiary abroad is still a euro dollar deposit. A bank deposit is counted as a part of euro currency if it is denominated in some currency other than that of the country in which the bank with which it is held is located.
than that of that country is called a euro instrument. Euro deposit is an example of euro instrument.
corporates. Euro bonds are the bonds that are denominated in the currency other than that of the country
multicurrency bonds. They usually give the lenders the right to request repayment in one or two or more currencies. The amount of repayment are often set equal in value at the exchange rates
FRNs Floating Rate Notes (FRNs) and their variants have been important innovations in the euro bonds
the perpetual FRNs are some of the variants of this instrument. Foreign Bonds (Japan). They are also bearer and unsecured bonds listed on domestic stock exchanges. They may be subscribed to by the domestic and overseas investors. Foreign Currency Convertible Bonds (FCCBs) are the
Foreign Capital Flows
22.7
specifying the rates at which they would be converted; interest and principal on them are paid in foreign currency. Note Issuance Facility (NIF): It is a funding arrangement which combines the features of a syndicated
Underwritten Multiple Component Facility (UMCF) and Uncommitted Euro Commercial Paper Facility (UEPF). The UMCF enables the borrower to switch between different markets to take the advantage of the
and tender panel system.
traded in the secondary market. Country Funds, ADRs, IDRs and GDRs Foreign Equity Investment: These can be obtained through abroad through the sale of straight equity or convertible bonds or bonds with warrants. The straight equity issues are made through International Depository Receipts (IDRs) and Global Depository Receipts (GDRs). An ADR i
traded on major US equity markets. A GDR in a foreign company. The shares are held by a foreign branch of an international bank. The shares trade as domestic shares but are offered for sale globally through various bank branches. American Depository Receipts (ADRs) are meant to facilitate public issues and trading in the United States. Global Depository Receipts (GDRs) are issued and traded in the euro market as well as in the United States. While both individual
All the depository receipts including GDRs are essentially equity instruments created or issued abroad not
22.8
Financial Institutions and Markets
say 1 GDR = 10 shares. The GDRs are bearer and negotiable securities; they can be redeemed at the price of the corresponding shares ruling on the date of redemption. They are traded on international markets. They
dollars (foreign currencies) at the going exchange rate. While the dividends are taxable (at 10 percent at
can then be traded on the local stock markets. The issue price of GDRs depends upon the market price of the underlying shares at the time of the issue. The services of the underwriters can be used for issuing EUROCLEAR. Global Depository Receipts facilitate greater awareness and enhanced image of the company in global
issue GDRs only as per the guidelines in force at different points of time. The holders of GDRs are entitled
about his intention and then cancels the GDRs. The depository then directs the custodian to release underlying
22.5 COMPONENTS OF FOREIGN CAPITAL IN INDIA
more
LO 4 Describe the components of foreign capital in India
than with an original maturity of 1 year or less
Multilateral Creditors: These are primarily multilateral institutions such as the International Development bank (ADB) and so on.
Foreign Capital Flows
22.9
Bilateral Creditors:
Trade Credits/Export Credits: These refer to loans and credits extended for imports directly by overseas suppliers’ credit or buyers’ credit. (i) Suppliers’ Credit extended by the overseas supplier of goods in the form of deferred payments. (ii) Buyers’ Credit
the concerned country. External Commercial Borrowings (ECBs):
Track I: Medium term foreign denominated ECB with Minimum Track II: of 10 years. Track III:
Track III it is same as Track I.2 NRI Deposits: to send capital to India through certain other forms of investment also. The following deposits schemes have
to exist. continues to be in force. withdrawn from 2006. August 1994. 2006.
2
For details please see RBI, External Commercial Borrowings (ECB) Policy—Revised framework, Circular No. 32, November 30, 2015
22.10
Financial Institutions and Markets
The features of currently existing different NRI deposit accounts are as follows (A) Non-Resident Ordinary Rupee Account (NRO Account) 1. Any person who is a resident outside India may open an NRO account with an authorised dealer or an
Reserve Bank of India.
4. Account should be denominated in Indian rupees.
applicable taxes.
holder may opt for nomination facility.
brought by him to India.
(B) Non-Resident (External) Rupee Account (NRE Account) maturity of minimum one year).
3
RBI, Facilities for Non Resident Indians (NRIs) and Persons of Indian Origin (PIOs), September 2014
22.11
Foreign Capital Flows
close relative shall be eligible to operate the account as a power of attorney holder in accordance with
4. Balances held in the NRE account are freely repatriable. 5. Accrued interest income and balances held in NRE accounts are exempted from income tax and wealth
`
certain types of refunds and so on.
Indian company and so on. 9. Loans can be extended against security of funds held in NRE account either to the depositors or third parties without any ceiling subject to usual margin requirements. 10. Such accounts can be operated through power of attorney in favour of residents for the limited purpose of withdrawal of local payments or remittances through normal banking channels to the account holder himself. (C) Foreign Currency Non Resident (Bank) Account: FCNR (B) Account 2. Foreign Currency Non Resident (B) Accounts are only in the form of term deposits of 1–5 years.
4. Account can be held in any freely convertible currency. 5. Loans can be extended against security of funds held in FCNR (B) deposit either to the depositors or third parties without any ceiling subject to usual margin requirements. 6. The interest rates are stipulated by the Department of Banking Operations and Development and
22.12
Financial Institutions and Markets
period shall be 6 months.
security of funds held in accounts and so on shall apply mutatis mutandis
the account as a power of attorney holder in accordance with extant instructions during the life time of The investment avenue for NRIs comprises Direct Investment Schemes (DISs) and a Portfolio Investment
the manufacturing sector on repatriation basis; (b) 100 percent equity investment in industries establishing
air taxi scheme on repatriation basis; (f) 40 percent equity participation in private banks on repatriation basis;
Rupee Debt: borne by the borrower exchange rate risk is borne by the creditor foreign currency (exports in case of rupee debt owed to Russia).This implies that the borrower gains (and the creditor loses) when the local currency depreciates since less has to be repaid in foreign currency terms and vice versa (i) Rupee Debt Union of Soviet Socialist Republic (USSR). The debt is denominated in rupees and repayment of such debt is made primarily through the export of goods to Russia. (ii) Rupee Denominated
viz
Account is categorised as an external debt liability since the principal amount held in such accounts as well as the interest accrued are repatriable. securities. . The external debt can also be divided into sovereign (government) and non-sovereign (non-government) debt. Sovereign debt includes (i) external debt outstanding on account of loans received by Government of India under the ‘external assistance
Foreign Capital Flows
22.13
debt includes the remaining components of external debt. Foreign Direct Investment (FDI):
a foreign company has set up a subsidiary in India and is conducting its business through that company. Starbucks partnering with Tata Global Beverages Limited is a recent example of FDI through joint venture. Foreign Institutional Investment (FII):
Difference between FDI and FII
production. It helps in increasing capital availability in general rather than enhancing the capital of a Investor. FDI not only brings in capital but also helps in good governance practices and better management skills and even technology transfer. Though the Foreign Institutional Investor helps in promoting good
production sharing contracts; risk service contracts; and international subcontracting.
22.6 TRENDS IN FOREIGN CAPITAL INFLOW 22.6.1 Foreign Debt
disbursements under ECBs rose from `
LO 5 Understand the trends in foreign capital inflow `
some hardening of domestic interest rates. Greater risk appetite of global investors for emerging market
22.14
Financial Institutions and Markets
elongation of maturity or repayment periods and is measured by the difference between the face value of a credit and the sum of the discounted future debt service payments. Different multilateral institutions
Table 22.1 throws interesting light on the level and composition of foreign debt of India. The external debt of `
Table 22.1 Types of and total external debt of India Type/Year
2001
2005
2006
2007
2008
2009
(` in billion) 2010
2011
2012
2013
2014
Multilateral
1451.05 1388.97 1455.03 1540.53 1579.01 2014.25 1934.36 2166.72 2570.89 2793.50 3207.92
Bilateral
745.19
745.30
703.02
700.34
788.02
0.00
45.03
43.78
44.84
44.79
51.88
272.64
281.63
315.28
324.39
382.11
276.25
219.76
241.75
312.37
412.96
737.72
760.11
831.12
971.17
964.06
917.92
IMF Trade credit
1049.97 1019.76 1149.04
1370.86 1363.96 1492.90
Commercial bor- 1138.39 1155.33 1179.91 1806.69 2492.43 3182.09 3192.21 4484.48 6146.23 7624.38 8807.40 rowings NRI deposits
772.73
1432.67 1618.34 1797.86 1746.23 2101.18 2170.62 2308.12 2998.40 3852.02 6241.01
Rupee debt
173.45
100.71
91.84
85.08
80.65
77.60
74.80
71.47
69.22
68.39
88.26
Total long-term 4557.06 5087.77 5333.67 6287.71 7144.09 9214.69 9424.50 11292.58 14442.05 16990.70 21137.53 debt Short-term debt 169.19
775.28
871.55
1226.31 1828.81 2206.56 2361.88 2901.49 3999.62 5259.30 5362.78
Gross total
4726.25 5863.05 6205.22 7514.02 8972.90 11421.25 11786.38 14194.07 18441.67 22250.01 26500.31
Concessional debt
1673.09 1799.96 1762.28 1728.22 1767.66 2135.77 1980.11
2114.92
2452.74 2469.75 2782.53
35.40
30.70
28.40
23.00
19.70
18.70
16.80
14.90
13.30
11.10
10.50
51.2
35.6
33.3
28.6
25.9
28.5
28.6
26.3
24
20.9
19.5
Share of private creditors
48.8
64.4
66.7
71.4
74.1
71.5
71.4
73.7
76.0
79.1
80.5
Share of government borrowings in total debt
43.4
35.6
33.3
28.6
25.9
24.9
25.7
24.6
22.7
19.9
18.8
Share of Nongovernment borrowings in total debt
56.6
64.4
66.7
71.4
74.1
75.1
74.3
75.4
77.3
80.1
81.2
Concessional debt as % of total debt creditors
Source: External Debt Management Unit, Ministry of Finance and RBI, Hand Book of Statistics
22.15
Foreign Capital Flows
country has been always higher than the bilateral debt. The concessional debt as a percentage of total debt creditors in total external debt has declined over the years (Table 22.1). The share of private creditors has increased from 48.8
mentioning that the share of rupee denominated debt in total external debt increased from 12.4 percent at securities and corporate debt instruments compared to earlier periods. Although in the absolute term the
Table 22.2 Currency composition of external debt Year
US dollar
SDR
Euro
Pound sterling
Others
12.4
10.1
5.8
2.9
1.0
14.1
11.9
10.2
5.7
2.9
0.9
15.2
17.3
10.7
6.2
3.0
1.0
40.5
15.5
22.7
11.6
5.8
3.4
0.5
2005
47.7
14.9
19.4
10.4
4.6
2.6
0.4
2006
48.8
14.3
18.8
10.9
4.4
2.6
0.2
2007
51.1
12.4
18.5
11.4
3.9
2.4
0.3
2008
55.3
10.6
16.2
12.0
3.5
2.2
0.2
2009
54.1
9.8
15.4
14.3
4.1
1.9
0.4
2010
53.2
10.7
18.7
11.5
3.6
1.8
0.5
2011
55.3
10.9
18.8
9.4
3.6
1.6
0.4
2012
56.9
8.7
20.5
8.3
3.7
0.9
1.0
2013
59.1
7.2
22.9
6.1
3.4
0.7
0.6
2014
61.1
6.8
21.8
5.0
3.3
1.1
0.9
2001
55
12.8
2002
54.3
2003
46.6
2004
Indian rupee Japanese yen
(Percentage)
Source: External Debt Management Unit, Ministry of Finance.
Table 22.3 External debt on government account under external assistance Year
Multilateral (US$ Million)
Bilateral (US$ Million)
Total (UD$ Million)
Total external assistance to total debt (%)
2001
27417
13310
40727
86.17
2006
29997
13513
43510
70.11
2007
32515
13640
46155
61.42
2008
36171
16370
52541
58.55 (Contd.)
22.16
Financial Institutions and Markets
2009
35724
16092
51816
45.36
2010
37825
17410
55235
46.86
2011
42579
19716
62295
43.88
2012
43686
19688
63374
34.36
2013
43539
17797
61336
27.56
2014
44598
17606
62204
23.47
Source: External Debt Management Unit, Ministry of Finance.
Table 22.4 Outstanding amount of various types of NRI deposits Year
NR(E)RA
1991
70.40
1996 1997
FCNR(A)
(` in billion)
FCNR(B)
NR(NR)RD
FC(B&O)D
FC(O)N
Total
198.45
—
—
5.15
—
274.00
134.52
146.16
196.48
121.66
—
0.45
599.27
178.86
82.82
269.06
201.16
—
0.14
732.04
1998
222.67
0.04
334.45
247.35
—
0.09
804.60
1999
256.29
—
332.22
280.58
—
—
869.09
2000
294.65
—
356.32
294.47
—
—
945.44
2001
333.57
—
423.57
319.66
—
—
1076.80
2002
412.05
—
471.75
343.92
—
—
1227.72
2003
711.84
—
486.51
162.53
—
—
1360.88
2004
929.77
—
495.72
78.95
—
—
1504.44
2005
931.59
—
501.08
10.15
—
—
1442.82
2006
984.43
—
582.72
—
51.19
—
1618.34
2007
1067.86
—
659.55
—
70.47
—
1797.88
2008
1068.24
—
566.51
—
111.48
—
1746.23
2009
1191.81
—
668.03
—
241.34
—
2101.18
2010
1189.84
—
646.25
—
334.53
—
2170.61
2011
1178.02
—
696.58
—
433.52
—
2308.12
2012
1606.84
—
765.76
—
625.80
—
2998.40
2013
2497.80
—
826.08
—
528.14
—
3852.02
2014
3179.73
—
2513.54
—
547.74
—
6241.01
Source: RBI, Handbook of Statistics, 2014. Note: DSR = Debt Service Ratio; ISR = Interest Service ratio; DGDP = Debt to Gross Domestic Product ratio; STD = ShortTerm Debt; TD = Total Debt; FER = Foreign Exchange Reserves.
abroad on which India earns a low rate of return. The servicing of IMDs has become a problem. This suggests
Foreign Capital Flows
22.17
`6241.01 billion
as favourable economic conditions in the source regions of such deposits. Debt service payments have shot up sharply since 2011–2012. Debt service ratio showed a sharp decline
(Table 22.5). ECB forms a major part of debt service payments. Implicit interest rate on total external debt is estimated by taking interest payments during the year as a percentage of the outstanding debt at the end Table 22.5
India’s external debt service payments
Year
External assistance
ECB
1990–1991
2315
1995–1996
3691
1997–1998 1998–1999 2001–2002 2005–2006
(US$ million)
IMF
NRI deposits
Rupee debt
Total
Debt service ratio
3414
778
1282
1193
8982
35.3
5248
1860
1247
952
12998
26.2
3229
4934
667
1807
767
11404
23.0
3270
5070
419
1643
802
11204
19.5
3225
5563
0
1413
474
10675
18.7
2652
14839
0
1497
572
19560
10.1
2006–2007
2942
6331
0
1969
162
11404
4.7
2007–2008
3241
9771
0
1813
122
14947
4.8
2008–2009
3384
10543
0
1547
101
15575
4.4
2009–2010
3461
14742
0
1599
97
19899
5.8
2010–2011
3667
13959
0
1737
69
19432
4.4
2011–2012
3923
25198
0
2313
79
31513
6.0
2012–2013
4255
23240
0
3778
58
31331
5.9
2013–2014
4078
23398
0
4784
57
32317
5.9
Source: External Debt Management Unit, Ministry of Finance.
implicit interest rate on external commercial borrowings also witnessed marginal moderation from the year
22.18
Financial Institutions and Markets
Table 22.6 Implicit interest rates on India’s external debt (percentage) Year
Total debt
External assistance
External commercial borrowings
NRI deposits
2001
4.5
2.3
5.9
12.3
2002
4.3
2.4
4.4
10.9
2003
3.8
2.5
3.6
8.2
2004
4.3
1.7
8.2
7.1
2005
2.7
1.6
3.5
4.3
2006
3.9
1.5
9.5
4.6
2007
4.0
2.1
7.8
5.4
2008
3.9
2.3
7.5
4.4
2009
2.9
1.8
5.6
3.5
2010
2.5
1.5
4.2
3.9
2011
2.3
1.3
4.3
3.6
2012
2.8
1.1
5.0
4.5
2013
3.2
1.2
5.0
6.4
2014
2.7
1.1
4.1
6.8
Source: External Debt Management Unit, Ministry of Finance.
external debt situation is comfortable; India is unlikely to fall in debt crisis or debt trap. The solvency ratios
Table 22.7 Indicators of debt sustainability for India (percentage) Year
Solvency indicators
Liquidity indicators
DSR
ISR
DGDP
STD/TD
STD/FER
1991
35.3
15.5
28.7
10.2
92.67
1992
30.2
13.0
38.7
8.3
71.91
1993
27.5
12.5
37.5
7.0
32.93
1994
25.4
10.5
33.8
3.9
14.4
1995
25.9
9.7
30.8
4.3
19.68
1996
26.2
8.8
27.0
5.4
19.05
1997
23.0
7.3
24.6
7.2
22.9
1998
19.5
7.5
24.3
5.4
15.53
1999
18.7
7.8
23.6
4.4
11.24
2000
17.1
7.3
22.0
4.0
9.309
2001
16.6
6.6
22.5
3.6
6.705
2002
13.7
5.4
21.1
2.8
3.607 (Contd.)
22.19
Foreign Capital Flows 2003
16.0
4.1
20.3
2004 2005
4.5
4.133
16.1
—
18.0
3.9
5.9
2.5
18.1
13.2
2006
10.1
2.8
16.8
14.0
2007
4.7
2.3
17.5
16.3
2008
4.8
—
18.0
20.4
18.65
2009
4.4
—
20.3
19.3
17.69
2010
5.8
—
18.2
20.1
17.17
2011
4.4
—
18.2
20.4
22.08
2012
6.0
—
20.5
21.7
26.77
2013
5.9
—
22.0
23.6
31.78
2014
5.9
—
23.3
20.3
26.12
3.131 11.69 9.808 9.082
Note: DSR = Debt Service Ratio; ISR = Interest Service ratio; DGDP = Debt to Gross Domestic Product Ratio; STD = ShortTerm Debt; TD = Total Debt; FER = Foreign Exchange Reserves Source: External Debt Management Unit, Ministry of Finance.
has the lowest ratio among all the countries (Table 22.8). Table 22.8 Total debt to gross national income of select countries Country
2003
2004
2005
2008
2009
2013
India
22
17.9
15.4
19
18.2
23
China
15
12.9
12.5
8.7
8.7
9.5
Brazil
50
38.0
24.4
16.2
17.9
21.9
Mexico
23
20.8
22.1
19.1
22.3
35.9
104
117.4
64.6
39.9
40.1
22.7
50
38.0
—
28.7
31.3
22.8
Argentina Pakistan
Source: External Debt Management Unit, Ministry of Finance.
22.7 FOREIGN EQUITY INVESTMENT INFLOWS
22.20
Financial Institutions and Markets
` in crore) Year
Direct Investment
Portfolio Investment
Total
1990–1990
174
11
185
1991–1992
316
10
326
1992–1993
965
748
1713
1993–1994
1838
11,188
13,026
1994–1995
4126
12,007
16,133
1995–1996
7172
9197
16,364
1996–1997
10,015
11,758
21,773
1997–1998
13,220
6696
19,916
1998–1999
10356
–256
10,101
1999–2000
9338
13112
22,450
2000–2001
18,404
11,820
30,224
2001–2002
29,245
9290
38,535
2002–2003
24,397
4504
28,901
2003–2004
19,830
51,898
71,728
2004–2005
26,947
41,312
68,259
2005–2006
39,457
55,357
94,814
2006–2007
102,652
31,881
134,533
2007–2008
139,421
110,619
250,040
2008–2009
190,645
–65,045
125,600
2009–2010
157,819
153,967
311,786
2010–2011
132,358
139,381
271,739
2011–2012
154,961
85,571
240,532
2012–2013
146,954
146,467
293,421
2013–2014
186,830
29,680
216,510
Note: Data from 2013–2014 are provisional. Source: RBI, Handbook of Statistics, 2014.
by reinvestment earnings and acquisition of shares investments. The major components of foreign portfolio
Foreign Capital Flows
Items
22.21
2000– 2001
2003– 2004
2004– 2005
2005– 2006
2006– 2007
2007– 2008
2008– 2009
2009– 2010
2010– 2011
2011– 2012
2012– 2013
(A) Direct Investment (I + II + III)
4,029
4,322
6,051
8,961
22,826
34,835
41,874 37,745
32,901
46,553
36,046
(I) Equity
2400
2229
3778
5975
16,481
26,864
32,066 27,146
20,304
35,854
25,274
1456
928
1062
1126
2156
2298
454
534
1258
2233
7151
17,127
(a) Government (b) RBI (c) NRI (d) Acquisition
(III) Other capital + (B) Portfolio investment (a + b + c) (a) GDR/ADR (b) FIIs (c) Offshore funds and others Total (A + B)
5400
1945
3046
1185
12,994
20,427
14,869
67
—
—
—
—
—
—
—
—
—
362
735
930
2181
6278
5148
4632
3148
4491
11,360
8245
2291
702
1540
874
1,021
975
7679
9032
8668
11,939
8,205
8978
292
776
1931
658
2494
1794
27,271 –13,855 32,376
31,471
17,171
4822
(e) Equity capital of unincorporated bodies (II) Reinvestment earnings +
3471
21,332 18,987
61
32
528
435
896
1350
1460
1904
2760
5828
279
633
369
226
517
2760
11,377
9315
12,492
7003
831
459
613
2552
3776
1847
10,918
8686
9926
3225
298
4308
4955
6420
9187
23,343
62,106
6645
—
3328
2049
597
20
20,328 –15,017 29,048
1162
29,422
16,813
5009
—
—
—
—
28,019 70,121
64,372
63,724
40,868
—
Source: RBI, Bulletin, Various Issues
Table 22.11
Foreign direct and portfolio investment to selected countries
Country
Foreign direct investment (FDI) 2000
India
2005
2010
2011
(US$ billions)
Foreign portfolio investment (FPI)
2012
2013
2000
2005
2010
2011
2012
2013
3.58
7.27
27.40
36.50
24.00
28.15
2.35
12.15
30.44
–4.05
22.81
19.89
Argentina
10.42
5.27
7.85
10.72
15.32
11.39
–3.22
–0.05
–0.21
–0.17
0.88
0.46
Brazil
32.78
15.46
53.34
71.54
76.11
80.84
3.08
6.45
37.67
7.17
5.60
11.64
Chile
4.86
6.98
15.73
23.44
28.54
20.26
–0.43
1.57
1.76
4.65
5.64
6.03
China
38.40
111.21
6.91
20.57
31.36
5.31
29.90
32.59
Indonesia
–4.55
8.34
15.29
20.56
21.20
23.34
–1.02
–0.17
2.13
–0.33
1.70
–1.83
Malaysia
3.79
3.92
10.89
15.12
9.73
11.58
0.00
–1.20
Mauritius Mexico
272.99 331.59 295.63 347.85
0.26
0.04
0.43
0.43
0.59
0.26
0.00
0.04
7.82
5.92
0.52
0.71
17.77
24.74
25.90
23.63
18.13
42.09
0.45
3.35
0.37
–6.57
9.88
–0.94 (Contd.)
22.22
Financial Institutions and Markets
Philippines
2.24
1.66
1.07
2.01
3.22
3.66
–0.20
0.42
0.83
1.04
1.75
–0.03
Russian Federation
2.71
15.51
43.17
55.08
50.59
70.65
0.15
–0.16
–4.89
–9.80
1.16
–7.63
South Africa
0.97
6.52
0.11
0.10
0.11
0.11
4.17
7.23
5.83
–3.77
–0.68
1.01
Thailand
3.37
8.06
9.10
3.87
10.69
12.65
0.90
5.12
3.21
–0.41
2.66
–6.49
Source: Global Development Finance, World Bank Online
` their gross sales were ` ` `
while such investment was negative (`
Table 22.12 Volume of FII investments in India Year
Gross purchase (` crore)
Gross sales (` crore)
Net investments(+) or net sales(–)
Net investments (US$ million)
Cumulative net investments (US$ million)
1992–1993
18
4
13
4
4
1993–1994
5593
467
5127
1634
1638
1994–1995
7631
2835
4796
1528
3167
1995–1996
9694
2752
6942
2036
5202
1996–1997
15,554
6980
8575
2432
7635 9285
1997–1998
18,695
12,737
5958
1650
1998–1999
16,116
17,699
–1584
–386
8899
1999–2000
56,857
46,735
10122
2474
11,372
2000–2001
74,051
64,118
9933
2160
13,531
2001–2002
50,071
41,308
8763
1839
15,371
2002–2003
47,062
44,372
2689
566
15,936
2003–2004
144,855
99,091
45764
10,005
25,942
2004–2005
216,951
171,071
45,880
10,352
36,293
2005–2006
346,976
305,509
41,467
9363
45,657
2006–2007
520,506
489,665
30,841
6821
52,477
2007–2008
948,018
881,839
66,179
16,442
68,919
2008–2009
614,576
660,386
–45,811
–9837
59,082
2009–2010
846,433
703,776
142,658
30,252
89,333
2010–2011
992,596
846,158
146,438
32,226
121,559
2011–2012
921,285
827,562
93,725
18,923
140,482
2012–2013
904,845
736,481
168,367
31,047
171,529
Source: SEBI, Handbook of Statistics -2009, 2014.
22.23
Foreign Capital Flows
Table 22.13 Investments by foreign institutional investors in terms of debt and equity (` in crore) Year
Equity
Debt
Equity as a % of Total
Debt as a % of Total
Total
1992–1993
13
0
100.00
0.00
13
1993–1994
5,127
0
100.00
0.00
5127
1994–1995
4796
0
100.00
0.00
4796
1995–1996
6942
0
100.00
0.00
6942
1996–1997
8546
29
99.66
0.34
8575
1997–1998
5267
691
88.40
11.60
5958
1998–1999
–717
–867
45.27
54.73
–1584
1999–2000
9670
453
95.53
4.48
10,122
2000–2001
10207
–273
102.76
–2.75
9933
2001–2002
8072
690
92.11
7.87
8763
2002–2003
2527
162
93.98
6.02
2689
2003–2004
39,960
5805
87.32
12.68
45,765
2004–2005
44,123
1759
96.17
3.83
45,881
2005–2006
48,801
–7334
117.69
–17.69
41,467
2006–2007
25,236
5,605
81.83
18.17
30,840
2007–2008
53,404
12,775
80.70
19.30
66,179
2008–2009
–47,706
1895
104.14
–4.14
–45,811
2009–2010
110,221
32,438
77.26
22.74
142,658
2010–2011
110,121
36,317
75.20
24.80
146,438
2011–2012
43,738
49,988
46.67
53.33
93,726
2012–2013
140,033
28,334
83.17
16.83
168,367
2013–2014
79,709
–28,060
154.33
–54.33
51,649
Source: SEBI, Annual Report, 2013.
Foreign Investment in India is governed by the FDI policy announced by the Government of India and the provision of the Foreign Exchange Management Act (FEMA) 1999. The Reserve Bank of India (RBI) in this
Government of India is the nodal agency for monitoring and reviewing the FDI policy on continued basis and
22.24
Financial Institutions and Markets
prior approval from the RBI or Foreign Investment Promotion Board (FIPB) would be required.
throughout the period (Table 22.14). The major percentage of FDI was coming to India through the
Country
2003– 2004
2004– 2005
2005– 2006
2006– 2007
2008– 2009
2009– 2010
2010– 2011
2011– 2012 P
2012– 2013 P
Cumu- Percentlative age
Mauritius
381
820
1363
3780
10,165
9801
5616
8142
8059
48127
34.94
U.S.A
297
469
346
706
1236
2212
1071
994
478
7809
5.67
UK
157
84
261
1809
690
643
538
2760
1022
7964
5.78
Singapore
15
64
166
582
3360
2218
1540
3306
1605
12856
9.33
Germany
69
143
45
116
611
602
163
368
467
2584
1.88
Netherlands
197
196
50
559
682
804
1417
1289
1700
6894
5.01
Japan
67
122
86
80
266
971
1256
2089
1340
6277
4.56
France
34
44
12
100
437
283
486
589
547
2532
1.84
5
64
68
57
135
96
133
211
268
1037
0.75 0.73
Switzerland South Korea Total FDI
22
14
61
68
95
159
136
226
224
1005
1462
2320
3359
9307
22,697
22,461
14,939
23,473
18,286
118304
—
Note: ‘P’ refers to provisional. Source: RBI, Various Publications
(values are in percent except cumulative total)
Year
Government (SIA/FIPB)
RBI (Automatic route)
Acquisition of shares*
Equity capital of unincorporated bodies #
1990–1991
Cumulative total (US$ millions) —
1991–1992
51.16
0.00
48.84
0.00
129
1992–1993
70.48
13.33
16.19
0.00
315
1993–1994
47.78
15.19
37.03
0.00
586
1994–1995
53.35
13.01
33.64
0.00
1314
1995–1996
58.26
7.88
33.86
0.00
2144 (Contd.)
22.25
Foreign Capital Flows 1996–1997
68.13
4.79
27.08
0.00
2821
1997–1998
77.42
5.68
16.90
0.00
3557
1998–1999
73.96
7.27
18.77
0.00
2462
1999–2000
65.43
7.94
26.64
0.00
2155
2000–2001
60.67
18.92
17.88
2.54
2400
2001–2002
54.24
18.73
22.37
4.66
4095
2002–2003
33.25
26.74
33.14
6.87
2764
2003–2004
41.63
23.96
32.97
1.44
2229
2004–2005
28.11
33.30
24.62
13.98
3778
2005–2006
27.75
33.27
32.50
6.48
6,711
2006–2007
13.08
43.39
38.09
5.44
16,481
2007–2008
8.55
63.75
19.16
8.53
26,864
2008–2009
16.84
66.53
14.45
2.19
32,066
2009–2010
12.79
69.94
11.60
5.67
27,146
2010–2011
8.74
58.40
28.93
3.93
22,250
2011–2012
8.50
56.97
31.68
2.85
35,856
2012–2013
10.14
69.77
15.46
4.63
22,884
2013–2014
4.69
58.83
32.62
3.86
25,274
2014–2015
6.79
61.30
28.87
3.04
17,665
Note: * Acquisition of shares—It relates to acquisition of shares of Indian companies by non-residents. Source: RBI, Various publications
2006– 2007
2007– 2008
2008– 2009
2009– 2010
2010– 2011
2011– 2012 P
2012– 2013 P
Cumula- Percenttive Total age
Manufacture
1641
3726
4777
5143
4793
9337
6528
35945
27.53
Construction
967
2551
2237
3516
1599
2634
1319
14823
11.35
Financial Services
1,330
3850
4430
2206
1353
2603
2760
18532
14.19
Real Estate Activities
431
1336
1886
2191
444
340
197
6825
5.23
Electricity and other Energy Generation, Distribution & Transmission
174
829
669
1877
1338
1395
1653
7935
6.08
(Contd.)
22.26
Financial Institutions and Markets
Communication Services
423
66
2067
1852
1228
1458
92
7186
5.50
2425
1158
643
1554
569
1590
643
8582
6.57
Miscellaneous Services
298
1901
1458
888
509
801
552
6407
4.91
Computer Services
824
1035
1647
866
843
736
247
6198
4.75
Restaurants & Hotels
153
280
343
671
218
870
3129
5664
4.34
Retail & Wholesale Trade
47
200
294
536
391
567
551
2586
1.98
Mining
42
461
105
268
592
204
69
1741
1.33
Business Services
165
816
401
220
344
410
213
2569
1.97
Trading
82
176
400
198
156
6
140
1158
0.89
Education, Research & Development
43
156
243
91
56
103
150
842
0.64
9307
19,425
22,697
22,461
14,939
23,473
18,286
130,588
Transport
Total FDI
Source: RBI, Various Publications.
allowed by the authorities at present. These limits were raised to 100 percent in the case of sectors such
At present automatic approvals route for 100 percent FDI into equity shares or convertibles for NRIs is (i) The industry in which FDI is planned does not require industrial license as per license rules. (ii) The shares or convertibles are not issued to acquire another Indian Company. (iii) Investors wishing to take over completely or wishing to have a collaboration need to take central (iv) The issue price should not be less than SEBI price in case of listed companies.
marketing; (e) Housing and real estate development; (f) Venture capital funds and venture capital companies; (g) Companies investing in infrastructure and service sectors; (h) Atomic energy and related projects; (i)
Foreign Capital Flows
22.27
Table 22.17 Current permitted FDI limits in different sectors
1. 1.(a) 2. 2.(b) 3.
Sector
Limit (%)
Agriculture & Animal Husbandry
100%
Tea plantation
100%
Mining
100%
Coal and lignite
100%
Petroleum & Natural Gas
100%
3.(b)
49% without any disinvestment or dilution of domestic equity in the existing PSUs.
4.
Defence
49%
5.
Broad casting carriage services
74%
5.(a)
Cable networks
49%
5.(b)
Broadcasting content services (terrestrial broadcasting FM/Uplinking of ‘news and current affairs’ TV channels)
26%
5.(c)
Up-linking of Non-‘news and current affairs’ TV channels/downlinking of TV channels
100%
6.
Print media (publishing of newspaper and periodicals dealing with news and current affairs/publication of Indian editions of foreign magazines dealing with news and current affairs)
26%
6.(a)
100% journals/periodicals/publication of facsimile edition of foreign newspapers Airports
100%
7.(a)
7.
Scheduled air transport service/domestic scheduled passenger airline
49% FDI (100% for NRIs)
7.(b)
Non-scheduled air transport service
74% FDI (100% for NRIs)
7.(c)
Helicopter services/seaplane services requiring DGCA approval
100%
8.
Satellites-establishment and operation
74%
9.
Private security agencies
49%
10.
Telecom services
100%
11.
E-commerce activities
100%
12.
Single brand product retail trading
100%
12.(b)
Multi brand retail trading
51%
13.
Asset reconstruction companies
100% of paid-up capital of ARC (FDI + FII/ FPI)
14.
Banking—Private sector
74% including investment by FIIs/FPIs
14.(b)
Banking—Public sector
20% (FDI and Portfolio Investment)
Commodity exchange
49% (FDI + FII/FPI) [Investment by registered FII/FPI under Portfolio Investment Scheme (PIS) will be limited to 23% and investment under FDI Scheme will be limited to 26% ]
15.
(Contd.)
22.28
Financial Institutions and Markets
16.
Credit information companies
74% (FDI + FII/FPI)
17.
Infrastructure company in the securities market
49% (FDI + FII/FPI) [FDI limit of 26 percent and FII/FPI limit of 23 percent of the paidup capital ]
18.
Insurance
26% (FDI + FII/FPI + NRI)
19.
100%
20.
Pharmaceuticals
100%
21.
Power exchanges
49% (FDI + FII/FPI)
Source: Ministry of DIPP, FDI Manual
22.8 FDI IN THE RETAIL SECTOR IN INDIA LO 6 Review FDI in the retail sector in India the state governments to allow or not to allow the FDI in retail sector in their states.
22.8.1 Single Brand Retailing4 1. Foreign Investment in single brand product retail trading is aimed at attracting investments in increased sourcing of goods from India and enhancing competitiveness of Indian enterprises through
retail withholding the FDI in multi brand retail due to various political reasons.
under the same brand in one or more countries other than India. manufacturing.
through a legally tenable agreement with the brand owner for undertaking single brand product retail trading. The onus for ensuring compliance with this condition will rest with the Indian
4
http://dipp.nic.in/English/policies/FDI_Circular_2015.pdf.
Foreign Capital Flows
22.29
approval.
which the company will be required to maintain. This procurement requirement would have to be
which proposes to undertake single brand retail trading in India would be made to the Secretariat for Industrial Assistance (SIA) in the Department of Industrial Policy & Promotion. The applications
categories proposed to be sold except food products would be provided to the RBI. 4. Applications would be processed in the Department of Industrial Policy & Promotion to determine for government approval.
22.8.2 Multi Brand Retailing5
5
http://dipp.nic.in/policies/FDI_Circular_2015.pdf.
22.30
Financial Institutions and Markets
have to be met on an annual basis.
(vi) Retail sales outlets may be set up only in cities with a population of more than 10 lakh as per 2011
will be made for requisite facilities such as transport connectivity and parking.
policy.
for Government approval.
Implications of FDI in Retail Sectors: An Indian Scenario
the entry of foreign retailers will have an effect on different stakeholders both on the demand side as well
Foreign Capital Flows
22.31
government agents. The net effects are in terms of increase (or decrease) of total surplus of the system.
addressed adequately. The retail sector is the second largest employer in India; the primary issue is to retain the existing players and enabling them to earn their livelihood or accommodating them appropriately.
of business toa new system where all players can operate in a single platform. It is also postulated that the lot.
22.9 SOVEREIGN WEALTH FUND (SWF)
funded by foreign exchange assets. SWFs can be structured as a fund or as a reserve investment corporation. Some funds also invest indirectly in domestic thus they have a higher risk tolerance than traditional foreign exchange reserves.
LO 7 Discuss the benefits, issues and development of sovereign wealth funds
entities from foreign exchange reserves held by central banks. The former can be characterised as maximising central banks in recent years possess reserves massively in excess of needs for liquidity or foreign exchange
assertion. Some central banks even have begun buying equities or derivatives. SWFs are a heterogeneous group and may serve various purposes. Five types of SWFs can be distinguished
22.32
Financial Institutions and Markets
the opportunity costs of reserves holdings. The growth of SWFs has also raised several issues. In addition investment strategies—they also raise the issue of the expanded role of governments in international markets
22.9.2 Development of SWFs
in the future. Current fund projections show that some sovereigns will continue to accumulate foreign assets as a result of large and persistent current account surpluses. An important point to note is the ‘SWF to Foreign
Foreign Capital Flows
22.33
Table 22.18 Largest SFWs by assets under management (as on December 2015) Country
SWF name
Assets under management US$billion
Inception
Origin
1. Norway
Government Pension Fund
847.6
1990
Oil
2. UAE
Abudhabi Investment Authority
792
1976
Oil
3. China
China Investment Company
746.7
2007
4. Soudi Arabia
SAMA Foreign Holdings
598.4
NA
Oil
5. Kuwait
Kuwait Investment Authority
592
1953
Oil
6. China
SAFE Investment Company
474
1997
Non-commodity
7. Hong Kong
Hong Kong Monetary Authority Investment Portfolio
442.4
1993
Non-commodity
8. Singapore
Government of Singapore Investment Corporation
344
1981
Non-commodity
9. Qatar
Qatar Investment Authority
256
2005
Oil and Gas
236
2000
Non-commodity
10. China
National Social Security Fund
Others
1927.7
Total
7256.8
Non-commodity
Table 22.19 Assets under SWF across sector and region (percentage to total) 2010
2015
Across the sectors (%) Investment in oil and gas-related activities
55.21
57.03
Others
44.79
42.97
Region wise (%) Middle East
39.06
40.24
Asia
39.76
39.74
Europe
15.08
13.11
America
2.7
2.8
Africa
1.8
2.7
Others
1.6
1.4
Source:
22.9.3 Some Facts about SWFs
SWFs have been largely conservative investors. with considerable stakes in equities and a wider geographical dispersion.
22.34
Financial Institutions and Markets
markets. (iv) There is no clear evidence that SWF investments have been motivated by narrow political objectives.
external stability.
large SWFs may have an interest in pursuing portfolio reallocations gradually so as to limit adverse
as highly leveraged and there is little evidence of sudden shifts in portfolio allocations. in which they could cause volatility in markets. (viii) The shift from reserve assets to SWFs could have implications for the absolute and relative price of
Objectives and Investment Strategy: The standard should establish the presumption that the international
to think that an investment strategy should be etched in stone although principles of sound public policy Governance: The standard should set out clearly the role of the government and the managers of the arrangements. To the extent that the international investment mechanism is making anything other than governance should be enunciated and followed. Responsibility for ensuring compliance with those guidelines
Foreign Capital Flows
22.35
Transparency: The operations of the investment mechanisms should be as transparent as possible.
should involve at least annual reports and preferably quarterly reports. It would be desirable to have actual investments. It would also be desirable subject to independent audits. Behaviour: guidelines might cover the scale and rapidity with which the entity adjusts its portfolio. They might also create the presumption of consultation with the relevant countries with respect to the allocation among assets denominated in different currencies or located in different countries.
will be made from time to time along with higher overall returns. The aim is to prevent misunderstandings
22.9.4 SWFs and India
recently been taken after considerable deliberations. An announcement was made by the Finance Minister
22.36
Financial Institutions and Markets
projects for capital expenditure outside India without creating any monetary impact. The lending by the SPV under the arrangement would be treated as external commercial borrowings (ECB) and would be subject to
balance sheet.
22.10 DRAWBACKS OF FOREIGN CAPITAL Micro-Economic Distortions and Macro-Economic Instability: Foreign
externalities associated with country risk and the credit rationing tend to
LO 8 Show the drawbacks of foreign capital
production.6 There is enough evidence and experience to show that not all international lending has been carried out with
Volatility:
6
Ferandez Arias, E; and Montiel P J, ‘The Surge in Capital Inflows to Developing Countries: An Analytical Overview’, The World Bank Economic Review, January 1996.
Foreign Capital Flows
22.37
and serious BOP crisis. The increased uncertainty and risk due to all this instability leads to a fall in the productive investment.
with respect to the external shocks and the internal policies. Attempts to reduce the capital account volatility per se.8 Monetary Policy: regulatory authorities about taming the global money. The international capital markets have come to deal in
Economic Cost:
shift in the motivation of the suppliers of capital. This is an important reason for exercising utmost restraint while seeking to raise funds abroad. Non-Economic Costs: but conveniently forgotten that the foreign capital creates a large number of very serious problems of foreign
practices in foreign markets keep on changing which increases the information costs.
The theoretical merits of the foreign equity vis-a-vis the debt capital are hardly experienced in practice; its very few advantages are easily surpassed by its many disadvantages. There is much serious evidence against concerned about the increasing holdings of the FIIs in the companies. Associations such as the FICCI and the CII have raised a strong voice against the growing hold of the FIIs. They have cautioned the Indian
7
Carbo, V and Hernandez, L, ‘Macroeconomic Adjustment to Capital Inflows: Lesson from Recent Latin American and East Asian Experience’, World Bank Research Observer, February 1996. 8 Claessen, S, and others, ‘Portfolio Capital Flows: Hot or Cold?’ World Bank Economic Review, January 1995; and Bhole L M, Financing of Private Corporate Sector, In India, Himalaya Publishing House, Mumbai, 2000.
22.38
Financial Institutions and Markets
the expansion of the international equity markets and the growth in their interdependence has increased the risk of spreading shock waves from one market to another at an incredible speed.
SUMMARY ◆
superior physical and managerial technology. ◆
private commercial debt and equity capital. ◆
◆
for India. ◆
◆
◆
debt. ◆
investment. ◆
setting up a wholly subsidiary or getting into a joint venture for the business. ◆
company that is listed in hosting country or in bonds offered by the hosting country. ◆
◆
The multilateral external debt of India has been always higher than the bilateral debt.
◆ ◆
service burden of the country is increasing. ◆
◆
◆
them contributes to total deposits more or less equally. On the basis of certain indicators of debt sustainability for India it has been argued that her external debt situation is comfortable; India is unlikely to fall in debt crisis or debt trap.
Foreign Capital Flows
22.39
◆ ◆
◆
KEY TERMS Foreign capital World Bank International Monetary Fund Asian Development Bank Bank for International Settlement
New Development Bank Global depository receipt American depository receipt Euro issues External commercial borrowings
Foreign direct investment Foreign institutional investment Trade credit External assistance Sovereign wealth fund
QUESTIONS 1. How has the foreign capital been used for the economic development and what are its major determinants? 2. What are the different sources through which the foreign capital is available? and BIS which supply foreign capital for different purposes. foreign capital can be mobilised. 5. Analyse the trends in components of foreign capital in India? 6. What is the difference between FDI and FII?
9. What are the debt sustainability indicators and present the synoptic view of this for India? 10. Highlight the different policy measures taken to increase the FDI in India.
(a) (b) (c) (d) (e)
Foreign direct investment Foreign institutional investment Concessional debt Euro issues Sovereign wealth fund
Part 7 Interest Rates This part is devoted to comprehensive and in-depth analysis of determination of interest rates.
CHAPTERS 23. Theories of the Level and Structure of Interest Rates 24. Interest Rates in India
Theories of the Level and Structure of Interest Rates
23
CHAPTER
Learning Objectives LO 1 LO 2
Know the level of interest rates Understand the structure of interest rates
LO 3 LO 4 LO 5
Explain the theories of the term-structure of interest rates Discuss other factors affecting term-structure of interest rates Review the determinants of the general structure of interest rates
23.1 INTRODUCTION The working of various parts of the money market and capital market has been discussed in the previous
picture of the behaviour of interest rates in respect of their level and inter-relationship may emerge. This and next chapter is devoted to this task. The theories of the level and structure of interest rates will be discussed in this chapter, and the behaviour of interest rates in India over a period of about 40 years will be analysed in the next chapter. Although economists are fond of talking of the rate of interest in the economy, actually there are a bewildering
as bank rate, treasury bill rate, call rate, hundi rate, bazar bill rate, short deposit rates, commercial bill rate, public deposit rates, term loans rate, yield rate on government securities, industrial debenture yield, UTI dividend rate, yield on ordinary shares, and so on. There are also various concepts like the ceiling rate of interest, coupon rate, yields such as income yield, running yield, market yield, redemption yield, earnings yield, dividend yield, gross yield, net yield, and so on. The ceiling rate refers to the maximum rate of interest
rare, although it may not be altogether absent. For example, in the U.S., the rate of interest on government
23.4
redemption) that is subjected to a ceiling. The coupon rate which is also known as the ‘bond rate’ is the rate of interest stated and paid on the face value
yield or market yield or current yield) is the annual interest payment as a proportion of the market price of
and earnings yield are concepts usually used in evaluating investment in ordinary shares. The dividend yield while earnings yield is the distributable earnings per share of the company as a proportion of the market price
available to the investor.
23.2 LEVEL OF INTEREST RATES Interest is the price the borrowers must pay to lenders to obtain the use of money for a period of time. As all the other prices are determined in different markets, the equilibrium rate of interest is also determined by the forces of supply and
LO 1 Know the level of interest rates
for what? Different people have answered this question differently which has given rise to different theories
23.2.1 The Classical Theory This theory is associated with the names of Ricardo, Hume, Fisher and others. It is a static theory, and, according to it, the rate of interest is a real phenomenon in the sense that it is determined by the real factors. It is the supply of savings and the demand for investment that determine the equilibrium rate of interest. The aggregate saving is the difference between the total national income and the total consumption expenditure. The savings may be affected by individuals, households, business and the government. Given the current income, there is a natural or normal tendency on the part of economic units to spend that income on current or present consumption that is there is a time preference in favour of present rather than future consumption. now is valued more than the money next year.
23.5
savings. Interest rates are intimately involved with the role of time in economic activities and in the lives of economic units. They arise out of, and in a sense they measure, the preference for the present over future. Irving Fisher, particularly, emphasised time preference or impatience or waiting or abstinence as a factor limiting the supply of saving. If people did not care about time, they would save more of their incomes so long as interest rate was positive. The existence of time preference is necessary to explain the existence of the interest. For greater savings, higher rate of interest needs to be offered. There would be no saving at zero rate of interest, and greater and greater saving could be induced by offering higher and higher interest rates. investment takes place because by investing in roundabout or indirect methods or processes of production, consumption. The opportunities, to produce more effectively by using roundabout methods of production, determine investment demand. While the saving schedule is upward sloping, the investment schedule is downward sloping. The equilibrium rate of interest is determined by the interaction of these savings and investment schedules in the economy. The classical view thus ‘regards interest as determined by demand and supply, the productivity of capital goods providing the main elements of demand and the supply of capital being limited by the reluctance to abstain from current consumption and do more saving’1. The rate of interest so determined is variously known as the ‘natural rate’, ‘full-stock equilibrium rate’, ‘classical real rate’ and ‘true real rate’. In a static situation, this rate is not affected by the level of money and prices because changes in the quantity of money lead to a proportionate change in all prices, leaving the percentage ratio of money yield to money principal The classical theory of interest abstracts from innumerable factors which are known to be of importance in
changes that are continuously occurring in the economic system tend to raise the return to capital and thereby affect equilibrium interest rates. The existence of risk and uncertainty about the future in real life means that interest rates in real life will not be pure or risk-free rates as posited in the classical theory, but the level of interest rate would be equal to the pure rate plus the appropriate measure of the risk-premium. Further, the absolute adherence to the concept of time preference ignores other reasons behind savings, such as smoothening expenditures from year to year when income varies, or accumulating funds for retirement. The classical saving function is postulated for a given full employment level of income. At less than this level of income, the ability to save may diminish and the amount of saving may decline. Accustomed to certain levels of consumption, people tend to reduce their saving drastically to maintain their lifestyles when the income temporarily declines. This suggests that income level has a powerful impact on interest rates via its 1
Samuelson, P A, ‘Money, Interest Rates, and Economic Activity: Their Interrelationship in a Market Economy’, in Gibson, W E, and Kaufman, G G (eds.), Monetary Economics: Readings in Current Issues, Tata McGraw-Hill, New Delhi, 1975, p. 51.
23.6
in savings that are income-generated.
23.2.2 The Loanable Funds Theory theory. It is a dynamic theory as opposed to the static nature of the classical theory. It also combines real and monetary factors as determinants of the rate of interest. Further, it takes a more short-run view of the process of interest rate determination in place of the secular or long-run view taken by the classical theory.
money loans and assets, the level of interest rate has nothing to do with the levels of money and prices, and investment outlets, they cannot affect the level of interest rate. The loanable funds theory discards the independence of the interest rate from the behaviour of money and banks. According to this theory, the real supply and demand curves determining interest rates should have added to them as a component of the supply of saving which is associated with the creation of new money or credit.2 The supply of credit may be
units. The rate of interest clears the market for savings plus credit.
are actually in a position to create loanable funds which they lend out to the would-be investors in the productive physical assets. This changes the mix of the national income towards capital formation and away from current consumption. Similarly, the expansionary monetary policy can keep investment spending higher than what would be the case in the absence of central banking. This occurs without reduction in current consumption because consumption is also higher than what would be the case in the absence of expansionary monetary policy.
23.2.3 The Keynesian Theory If the classical theory represents one extreme, the Keynesian theory represents the other extreme approach to the determination of interest rate. According to Keynes, interest rate is a purely monetary phenomenon. This means that the rate of interest, at least in the short-run, is determined by the monetary factors, that is, attitude of economic units towards holding money as an alternative to holding bonds. In other words, interest system.
2
Samuelson, P A, op. cit., pp. 51–53.
23.7 other hand, securities can and do vary in value and, therefore, there is a risk of incurring capital loss when securities rather than cash are held. Interest is the difference between the yield on safe money and the yield favour of holding securities. The demand to hold money is called the ‘liquidity preference’. There are three motives or reasons behind the transactions cash in order to be able to affect day-to-day transactions needs that arise because of non-synchronisation of receipts and payments. The economic units hold some cash for the purpose of providing for a rainy day or
is the sum of cash desired to be held by all economic units for all these motives. The supply of money in the modern economies is said to be under the ultimate control of the monetary authorities. Keynes himself proceeded with the assumption that money supply in the economy is exogenously determined, that is, it is determined by the monetary authorities. The demand and supply of money determines the rate of interest. To lower the rate of interest, it is necessary to increase the supply of money or to reduce the demand for it or to do both. Among these different theories, which one should we choose? We think that an eclectic approach accepting interplay of the real and monetary factors in determining the rate of interest would be closer to the realities of the actual economic systems. In the short-run, changes in money supply may produce an opposite effect determine the level of interest rate. These forces are related to changes in economic activity, income, and prices. When interest rates go down as a result of an increase in the money supply, there may be a stimulation of economic activity and an increase in the national income. This increase in income tends to offset the initial decline in yields and may subsequently raise them. If the increase in money supply exceeds the rate of increase in income, and if it is accompanied by market imperfections of diverse kinds, there may be a large increase in prices which may further push up the nominal rates. The actual level attained by the interest rate may also be subjected to direct intervention by the authorities in the market for loanable funds. In the long-run, however, the forces of thrift and productivity must come into their own in determining the rate of interest.
23.2.4 Interest Rate and Price Level The relationship between the rate of interest and the price level has proved quite intricate and controversial in economic literature. According to classical theorists, the equilibrium real rate of interest is independent, that is not affected by changes in the price level. However, the nominal or market rate of interest is posited to be vice versa. This inverse relationship between prices and interest rate arises because of the emergence of a disparity between the ‘natural rate’ and the ‘market rate’ of interest. As the ‘natural rate’ is expected to be fairly stable over time, between the desired investments and saving, and consequently a fall in prices. The market rate is determined
23.8
increasing the quantity of money which will create excess reserves with banks that will then be willing to lend at a lower rate of interest. In practice, interest rates and prices have often moved together in the same direction in many economies, was therefore designated as the ‘Gibson paradox’ by Keynes. Does this paradox invalidate the classical relationship between prices and interest? Is it possible that it was conceived by the classical theorists themselves? According to Wicksell, in periods of rising interest and prices, the natural rate has been high and the market rate has lagged behind the natural rate. A rising market rate means that banks have been trying transitional state, there occurs an expansion in bank credit leading to rise in prices.3 Another explanation for the positive relationship between prices and interest is provided in terms of what has come to be known as the ‘Fisher effect’. According to Irving Fisher, a cumulative rise in prices, after some time-lag, generates expectations of a further rise in prices. This makes investors willing to lend only at a higher rate of interest in order to protect themselves against depreciation in the value of money. Interest rates and prices, therefore, tend to rise or fall together. It may be pointed out that the two explanations are dissimilar because while, according to Wicksell, the upward movement in the market rate is a matter of adjustment with the natural rate and the rise in prices is a result of the difference between the two rates. According to Fisher, an upward movement in the market rate is caused by the expected rise in prices.
23.3 STRUCTURE OF INTEREST RATES The theories of the determination of the general level of interest rate discussed above do not explain the actual working of the market for funds and the complex
LO 2 Understand the structure of interest rates
What is it that determines the difference between long-term and short-term interest rates that is what is it that determines the term-structure of interest rates? The 90-day treasury bill rate was 7.96 percent in 1996–1997, same year. Why do securities maturing at different lengths of time offer different yields? What is it that determines the general structure of interest rates? In 1997–1998, while the government of India could issue 10-year bonds at the coupon rate of 13 percent, the private sector joint-stock companies had to The following theories of the structure of interest rates throw some light on questions such as these.
3
Patinkin, Don, Studies in Monetary Economics, Harper, New York, 1972, p. 84.
23.9
23.4 THEORIES OF THE TERM-STRUCTURE OF INTEREST RATES The term-structure of interest rates refers to the relationship between different marketability and liquidity and tax status) except the length of time to maturity
LO 3 Explain the theories of the term-structure of interest rates
23.4.1 The Expectations Theory
● ● ●
● ●
The investors are rational, that is, they wish to maximise the yield of their holding period.4 Investors have a perfect foresight, and a large enough body of investors hold uniform expectations about the future level and changes of short-term interest rates and security prices. There are no transactions costs. Securities of different maturities are perfect substitutes for each other, that is, they are homogeneous.
geometric) average of the current short-term rate and the successive forward or expected one-period short-
(1 + Rnt ) = [(1 + R1t )(1 + r1t +1) º (1 + r1t + n - 1)1/ N Rn = The actual long-term rate N = Term to maturity t R1 t + i r = The expected one-year yield during some future period, t + i, is also known as forward rate. 1
We can compute the one-period forward rate beginning at time t + n and implied in the term-structure at time t is (1 + R1tt ) (1 + r1tt + 1) º (1 _ r1tt + n ) 1 + r1tt + n = (1 + R1tt ) (1 + r1tt + 1) º (1 + r1tt + n - 1) =
r1tt + n =
4
(1 + Rnt + 1) n + 1 (1 + Rnt ) n (1 + Rnt + 1) n + 1 (1 + Rnt ) n
-1
Holding period is the period of time for which the investor plans to hold or actually holds the security. It may be the same as the maturity period or it may differ from the latter. If it is longer than the maturity period, the investor must reinvest; if it is shorter, he must sell the security before the maturity period is over
23.10 Where r1tt + n is the one-year forward rate prevailing at t + n, using the term-structure at time t. The general formula for computing the j-period forward rate beginning at time t + n as of time t r jtt + n =
j
(1 + Rnt + j ) n + j (1 + Rnt ) n
-1
Example 7
(1 + t R ) -1 (1+ t R )6 7
6
=
(1 + 0.15)7 (1.15)7 1 = = 0.277 = 27.7 percent (1 + 0.13)6 (1.13)6
if investors expect future short-term spot rates to be higher than the current short-term spot rates. Similarly, investors expect future short-term spot rates to fall below the current short-term spot rates. If no changes in
variations in the price of bonds outstanding that yields calculated for the same period will be equalised for bonds with different terms to maturity. Thus, the pure expectations theory views expectations about the future short-term interest rates as the only determinant of the term-structures of interest rates. These expectations determine the demand for securities which affects their prices which, in turn, determine their relative yields. The relative supplies of securities in various ranges of maturity spectrum do not change and affect yields as per this theory. It holds that it is not the only merit of this theory is that it has emphasised the role of expectations. It suffers from too many serious drawbacks to make it useful in explaining the structure of interest rates in practice. First, it totally lacks realism. Its assumptions are very restrictive and unrealistic. It cannot explain rates structure in informal and rural markets where there is no trading of securities in the manner assumed by it. Similarly, it appears to be irrelevant with regard to interest rates on bank deposits where there is no buying and selling of securities. A very practical question that can be raised is that if the expected return is the same irrespective of the maturity chosen, why do investors hold securities of different maturities? The cannot affect interest rates through open market operations, in practice, central banks do use this technique to Second, while this theory allegedly explains the long-term rate, it does not explain how short-term rates themselves are determined and how expectations about short-term rates are formed. Similarly, the theory
23.11 is silent about the role of expectations about the future long-term rates and prices in determining the termstructure of interest rates. It has been rightly pointed out by Dorrance and Hicks that it is much more realistic to talk of the structure of interest rates in terms of expectations about future long-term rates, since the assuming that a participant in the market has expectations about the price of the long-term bond at the date when the short-term security falls due, we get along well with the simple comparison of the current shortterm interest rate with the yield on the longer-term bond expected for the same time span. Third, a critical reading of this theory reveals that it really states how expectations can be derived from the observed yield curve rather than how yield curve can be constructed with the help of expectations. It utilises does not use expected forward rates to explain the current level of the long-term rate. Thus, we set out to explain the term-structure with the help of expectations but end up with deriving expectations with the help 6 It is to be noted that this theory does not say anything about what can be the shape of yield curve theoretically. It merely helps to interpret the meaning of the holding period is independent of considerations of risk, return, liquidity and so on.
23.4.2 Liquidity Premium Theory pure expectation theory and, therefore, it is sometimes called a biased expectations theory. Two important characteristics of investments are return and risk. The choice of securities depends upon the risk-return preferences of the investors. The expectations theory ignores risk and assumes that investors want to maximise return. The segmentation theory, which we will discuss, assumes that investors de-emphasise return and try want to maximise return, whatever the risk is. Similarly, they do not want to minimise risk even if it entails a very low return. This theory also holds that long-term securities, on balance, are more risky than short-term securities. While the variance of return of capital value is greater for long-term securities than for short-term ones, the variance of return of interest income is greater for short-term securities than for long-term ones. If it is assumed that the stability of capital is valued more highly than the stability of interest, the long-term securities have a net risk disadvantage. Investors will accept this additional risk only if long-term securities are priced in such a way as to offer a higher yield. In other words, because of the higher risk on long-term securities, other to borrow long-term securities in order to reduce the risk of inability to meet principle payments that is in positive liquidity or risk premium must be offered to induce investors to purchase long-term securities. This premium is over and above the average of the current and expected short-term rates. Thus, this theory implies the existence of the upward sloping yield curve more often rather than non-existence. The liquidity premium
5 6
Lutz, F A, The Theory of Interest, D Reidal Co., Dordrecht, Holland, 1967, pp. 218–219. Henning, C N, and Others, Financial Markets and the Economy, Prentice-Hall, Englewood Cliffs, New Jersey, 1978, p. 386
23.12 (1 + RNt ) = [(1 + R1t ) (1 + r1tt +1 + L2) º (1 + r1tt + N - 1 + LN )]1/ N L represents the liquidity premium and it is expected to increase with maturity as the volatility increases with maturity. The liquidity premium theory highlights the preference for liquidity and the desire to minimise the sum of income capital risk as the additional factors determining the term-structure of interest rates. It is more realistic because it incorporates the complexity of forces such as lenders’ and borrowers’ preferences, and differences in risk-return attributes of securities of different maturities. It has served a useful purpose so far as it has exposed the fact that even in respect of securities with no default risk, other types of risks remain present, and the greater the risks the longer the maturity period. It may, however, be added that in the context of discussing term-structure of interest rates, liquidity premium, strictly speaking, is not a correct nomenclature because the premium that needs to be paid to lenders is for inducing them to take greater risk and not for parting with liquidity. It is also doubtful whether the investors are really more averse to capital risk than to income selection and the empirical evidence suggest that long-term securities have greater systematic risk7 than the short-term ones which, rather than investor bias against capital risk, explains higher expected return on longterm securities than on short-term ones.8 Similarly, this theory is not explicit about the cause or origin of the change in the value of the principal. Is it the change in ‘real value’ or ‘nominal value’ of capital which is indicated by the theory? As we know, while the real value would change due to changes in prices, the nominal value would change due to expected premium will be mostly positive, the theory implies that the prices or interest rates will be mostly increasing. This is questionable.
23.4.3 Market Segmentation Theory The third major theory of term-structure of interest rates is the market segmentation theory propounded minimisers or risk-averters.9 The way to minimise risk is to match maturities of assets and liabilities or to match maturities with holding periods. If a lender knows exactly how long his money will be available for investment, he can select the maturity date of the claim in such a way that he runs neither the income risk nor the capital risk. The co-incidence of the maturity date of the claim with the date of his need for cash insures him against both these risks. All these results in the capital market being divided into a number of segments in which demand for and supply of funds of each given maturity determine the rate of interest irrespective of what happens in other segments. The market segments may also be created on account of certain legal totally independent of each other. Although some amount of inter-dependence between various segments is 7
Systematic risk is the deviation of realised return from expected return on an efficient portfolio due to the tendency for rates of return on individual securities and portfolios to move with the rate of return on the market as a whole. In other words, it is the risk which cannot be reduced by diversifying the investment portfolio. 8 Robinson, R I, and Wrightsman, D, Financial Markets, McGraw-Hill, New Delhi, 1981, pp. 164–165. 9 Risk averters prefer to forgo possible capital gains in order to escape capital losses and they decline possible higher returns to avoid possible lower rates.
23.13 admitted, this theory holds that securities in different maturity ranges, particularly in more distant maturity ranges, are imperfect substitutes for each other. In other words, although the theory does not deny the possibility of some market continuity and some maturity indifference, it holds that institutions may have to be paid a differential premium to induce them to move from their preferred maturity segment. Moreover, liquidity premium. In such segmented markets, the term structure of interest rates is determined exclusively by the supply of and demand for securities. If on the demand side, demands for long-term capital were to pre-dominate and on the supply side, the offer of short-term money, the long-term rates would come to lie above the short-term rates, and vice versa in the opposite case. This theory, thus, stresses the maturity structure of debt as an important factor determining the term-structure of interest rates. As per this theory, debt management policies of the Although the market segmentation theory has added an important dimension to the explanation of interest
maturity with the smallest total yield-risk without comparing risks with yields that is to assume that he would attempt to avoid risk at any price.
23.5 OTHER FACTORS Apart from the factors pointed out by the three theories, there are other factors factor, to which many analysts pointedly draw attention to, is the phenomenon 10
LO 4 Discuss other factors affecting term-structure of interest rates
The expectations theory and
uncertainty about interest rates. All it means that investors cannot make completely risk-free investments and the risk of investment increases as the period for which investors are required to make forward commitments of their funds lengthens. The least-risk strategy for them is to invest in successive one-year bonds. This means that borrowers must offer some incentives if they want investors to lend long-term investments. Thus, The existence of transactions costs has been pointed out as another relevant factor in the present context. The impact of transactions costs on term-structure, however, has to be regarded as uncertain. This impact is lower, the longer the term to maturity because the number of transactions would be lower. According to the second, the transactions costs tend to increase with the length of time to maturity because of the greater risk of long-term securities to dealers who make the market. Whether the yield curve would be downward sloping or upward sloping will depend upon the relative strength of these two forces.11 10 11
Robinson, R I and Wrightsman, D, op. cit Van Horne, J C, The Function and Analysis of Capital Market Rates, Prentice-Hall Englewood Cliffs, New Jersey, 1970, pp. 80–83.
23.14
23.6 DETERMINANTS OF THE GENERAL STRUCTURE OF INTEREST RATES exclusive) attention from monetary economists, one must realise that maturity is not the only dimension in understanding the structure of interest rates. Financial economists have rightly emphasised the importance of the following factors in this context.
23.6.1
LO 5 Review the determinants of the general structure of interest rates
Default Risk
assets. In essence, it refers to the possibility of an adverse outcome to an event. There are many types of risks in yields. The default risk is a major determinant of the general structure of interest rates and it refers to the possibility of the failure to meet the terms of a loan agreement, of delay in payment, of total non-payment, of are subjected to some degree of default risk although they differ in their degree of risk. These differences higher the interest rate it has to offer. Given the attitude of the investors towards absorption of risk and also given the risk in investment projects that borrowers wish to undertake, the yield on risky assets will rise to an equilibrium position that will be higher than the yield on assets that have no risk of default. The difference between these two yields is called the default risk premium. The default risk is determined by the internal which he operates.
23.6.2 Call Risk In the US, most of the corporate bonds are issued with a clause which gives the companies an option or power their bonds being called back before they voluntarily take their money back. The call practice involves certain disadvantages from the point of view of the investor. First, since the call price sets a ceiling on the market price, holders of callable bonds can hope to earn only a limited amount of capital gains. Second, since bonds are usually called back when market yields are low, the long-term investors have to re-invest their money continuous overhanging uncertainty that the bond may or may not be called back. Therefore, interest rates on callable bonds will have to be higher than the rates on bonds without a call feature. The difference between the two can be called a ‘call risk premium’.12 In India, the practice of issuing callable bonds is not prevalent. However, the opposite practice, namely, issuing bonds with buy-back option has become quite widespread in the recent past. In this case, the buyers of non-convertible debentures have the option of selling their bonds to the company at face value whenever 12
Robinson, R I and Wrightsman, D., op. cit., pp. 155–157.
23.15
lower than the rates on bonds without such a feature.
23.6.3 Marketability or Liquidity
things being equal, the security which is easily marketable earns a lower rate of interest than the one whose marketability is limited or restricted. The marketability of assets depends in part on the features of the instrument itself and in part on the nature of markets where the assets are traded. Assets, which are homogeneous, appeal to a wide variety of buyers and can be easily transferable without undue cost or delay, have a high degree of marketability. Similarly, if the primary and secondary markets are well developed, if they have depth, breadth, and resiliency, the assets will have greater marketability.
23.6.4 Tax Status gains are taxed at a lower rate compared to income and that different securities differ in respect of tax exemption of interest income and principal amount of investment, result in differences in interest rates on different claims.
SUMMARY ◆
economy. For theoretical purposes, however, it is conventional to talk as if the economy has the rate of interest. ◆
generated by an investment with the cost of that investment. ◆
◆
◆
payment in respect of percentage of the market price of the security. The redemption yield is the annual interest payment plus the average annual appreciation of bond value as a percentage of its redemption value. The coupon rate is the rate of interest stated and paid on the face value of the bond.
◆
savings and the demand for investment, the productivity of capital goods providing the main elements of demand and the people’s time preference limiting the supply. ◆
◆
◆
system on the one hand, and total borrowings in the economy on the other, determine the rate of interest. The Keynesian theory states that the rate of interest is a reward for parting with liquidity, and it is determined by the demand for and supply of money in the economy. In real life, prices and interest rates are often positively related and are designated as the ‘Gibson paradox’.
23.16 ◆
◆
◆
◆
The ‘Fisher effect’ means that a cumulative rise in prices generates positive price expectations which then results in the increase in the nominal rate of interest. According to Wicksell, when the market rate of interest is lower than the ‘natural rate’, prices tend to increase which, in turn, leads to upward adjustment in the market rate of interest. The expectations theory views expectations about the future short-term interest rates as the only determinant of the term structure of interest rates. As per the liquidity premium theory, investors try to balance risk-return considerations. The long-term
◆
◆
and the rate of interest in each of these segments is determined by its supply of and demand for funds. The general structure of interest rates is determined by differences in the default risk, call risk, liquidity
KEY TERMS Rate of Interest Natural Rate of Interest
Default Risk
Term-Structure Interest Rate
Expectation Theory Market Segmentation Theory Forward Rate
QUESTIONS 1. Discuss the role of real forces of thrift and investment in determination of the rate of interest. 2. In what respect is the loanable funds theory of interest an improvement in the classical theory? 3. Discuss the Keynesian theory of liquidity preference as an explanation of the determination of the interest rate.
Keynesian theory of interest. rates. 7. Discuss the different theories that explain the relationship between the yield period to maturity. 8. What determines the general structure of interest rates?
Interest Rates in India
24
CHAPTER Learning Objectives LO 1 LO 2 LO 3 LO 4 LO 5 LO 6
Recognise the interest rate system and the system of administered interest rate system in India Know more about deregulation of interest rates Identify the features of current interest rates system and the interest rate trends in India Explain real interest rates and the implications of deregulation Discuss the relationship between interest rates and other macroeconomic variables in India Understand the determinants of savings and investments and the issue of relative rates of return
24.1 INTRODUCTION
24.2
Financial Institutions and Markets
24.2 INTEREST RATE SYSTEM IN INDIA
Phase-I: Phase-II: Phase-III:
LO 1 Recognise the interest rate system and the system of administered interest rate system in India
Phase-IV: Phase-V:
24.3 SYSTEM OF ADMINISTERED INTEREST RATE REGIME
viz
24.3.1 Reasons for Regulation
Interest Rates in India
24.3
paramount importance to the high rate of capital formation as the most critical development factor had shaped
24.3.2 Effects of Regulation
ad hoc
24.4
Financial Institutions and Markets
●
●
●
● ●
Quantitative credit controls had come under severe stress in the absence of support from any price
●
24.4 DEREGULATION OF INTEREST RATES LO 2 Know more about deregulation of interest rates
1
RBI, Report of the Committee to Review the Working of the Monetary System, Bombay, 1985, p. 173. For a detailed theoretical and empirical discussion of these points, see Bhole, L.M., ‘Administered Interest Rates in India’, op. cit., pp. 1096–1103. 3 RBI, ibid., pp. 174–183. 2
Interest Rates in India
24.5
` the multiplicity of lending rates and the complexity of interest rates structure by reducing lending categories ` two
24.6
Financial Institutions and Markets
24.5 FEATURES OF CURRENT INTEREST RATES SYSTEM IN INDIA LO 3 Identify the features of current interest rates system and the interest rate trends in India
marginal cost of funds will comprise of marginal
operating cost Tenor premium arises from loan
4
http://www.livemint.com/Money/3CwLeEqXRgJS2sATs6f6SK/How-MCLR-will-affect-your-home-loan.html
24.7
Interest Rates in India
24.6 TRENDS IN INTEREST RATES IN INDIA
Table 24.1 Nominal Interest Rates in India, 1952–1953 to 2015–2016, Annual Averages Year
RR
Rv.RR
MSF
BR
CRR
CMR
TBR
GBY
LR
1952–1970
—
—
—
4.2
—
4.59
2.74
4.23
1971–1990
—
—
—
8.8
7.21
8.67
4.33
6.56
13.2
10.6
12.36
11.21
7.32
11.93
15.5
9.03
5.85
5.59
7.42
11.5
1990–2000
—
—
—
2001–2005
8.75
6.625
—
6.25
4.95
2005–2006
7.86
5.96
—
6
6.91
5.6
5.51
7.46
11.5
2006–2007
7.5
5.75
—
6
5.62
7.22
6.8
8.73
13.5
2007–2008
8
6.99
—
6
7
6.07
6.86
7.88
14.0
2008–2009
6.97
4.93
—
6
7.27
7.26
6.88
7.58
14.15 13.37
2009–2010
5.62
4.33
—
6
5.75
3.29
3.4
7.32
2010–2011
7.53
6.53
8.9
6
5.75
5.89
6.2
7.91
2011–2012
8
7
9
7.75
4.75
8.22
8.43
8.44
8.87 10.37 (Contd.)
24.8
Financial Institutions and Markets
2012–2013
7.55
6.55
8.55
8.75
4
8.09
8.14
8.21
10.00
2013–2014
8
7
9
9.12
4
8.28
8.85
8.45
10.12
2014–2015
7.31
6.31
8.31
8.62
4
7.97
8.34
8.29
10.12
2015–2016
6.37
5.87
6.87
8
4
6.58
7.27
7.78
9.50
SDR
1-3 TD
3-5 TD
1952–1970
—
6.5
> 5 TD
NIFTY
SENSEX
EPF
NSC
7.85
—
—
—
—
7
1971–1990
—
8.25
9.35
10.56
—
22.23
1990–1900
—
10.97
11.78
11.95
17.56
19.86
8.27 12
10.5 12
2001–2005
4.00
6.85
7.3
7.51
13
14.28
9.5
9.75
2005–2006
3.50
6.5
7
7
11.22
11.41
8
8.5
2006–2007
3.50
9
9
9
67.17
73.73
8.5
2007–2008
3.50
8.75
8.75
9
12.31
15.88
—
—
8.5
2008-2009
3.50
8.75
8.5
8.5
23.88
19.67
8.5
—
2009–2010
3.50
7
7.5
7.75
–36.19
–37.93
8.5
—
2010–2011
3.50
9
8.75
8.75
73.75
80.53
9.5
8
2011–2012
3.96
9.25
9.25
9.25
11.14
10.93
8.25
8.4
2012–2013
4.00
9
9
9
–9.22
–10.49
8.5
8.6
2013–2014
4.00
9.25
9.1
9.1
7.30
8.75
8.5
2014–2015
4.00
8.75
8.75
8.5
17.96
18.84
8.227
8.75
8.5
2015–2016
4.00
7.5
7.5
7.3
26.65
24.88
8.8
8.5
Notes: RR = Repo Rate; Rv. RR = Reverse Repo Rate; MSF = Marginal Standing Facility Rate; BR = Bank Rate; CRR = Cash Reserve Ratio; CMR = Call Money Rate; TBR = 91 days Treasury Bill Rate; GBY = 10 Years Government Bond Yield; LR = Lending Rate, SDR = Savings Deposit Rate, 1-3TD = 1 to 3 year Term Deposit Rate; 3-5TD = 3–5year Term Deposit Rate; >5TD = Term Deposit above 5 Years Maturity, NIFTY: Index Return from Nifty Fifty; SENSEX: Index Return from BSE
Source: RBI, Hand Book of Statistics, Various Issues.
Interest Rates in India
24.6.1
5
24.9
Temporal Changes
See also Bhole, L M, ‘Administered Interest Rates in India’, Economic and Political Weekly, June 22–29, 1985; ‘The Structure of Interest Rates In Theory And Practice’, The Indian Journal of Economics, October 1988; ‘Some Issues Concerning Interest Rates Theory and Policy’, The Indian Economic Association, Conference Volume, December 1988; ‘Determinants of Interest Rates In A Deregulated Economy’, The Indian Journal of Economics, October 1996; ‘Determinants of Long-term Interest Rates in India During 1970s–1990s’, Prajnan, Vol. XXXII, No. 2, 2003–2004 (with P. Dash)
24.10
Financial Institutions and Markets
of relatively higher interest rates on small savings has to be sought in the fact that the government deliberately decided to offer relatively more attractive rates on these assets in order to channelise household savings to the
24.6.2 Relationship between Short-Term and Long-Term Interest Rates
6
Brahmanandan, P R, ‘Thought on Interest Rates under Indian Conditions’, in RBI, Recent Development in Monetary Theory and Policy, Bombay, 1978, p. 157.
Interest Rates in India
24.6.3 Analysis on the Monetary Policy Corridor
24.11
24.12
Financial Institutions and Markets
24.6.4 Interest rates for Non-Resident Deposits7
24.6.5 Concessional Interest Rates
arisen because of the policy of ‘differential interest rates’ adopted by the authorities with a view to achieving
7
ttps://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?Id=8137&Mode=0.
24.13
Interest Rates in India
24.7 INTERNATIONAL COMPARISON to which interest rates in India and abroad are correlated and how the interest rate differential between India
in India vis-a-vis
Table 24.2 Short-Term Interest Rates in India and a Few Other Countries during 1970–1971 to 2015–2016
8
Year
India
Australia
Canada
Japan
UK
USA
1971
6.30
7.008
4.56
4.72
3.45
5.005
1980
7.24
12.02
13.12
10.88
5.77
1985
10.00
15.98
9.59
6.62
4.92
13.06 8.04
1990
15.57
14.54
13.01
7.71
8.91
8.14
1995
15.57
7.72
7.12
1.23
2.94
5.91
2000
9.26
6.17
5.69
0.24
3.17
6.45
2001
7.65
4.89
3.99
0.12
2.86
3.68
2002
6.15
4.74
2.62
0.06
1.12
1.72
2003
5.81
4.89
2.96
0.04
0.32
1.15
2004
4.63
5.47
2.31
0.03
0.48
1.56
2005
4.99
5.64
2.81
0.03
0.81
3.51
2006
5.51
5.98
4.17
0.24
1.55
5.15
2007
7.75
6.66
4.56
0.79
5.95
5.28
2008
7.41
6.97
3.20
0.92
5.49
3.20
2009
4.77
3.43
0.45
0.47
1.19
0.93 (Contd.)
Bhole, L M, ‘International Aspects of Monetary Policy in India’, International Journal of Development Banking, January 1991; and Bhole, L M, and Sebastian, V J, ‘Determinants of Interest Rates in a Deregulated Open Economy’, The Indian Journal of Economics, October, 1996.
24.14
Financial Institutions and Markets
2010
5.95
4.68
0.79
0.23
0.69
0.52
2011
8.06
4.84
1.19
0.19
0.88
0.41
2012
7.91
3.72
1.193
0.193
0.83
0.42
2013
7.60
2.78
1.196
0.15
0.49
0.33
2014
7.91
2.67
1.21
0.12
0.53
0.27
2015
7.00
2.25
0.84
0.09
0.55
0.46
2016
6.38
2.00
0.81
–0.03
0.51
0.92
Source: OECD Statistics and RBI, Annual Reports, Various Issues.
Table 24.3 Long-Term Interest Rates in India and a Few Other Countries during 1970–71 to 2015–16 Year
India
Australia
Canada
Japan
UK
USA
1971
5.64
6.71
6.94
7.28
7.86
6.15
1980
6.71
11.59
12.33
7.22
13.91
11.46
1985 1990
9.22 10.9
13.90
10.91
6.34
10.97
10.62
13.19
10.72
6.95
11.80
8.55
12.6
9.21
8.16
3.44
8.20
6.58
2000
11.50
6.31
5.93
1.74
5.32
6.02
2001
11.20
5.61
5.47
1.31
4.93
5.01
2002
9.14
5.84
5.29
1.26
4.89
4.61
2003
7.43
5.36
4.80
1.01
4.52
4.01
2004
6.58
5.59
4.58
1.49
4.88
4.27
2005
6.63
5.33
4.06
1.35
4.41
4.29
2006
7.46
5.58
4.21
1.74
4.50
4.79
2007
7.88
5.99
4.27
1.67
5.01
4.62
2008
7.59
5.81
3.60
1.48
4.59
3.66
2009
7.32
5.04
3.23
1.34
3.64
3.25
2010
7.91
5.36
3.235
1.16
3.62
3.21
2011
8.44
4.88
2.78
1.11
3.13
2.78
2012
8.21
3.37
1.87
0.84
1.91
1.80
2013
8.45
3.69
2.26
0.70
2.39
2.35
2014
8.29
3.65
2.23
0.55
2.56
2.54
2015
7.78
2.71
1.52
0.35
1.90
2.13
2016
7.07
2.19
1.24
–0.05
1.27
1.80
Source: OECD Statistics and RBI, Annual Reports, Various Issues.
24.8
REAL INTEREST RATES
ex-post calculated as the nominal rate of interest minus rate of change in the general
LO 4 Explain real interest rates and the implications of deregulation
Interest Rates in India
24.15
rates the greater their capacity to absorb prices increases before they become negative; (b) the relative rates
Table 24.4 Ex-Post Real Interest Rates in India from 1952–1953 to 2015–2016, Annual Averages Year
RR
Rv.RR
MSF
BR
CRR
CMR
TBR
GBY
LR
1952–70
—
—
—
—
—
—
—
—
—
1971–90
—
—
—
–0.22
–1.81
–0.35
–4.69
–2.46
4.03
1990–2000
—
—
—
4.14
5.90
4.75
0.86
5.47
8.64
2001–2005
3.53
1.41
—
1.03
3.81
0.63
0.37
2.20
5.85
2005–2006
3.62
1.72
—
1.76
2.67
1.36
1.27
3.22
7.26
2006–2007
0.78
–0.97
—
0.72
–1.10
0.50
0.08
2.01
6.78
2007–2008
0.29
–0.72
—
–1.71
–0.71
–1.64
–0.85
0.17
6.29
—
2008–2009
5.32
3.28
2009–2010
–4.74
–6.03
4.35
5.62
5.61
5.23
5.93
12.48
–4.36
–4.61
–7.07
–6.96
–3.04
3.01 –0.81
2010–2011
–2.15
–3.15
–0.78
–3.68
–3.93
–3.79
–3.48
–1.77
2011–2012
0.30
–0.70
1.30
0.05
–2.95
0.52
0.73
0.74
2.68
2012–2013
1.85
0.85
2.85
3.05
–1.70
2.39
2.44
2.51
4.28
2013–2014
2.00
1.00
3.00
3.12
–2.00
2.28
2.85
2.45
4.12
2014–2015
9.61
8.61
10.61
10.92
6.30
10.27
10.64
10.59
12.42
8.28
2015–2016
6.87
6.37
7.37
8.50
4.50
7.48
7.77
SDR
1-3 TD
3-5 TD
> 5 TD
NIFTY
SENSEX
PF
—
1952–1970
—
—
—
—
1971–1990
—
–0.77
0.33
1.54
10.00 NSC
—
—
—
13.21
–0.75
1.48
1990–2000
—
4.51
5.32
5.49
11.10
13.40
5.54
5.54
2001–2005
—
1.63
2.08
2.29
7.78
9.06
4.28
4.53
2005–2006
–1.22
2.26
2.76
2.76
6.98
7.17
3.76
4.26
2006–2007
–0.74
2.28
2.28
2.28
60.45
67.01
1.78
1.78
2007–2008
–3.22
1.04
1.04
1.29
4.60
8.17
—
2008–2009
–4.21
7.10
6.85
6.85
22.24
18.03
6.85
—
2009–2010
1.85
–3.36
–2.86
–2.61
–46.56
–48.30
–1.86
—
2010–2011
–6.86
–0.68
–0.93
–0.93
64.07
70.85
–0.18
–1.68 (Contd.)
24.16
Financial Institutions and Markets
2011–2012
–6.18
1.55
1.55
1.55
3.44
3.24
0.55
0.70
2012–2013
–3.74
3.30
3.30
3.30
–14.92
–16.20
2.80
2.90
2013–2014
–1.70
3.25
3.10
3.10
1.31
2.23
2.75
2.50
2014–2015
–2.00
11.05
11.05
10.80
20.27
21.15
11.05
10.80
2015–2016
6.30
8.00
8.00
7.80
27.16
25.39
9.30
9.00
Notes: RR = Repo Rate; Rv. RR = Reverse Repo Rate; MSF = Marginal Standing Facility Rate; BR = Bank Rate; CRR = Cash Reserve Ratio; CMR = Call Money Rate; TBR = 91 days Treasury Bill Rate; GBY = 10 Years Government Bond Yield; LR = Lending Rate, SDR = Savings Deposit Rate, 1-3TD = 1 to 3 year Term Deposit Rate; 3-5TD = 3–5year Term Deposit Rate; >5TD = Term Deposit above 5 Years Maturity, NIFTY: Index Return from Nifty Fifty; SENSEX: Index Return from BSE
Source: RBI, Hand Book of Statistics, Various Issues.
24.9 IMPLICATIONS OF DEREGULATION
on any interest rate (viz
24.10 INTEREST RATE CHANGES AND OTHER MACROECONOMIC VARIABLES LO 5 Discuss the relationship between interest rates and other macroeconomic variables in India
Interest Rates in India
Table 24.5
24.17
Annual Average Growth rates of Major Macroeconomic Aggregates Indicators
1991–1992 to 1996–1997
1997–1998 to 2001–2002
2002–2003 to 2006–2007
2007–2008 to 2015–2016
GDP at Factor Cost
5.8
5.5
7.63
7.45
Index of Industrial Production
6.2
5
8.16
6.28
16.1
11.8
18.55
12.73
Savings Investments
14.9
10.5
19.11
13.32
Exchange Rate
31.1
43.2
45.76
49.83
11.4
12.6
10.06
13.39
103.9
40.1
6.95
19.16
Total Government Expenditure Net Market Borrowings
Export
9.6
4.9
5.02
5.32
24.3
12.3
22.36
13.86
Total Bank Deposits
17.5
16.9
18.85
14.15
Total Bank Credit
15.9
16.2
26.95
14.69 15.62
Total Bank Credit to Commercial Sector
16.2
14.6
19.91
Bank Credit to Small Scale Industries
13.2
9.9
15.88
9.76
Bank Credit to Medium and Large Scale Industries
15.5
28.12
16.64
6.4
36.46
12.65
1.82
1.35
1.27
43.9 GDP/M3 GDP/M1 GDP/C
2.16
11
6.16
6.01
4.67
5.33
11.11
10.54
6.28
9.26
Source: RBI, Hand Book of Statistics, Various Issues.
24.10.1 Interest Rate and Money Supply
24.18
Financial Institutions and Markets
all the more intractable in India and that is why the price expectations hypothesis suffers all the more in
between changes in money supply and interest rates in India has been rather different from the one posited
of some sort of mechanical lowering of interest rates due to purchase of government securities by the central
trend of increase in the level of interest rates in India during the period under study had been better explained
9
It was estimated by P R Brahmananda that the expected rate of inflation in India till the end of 1977 was about 11–15 percent per year. This estimate can be assumed to be relevant for the later period also because inflationary conditions in that period have been more or less similar to those in the earlier period except in the recent past. See Brahmananda, P R, The Falling Economy and How to Revive It, The Indian Economic Association, 1977, p. 55.
Interest Rates in India
24.10.2 Interest Rates and Savings
24.10.3 Interest Rates and Investment
24.19
24.20
Financial Institutions and Markets
24.11 DETERMINANTS OF SAVINGS AND INVESTMENTS LO 6 Understand the determinants of savings and investments and the issue of Relative Rates of Return Table 24.6 Determinants of Real Savings and Investment in India during 1980–1981 to 2015–2016 Gross Total Domestic Savings Constant Interest Rate
Gross Total Household Savings
Gross Total Household Financial Savings
Gross Total Household Real Assets Savings
Total Gross Investments
35.29*** (24.69)
28.56*** (19.56)
21.33*** (16.52)
32.50*** (26.89)
19.65*** (15.61)
0.62** (2.61)
1.33 (1.31)
2.30** (5.12)
0.82 (0.24)
–2.34** (–3.65) (Contd.)
10
Bhole, L M, Impacts of Monetary Policy, Himalaya Publishing House, Mumbai, 1985; and ‘Administered Interest Rates in India’, op.cit.
Interest Rates in India Growth Rate of GDP
2.061** (4.51)
0.33 (0.40)
0.61 (0.35)
0.96 (0.18)
1.98* (2.25)
–1.432** (–2.90)
–0.41 (–0.40)
–1.96* (2.92)
–0.91 (–0.21)
1.66* (2.96)
24.21
Total Credit Availability
—
—
—
—
1.56*** (25.63)
Adjusted R2
0.69
0.56
0.61
0.65
0.78
D-W Statistics F-Statistics
1.62 101
2.02 78
1.99 98
2.89 135
2.68 198
Note: (1) Average of bank deposit rates (1–3 years maturity, and above 5 years maturity) and 10 years government bond
24.12 ISSUE OF RELATIVE RATES OF RETURN
other debt instruments; there has not been any restriction any time on the rates of return earned on units and
vis-a-vis
SUMMARY ◆
◆ ◆
vis-
◆
a-vis ◆
◆
24.22
Financial Institutions and Markets
◆
◆
◆
◆
ad hoc; (c)
◆
◆
◆
◆ ◆ ◆
◆
◆
◆
◆
◆
◆
Interest Rates in India
KEY TERMS Relative Rate of Return Rate Repo Rate Reverse Repo Rate
Real Interest Rate
QUESTIONS
24.23
Glossary
Accrued Interest: Interest that has been earned but not yet received. Accumulation: It is a careful and planned buying of a company’s shares in small numbers so as not topush the price up, but gradually building up a large holding in the company. Acquisition: It refers to one company’s taking over controlling interest in another company. Active Markets: These are the markets for securities or commodities which are characterised by fre-quent and large volume of trading, and in which the difference between buying price and sellingprice is small. Active Securities: These are the shows and other instruments in which frequent, day-to-day deals or trades take place. Current value of securities – Amount borrowed Actual Margin = Current value of securities Advance-Decline (A-D) Index: It is calculated as Number of traded shares which have risen in price Number of shares which have fallen in price It is calculated for a given exchange or market and it helps to detect bullish or bearish expectations or trends on the stock market. Adverse Selection: It refers to a situation in which at higher interest rates, the relatively safer borrowers drop out of the credit market and borrowers with higher risks undertake investment activity leading to deterioration in the quality of banks’ portfolios. Agency Costs: between stockholders and bondholders. Aim income fund, a growth fund or a balanced fund.
G.2
Glossary
Allotment of Securities: It is the decision taken by the company issuing fresh capital to approve oraccept in part or in full the number of security (shares) applied for by a given investor. Amalgamation: that their pooled resources generate greater common prosperity. It can be called a merger also. American Depository Receipt (ADR): convenience to investors in lieu of the underlying foreign corporate shares it holds in custody. American Option: Amortisation: (i) Repayment of loan in installments over a period of time, or (ii) write-off of anexpenditure (like issue cost of shares) over a period of time. Annuity Application Money: It is the amount of money an investor has to pay with the application for purchasing securities which are newly issued. It is usually less than the full value of the security at which it is issued. Arbitrage: It means buying and selling of the same share, commodity, derivatives etc. in different markets.An arbitrageur buys in the lower market and immediately or simultaneously Arbitrage Pricing Model (APT): This theorypredicts a relationship between the returns of a portfolio and the returns of a single asset through a linearcombination of many independent macro-economic variables. Arbitragers: Investors who seek discrepancies in security prices in order to earn riskless returns. Ask Price: The price at which the specialist or dealer offers to sell shares. Asset-Liability Management: Asset Management Company: Handles the daily administration of the fund’s activities and usually doubles as fund manager. Asset Stripping: runningthe company for steady and long-term gain, the asset stripping is said to have occurred. Assignment: It refers to the transfer of all rights to the principal and interest from the seller to the buyer.
Glossary
G.3
At Par: When the face value of the security is equal to the price at which it is sold or bought, it is saidto be sold or bought at par. Auction: Auction Market: A securities market where the prices of securities are determined by the actions Authorised Share Capital: Maximum number of shares or maximum amount of share capital that Authorities:
B Backwardation: When futures price prevail below the expected future spot price, it is known as backwardation. Badla (Contango): It is a percentage paid by the buyer of shares for the postponement of the transfer of those shares from one settlement day to the next settlement day. Balance of Payments: It is the balance sheet of the nation in respect of its international transactions Balanced Fund: It provides both capital appreciation and periodic returns over a long period of time. The portfolio of these kinds of funds constitute of both equity and debt. Balloon Payment: Bank Draft: It is an instrument in which a party or drawer instructs the bank (drawee) to pay, on made on demand, it is known as demand draft. Bankers Acceptance: A written demand, which has been “accepted” by a bank i.e., the bank has Bankruptcy: hence, its (his) assets are surrendered to a court for administration. Bank Rate: long run. Basic Yield: It is the lowest limit of yields actually attained in the market by high grade bonds of a given maturity and a given class. Basis: The Difference between spot price of an asset and its future price. Even through the spot and future prices generally move in tandem with each other, the basis is not constant.
G.4
Glossary
Basis Risk: The risk that the interest rate for different assets and liabilities may change in different magnitudes is called basis risk. Basis Point: One hundredth of one per cent. Bear Market: A market dominated by operators who have a pessimistic view of the future. A period of time during which indicators of the stock market decline. Bearer Bond: The bearer or the holder of the bond is the owner, so the bond issuer does not keep any record of ownership. Bearer Security: A security for which its possession is the primary evidence of its ownership. He is the shareholder or investor of the company, while a Depository is the Registered owner of the shares or securities held by it on behalf of the former. Beta: market portfolio divided by the variance of returns on the market portfolio. Or, it is typically found by regressing stock or portfolio return on a proxy for market return. It measures the with a beta of 1.25 would mean that the portfolio is expected to be 25 per cent morevolatile than the sensitive index itself. It is a measure of performance of a particular share or class of shares in relation to the general movement of the market in terms of the price of respective shares. It indicates systematic risk of investment in a share. It is calculated as the covariance between returns on the asset and returns on the market portfolio divided by the variance of the returns on the market portfolio. Bid-Ask (Offer) Price and Spread: It is the price which is quoted by the seller who want to
Bid or Tender System: A predetermined quantity of securities that is offered for sale and sold or “tendered” to the highest bidder. Bid Price: asset. Bill Discounting: Receiving payment on a bill of exchange prior to the bill’s maturity by surrendering the bill for face value less applicable interest for the time remaining to maturity. Bill of exchange Black Market: shortages of goods, services, or assets.
Glossary
G.5
Blue Chip Stocks: dends—shares of well known, stable, mature companies. Bonus Shares: Bonds: maturity value) at a given date in the future (maturity date), generally with periodic interest Bonus Issue: When an issuer makes an issue of securities to its existing shareholders as on a record date, without any consideration from them, it is called a bonus issue. Book Building: It is a mechanism through which a demand for the securities proposed to be issued by the company is elicited and built-up and the price for such a security is assessed for the determination of the quantum of such securities to be issued. Book Closure: It refers to closing the register of members by the company for a certain period (from one week to a month). This is done before declaring dividend, or issuing bonus shares, or right shares by the company. As a result, only those shareholders whose names appear on the register after the book closure are eligible to receive dividends, or bonus shares, or right shares. Book Value: The cost price of an asset less accumulated depreciation. Bretton Woods Agreement: An agreement, entered in 1946, whereby each member government or pegged, exchange rate for its currency vis-a-vis the dollar or transactions, thus promoting growth in world trade. Bridge Loan: Broad Market: The market which attracts funds in greater volume and from many investors. Broker: A person (agency) who arranges the purchase and sale of an asset by acting as an intermediary between the purchaser and the seller. Bull and Bear Markets: which is characterised by a prolonged period of falling share prices and selling pressures from investors and bears. Bulls and Bears: price to rise, while bears are those who expect the market price to fall. Business Risk:
G.6
Glossary
C Call Money: Loaned funds that are repayable upon the request of either party. Call Money Market: It is that part of the national money market where the day-to-day surplus funds, mostly of banks, are traded in. Call Provision: A feature of a bond that entitles the issuer to retire the bond before maturity. Call Option: period. Call Rate: The rate of interest paid on call loans is known as the call rate. Call Risk: It is associated with the corporate bonds which are issued with call-back provision or option whereby the issuer has the right of redeeming the bonds before their maturity. CAMEL: It is a system of bank rating which serves as an effective supplement to bank supervision.
a scale of “1”to “5”, where I denotes the highest rating and “5” the lowest. Cap: Capital Account: That part of a country’s balance of payments which records results of public and private international investment and lending activities. Capital Flight: The transfer of capital abroad in response to fears of political risk and due to changes in other factors such as interest rates. Capital Gain and Loss: The difference between the price that is originally paid for a security and cash proceeds at the time of maturity (face value of a bond) or at the time of sale (selling price of a bond or stock). When the difference is positive, it is a gain, but when it is negative, it is a loss. Capital Gains Yield: Capital gain as a percentage of the value of a security at the beginning of the than one year are bought and sold. Capital Markets: Capital markets deal with the long-term (maturity period above 1 year) claims. Capital Asset Pricing Model: A theory which shows the relationship between risk and return for Capital Adequacy Ratio: Capital Market Line: The relationship between expected rate of return and risk (measured by
Glossary
G.7
Capital Rationing: To restrict the availability of funds for investment purposes. Cash Management Bill: Capital Structure: shares, and long term debt. Cash Reserve Ratio: certain percentage of their demand and time liabilities. Cash Credit: An arrangement whereby the bank gives a short-term loan against the self-liquidating security. Cash Discount: A discount given to buyers for cash rather than credit purchase. CDs are (represent) bank deposit accounts which are transferable from one party to another. They are marketable or negotiable short-term instruments in bearer
ownership. Ownership is recorded in the broker’s books and client’s contract note. Characteristic Line: A regression line representing the relationship between the return on an individual security and the return on the market portfolio. The slope of the characteristic line is the beta of the security. Close Ended Fund (CEF): for subscription. Collateral: Asset which serves as security for a loan. Collateralised Borrowing and Lending Obligations (CBLO): It is a product of the Clearing Corporation of India Ltd (CCIL) and is a mechanism through which bank and non-bank Financial entities such as mutual funds, primary dealers, banks and insurance companies are participants in this market. Commercial Paper (CP): mostly by the leading, nationally reputed, credit-worthy, andhighly-rated large corporations. Competitive Bidding: Compensating Balance: Non-interest bearing bank deposits held by the corporates, more than what is required, strictly for transaction purposes, in order to compensate banks for their services.
G.8
Glossary
Compound Interest: Interest payable (receivable) on interest. Compounding: The process of determining the terminal value of an amount when compound Contango: spot price. This is known as contango. Conversion Premium: In the case of convertible securities, it is the difference between the market price of the security and its conversion value. Conversion Price: The par value of a bond or preferred stock divided by the conversion ratio. Conversion Ratio: The number of equity shares exchangeable per bond or preferred stock at the time of conversion. Conversion Value: A convertible security’s value based on the current price of the common stock. Convertible Security: the option of the holder. Conversion Premium: In the case of convertible securities, it is the difference between the market price of the security and its conversion value. Conversion Price: The par value of a bond or preferred stock divided by the conversion ratio. Conversion Ratio: The number of equity shares exchangeable per bond or preferred stock at the time of conversion. Conversion Value: A convertible security’s value based on the current price of the common stock. Convertible Security: the option of the holder. Co-operative Bank: are at the same time the owners and the customers of their bank. Correspondent Banks: These banks provide services to their multinational (MNC) clients to carry out their business worldwide through its local bank. Country Risk: The uncertainty or variability of return in respect of an investment in a foreign country is known as country risk. Coupon Rate: It is the interest rate received on the face value or the par value of the bond. Conduct regulation: It is used to regulate the behaviour of producers and consumers in the market. Collateralised Borrowing and Lending Obligation (CBLO): entities that have either no access to the interbank call money market or have restricted access in terms of ceiling on call borrowing and lending transactions.
Glossary
G.9
Covenant: Covered-interest Arbitrage: Movement of short-term funds between two currencies to take advantage of interest differentials with exchange risk eliminated by means of forward contracts. Credit: It is a sum of money to be returned normally with interest; it refers to a debt of economic unit. Credit Default Swap: It consists of swapping, usually on an ongoing basis, the risk premium inherent in an interest rate on a bond or a loan in return for a cash payment that is made in the event of default by the debtor. Credit Rating Agency is a company which rates the debtors on the basis of their ability to pay back the debt in timely manner. Credit Risk: It refers to the potential inability of a borrower to comply with contractual credit terms and bears the closest resemblance to the primary risk in domestic lending. Credit Crunch: demand for it. Credit Linked Note: be a default, credit spread, or rating change. Credit Risk obligations in accordance with agreed terms. Cross-rate: calculated by using the dollar rates for both currencies. Cum Dividend: With dividend. Cum Rights: With rights. Cumulative Dividends: A feature of preferred stock that requires all past dividends on preferred stock to be paid before any equity dividends are paid. Currency Swap: A currency swap is a contract exchanging foreign currency in the spot market with a simultaneous agreement to reverse the transaction in the forward market. Current Yield: The yield on a security resulting from dividing the interest payment or dividend on it by its current market price. Cum Dividend: With dividend. Cum Rights: With rights.
G.10
Glossary
Cumulative Dividends: A feature of preferred stock that requires all past dividends on preferred stock to be paid before any equity dividends are paid. Current Deposits: These are chequable accounts and there are no restrictions on the amount or the number of withdrawals from these accounts. Current Account: services, and unilateral transactions (gifts) between countries. Current Yield: The yield on a security resulting from dividing the interest payment or dividend on it by its current market price.
D Dealer: Debenture: An instrument for raising long-term debt. Debentures in India are typically secured by Debt Swap: that it can use to acquire local equity. Debit Cards: Debit cards are used to electronically withdraw funds directly from the cardholders’ accounts and it is also used for buying the commodities directly from the shops. Debt Swap: that itcan use to acquire local equity. Deep Market: below and above the market price. Default Risk: An economic unit whose current income is less than current expenditures.
In DCPP, the employee and employer make a predetermined contribution each year, and these funds are invested over the period of time till the retirement of employee. Whatever the value of these investments at the time of retirement, the employee will get a certain amount which he would use to purchase an annuity. Demand Bill: It is payable immediately “at sight” or “on presentment” to the drawee. A bill in .
Glossary
G.11
Demonetization: It is the act of stripping a currency unit of its status as legal tender. Derivatives: These are contracts which are written between two parties (counter parties)and whose value is derived from the value of underlying widely-held and easily marketable assets such as agricultural and other physical (tangible) commodities or currencies or short-term and rate), equity price index or bond price index. Devaluation: The devaluation (revaluation) of a currency refers to a policy-determined decrease Depreciation: Depreciation (appreciation) refers to a decline (increase) in the price or exchange rate system. Diffrent Return (Alpha): what the portfolio actually earned and what it was expected to earn given its level of systematic risk. Direct Financing: savings unit) by an ultimate investor (surplus spending unit). Discount: The amount by which a bond or preferred stock sells below its par or face value. For closed- end investment companies, the amount by which the net asset value exceeds the current market price. In foreign exchange market, it is the amount by which forward price is
Discounting: Discount Pricing: interest that will have to be paid till the maturity of the asset. Disintermediation:
Dividends: Periodic payments to the owners of corporate stock. Dividend Yield: Annual dividend stated as a percentage of a share’s market price.
G.12
Glossary
Dividend Valuation Model: The model which states that the current price of a stock is equal to the discounted value of its all future dividends. Doubtful Asset: for more than 12 months.
E Earnings Yield: The ratio of earnings per share to market price of the share. Earnings Multiplier Model: The model which states that the price of a stock is equal to the product of its earnings and a multiplier. Economic Instability: It refers to marked ups and downs in the economic system as a whole in
accurately. In such a market all new information is quickly absorbed by market participants and is quickly incorporated into market prices. intrinsic values. A portfolio which has the largest expected return for a given level of risk or the smallest risk for a given level of expected return. Entry Load: It is a sales charge that the investors pay when they buy some units of a mutual fund scheme. Equity Fund: A fund which invests primarily or heavily in common stocks. Escrow Account: depository) to ensure compliance with the terms of the deed between two parties only upon
mortgage property, etc. Eurobonds: one currency. Eurocommercial Paper: domestic markets. Eurocurrency: A currency deposited in a bank outside the country of its origin. Eurodollars:
Glossary
G.13
Euroequities: Common and preferred stocks offered outside the issuer’s domestic capital market. Euronote: A short-term note issued outside the country of the currency it is denominated in. European currencies. European Monetary System (EMS):
European Option Ex Dividend: Without dividend. Ex Post: After the fact, what has actually occurred. Ex Rights: Without rights to buy shares in the company’s rights issue. Exchange Rate: The exchange rate (ER) is the price of one country’s currency (money) in terms of another country’s currency (money). Exchange Rate System: It refers to the manner in which the exchange rate of domestic currency in terms of other currency (or currencies) is determined. For example, if the exchange rate of
Exit Load: It is the amount of money that the investor needs to pay to the mutual fund companies when intend to exit from a scheme. Exchange Rate Risk: international transactions or international exchange, on account of uncertain or unexpected changes in exchange rates. Expected Return: Expected Return is an anticipated, predicted, desired, ex-antereturn, which is Exercise Price: The price at which the holder of a call option may buy an asset, or the holder of a Expectation Theory of Interest Rate: It is posited that today’s long-term rate is the unbiased (arithmetic or geometric) average of the current short-term rate and the successive forward or expected one-period short-term rates during the period of long-term loan. Exotic Derivatives: The derivatives which have many non-standardised features, which might appeal to special classes of investors, are known as exotic derivatives. They are not exchangetraded, and they are structured between parties on their own.
G.14
Glossary
Expense Ratio: The ratio of total expenses to annual average net asset value. This measures the fund’s expense performance. Exercise Value: For a call option, the amount by which the striking price is below the underlying investment; for a put option, the amount by which the striking price is above the underlying investment. Expiration Date: In the case of options, the last date at which an option can be exercised.
F Factoring: Fama and French Three Factor Model: A factor model that expands on the capital asset pricing Fiat Money: Non convertible paper money. Fiduciary: Of a trust or trustee; held or given or issued on trust. Finance Ratio: It is the ratio of total issues of primary and secondary claims to national income. Finance: person. Financial Assets: form of interest or dividend. Financial Engineering: Financial Inclusion: services needed by all sections of the society in general and vulnerable groups such as weaker sections and low income groups in particular at an affordable cost in a fair and transparent manner by mainstream institutional players. Financial Institutions: Financial institutions are business organisations that act as mobilisers and Financial Integration: It refers to the establishment of close connections or effective linkages Financial Intermediation:
Glossary
G.15
Financial Inter-relation Ratio: Financial Markets: Financial markets are the centres or arrangements that provide facilities for Financial Reforms: Financial reforms involve instituting policies which will increase the allocative
Financial Repression: It represents the economic conditions in which the government’s regulatory
Financial Risk: Financial System: Financial systems are made of different intricate and complex models that
Financialisation of Saving Fiscal Policy: The policy of government with respect to government revenues and expenditures. Fisher Effect: It states that the nominal interest differential between two countries should equal the
Fixed Exchange Rate: An exchange rate whose value is not determined in the foreign exchange market; it is the rate determined by the policy makers in the country. Fixed-Income Securities: and preferred stock. Floating Exchange Rate: An exchange rate whose value is determined in the foreign exchange market. Floating Lien: Floating-rate Bond: Follow-on Public Offer(FPO). listed on an exchange, issues new shares to the investors or the existing shareholders, usually the promoters. FPO is used by companies to diversify their equity base. Foreign Bond Market: foreign companies or governments.
G.16
Glossary
Foreign Bonds: denominated in domestic currency, but occasionally denominated in another currency also. Foreign Direct Investment (FDI) Foreign Equity Market: by foreign companies. Foreign Exchange Market: It is the market in which different currencies (i.e. currencies of different countries) are bought and sold. The price in this market is the foreign exchange rate. Foreign Institutional Investment (FII): in the shares of company that is listed in hosting country or in bonds offered by the hosting country. Foreign Market Beta: A measure of foreign market risk that is derived from the capital asset pricing model. Forfaiting: It is a service which enables exporters to convert their credit sales into cash sales by discounting their receivables with an agency called “forfaiter”. Forward Contract: An agreement between two parties to exchange an asset for cash at a Forward Cover: Forward purchase or sale of foreign currency to offset an anticipated future cash Forward Exchange Rate: Forward Rate: time in the future. Free Float: An exchange rate system characterised by the absence of government intervention. Front Running: When the brokers trade on their own behalf, ahead of their customers’ orders, it is called front running. This indicates the extent of hedging against possible future contingencies. Full-service Lease (Rental Lease): Lease in which the lessor promises to maintain and insure the equipment. The market which minimises administrative and transactions costs, and which provides maximum convenience (minimum inconvenience) to borrowers and lenders while performing the function of transmission of resources, and yet
Glossary
G.17
Fund Manager: of the fund. Fundamental Analysis: The idea that a security has an intrinsic value at any time which is a be estimated. When the market price of a security is equal to its intrinsic Funded Debt: Debt that matures after one year. Funded Pension Plan (FPP): dedicated for that purpose, it is called a FPP. Future Value: Also referred to as compound value. The terminal value of a beginning amount of money compounded at a given interest rate over a given period of time. Futures Contract: the future at a predetermined price.
G G-5 Nations:
G-7 Nations:
Globalisation: boundaries. Gnomes: draw attention to themselves, who remain incognito wherever they go. Their identity is not known to the rest of the world. Going In The Tank: When the security loses its value fast or it has already lost its value, it is said to be (have) going (gone) in the tank. Going Private: A process of change of ownership from public to private is called as going private.
G.18
Glossary
Going Public: A process of change of ownership from private to public is called going public. Going-concern Value: Gold Standard: A system of setting currency values whereby the participating countries commit to Growth Fund: The fund whose portfolio consists of investments which have potential for sourcing income at regular intervals. The primary emphasis is on regular return. Growth Stocks: the opportunity cost of capital; the shares on which the return has been increasing and is expected to increase in future.
H These are assorted investment pools which use an array of hedging techniques to reduce portfolio volatility One investment purchased against another investment in order to counter any loss made by either. Hedgers are people who try to minimise risk or who try to protect themselves by buying to set off their losses with gains. Hedging is meant to minimise losses, or investment risk, not prices, others may rise in prices. It is the price which is quoted or provided by the buyer who wants to buy the assets. It is a commonly accepted measure of market concentration.
points are considered to be concentrated A company which holds a controlling interest in one or more other companies which are referred to as subsidiaries. The total return from an investment for a given period of time, including gain or loss. It is the movement of share price within a narrow range of ups and downs over an extended period, say, six months.
Glossary
G.19
It refers to takeover of a company by an individual, or a group or another company which does not approve of the management of the target company or its corporate philosophy. interest rate or to avoid political or other risks.
I Impact Cost: Implied Volatility: Implied volatility is the estimate of how volatile the underlying will be from the present until the currency of option. Implied Volatility: It is the estimate of how volatile the underlying will be from the present until the currency of option. Income Bonds: Income Fund: It provides regular and constant income to the investors. The portfolio of these funds bonds, corporate debentures, money market instruments. Indenture: A formal agreement between the issuer and the purchaser of a bond. Index Derivative: instrument at a given market. Index Fund: It is a fund which invests in the price index of a security (say equity index) with an Index Funds: These Funds are designed to replicate the performance of a well-established stock market index ora particular segment of the stock market. Indexed Bonds: Indirect Financing: intermediaries who, in turn, them from ultimate surplus spending units. pure rate of interest. purerate of interest. It is the risk that the real return on a security may be less than thenominal return.
G.20
Glossary
This is the degree of gain possible by the use ofcommonly available information. Amount of money investor puts up Initial Margin = Total value of transaction Initial Public Offer (IPO): It is the selling of securities to the public in the primary market. Initial Public Offering: engages in an initial public offering. Insider Trading: It is trading in security or commodity on the basis of inside information i.e. information about the organisation which is available to the people belonging to that organisation. Insolvency: If the borrower (say, a company) is unable to pay its creditors because it does not have liquid funds, he is said to be technically insolvent. The creditor then can sue the company which may have to sell off its assets to meet the obligation. If the company’s assets fall below its liabilities, then company is said to be bankrupt, which is a next stage of insolvency. Instability: It means changeability, sudden or easy changeability in value, waveringness or Institutionalisation of Saving: Insurance Policy: It is the contract between the insured (policy holder) and the insurer (insurance company). Insurance: Interest Agio: Difference between the interest rates of two countries. Interest Rate Futures: and CDs. Interest Rate Options: Interest Rate Parity: The concept that the difference between the interest rates in two countries is equal to the difference between the forward and spot rate of their respective currencies. Interest Rate Risk: The risk arising from a change in the price of a security resulting from a change in market interest rates. Interest Rate Spread: The difference between the rate of return from earning assets and the rate paid on interest-bearing liabilities.
Glossary
G.21
Intermediation Ratio: It is the ratio of secondary issues to primary issues, which indicates the
economy. Internal Rate of Return: It is the rate of discount which makes the present value of all the revenues The attempt to reduce risk by investing in more than one nation. investor scan typically reduce the variability of their returns. International Fisher Effect: It states that the interest differential between two countries should be an unbiased predictor of the future change in the spot rate. International Funds: They invest almost their entire portfolio in non-domestic markets. International Monetary System: The set of policies, institutions, practices, regulations, and mechanisms that determine the rate at which one currency is exchanged for another, and Interval Fund: This category of funds possesses the characteristics of both open-ended and closeended funds. Intrinsic Value: referred to as the fair value or reasonable value or investment value. Investment Banks: that take an active role in the distribution of the securities to ultimate investors. Issued Capital: It is that part of authorised capital of any company which has been issued (sold) to the individual and institutional investors or the buyers of the shares of the company.
J J-curve Theory: currency depreciates because higher prices on foreign imports will more than offset the reduced volume of imports in the short run. Jobbers: They are market players who provide both buy and sell quotes for particular scrips. They are also known as market makers. Jobbing Spread: prices.
G.22
Glossary
Junk Bond: market is also referred to as the “high-yield debt market”.
K Kerb Trading:
L Lease: A contractual arrangement whereby one party (the lessor) grants the other party (the lessee) Legal Risk: disallow some activities. Lender of Last Resort: ultimately receive assistance during a liquidity crisis, or when they are in need for funds. Lessor: Owner of a leased asset. Letter of Credit: A formal document issued by a bank on behalf of a customer, stating the conditions under which the bank will honour the commitments of the customer. Leveraged Buyout: Leveraged Lease: A lease arrangement under which the lessor borrows a substantial portion of the purchase price from a lender, usually a commercial bank. Lien: A lender’s claim on assets offered as security for a loan. Line of Credit: A pre-approved credit facility (usually for one year) enabling a bank customer to Liquidation Value: wound up its business, or which has gone into liquidation. Liquidity Adjustment Facility (LAF): LAF enables liquidity management on a day to day basis. Liquidity Premium Theory: The liquidity premium theory highlights the preference for liquidity and the desire to minimise the sum of income risk and capital risk as the additional factors determining the term structure of rates. Liquidity’ Premium: (1) Additional return for investing in a security that cannot easily be turned into cash. (2) Difference between the forward interest rate and the expected spot interest rate. (3) Additional return for investing in a long-term security.
Glossary
G.23
Liquidity Risk Liquidity: The extent to which or the ease with which an asset may quickly be converted into cash with the least administrative and other costs. Loan Ratio: London Inter-Bank Offer Rate (LIBOR): It is an interest rate at which banks can borrow funds Long Position: A position in which the investor is entitled to receive an asset in future. It is the position of a buyer of the securities. Loss Asset: the amount has not been written off, wholly or partly.
M Maintenance margin: The amount that is set aside to ensure that the balance in the margin account never becomes negative is called maintenance margin. It is usually lower than the initial margin. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call. Managed Float: Management Buyout: It is the purchase of the company by its own existing management. Management Fee: The amount paid by mutual funds to their investment advisers. Margin Buying: It refers to buying some shares with cash and paying for additional shares by borrowing from the stock broker. There are regulations on the limit up to which shares can be bought on the margin, and this limit is changeable from time to time. Margin Call: A demand by authorities from the broker for additional cash or securities as a result of the actual margin declining below the maintenance margin. Margin Trading: It is the purchase of shares by investors and brokers by using money borrowed Margin: That part of a transaction’s value that a customer must pay to initiate transaction, with the other part being borrowed from the broker. There are two types of margin: initial margin and maintenance margin. In another context, margin means that part of the value of collateral
G.24
Glossary
Market Capitalisation: It is equal to the share price of the company at a point of time multiplied by the outstanding number of its shares at that point of time. Market capitalisation of a given stock exchange is the total market capitalisation of the scrips listed on that exchange. Market Failure: It is a situation where scarce resources are not put to their highest valued uses. Market Lot: are bought and sold on the stock exchanges. In India, generally, for shares of face value of Rs `
Market Maker: A business entity that, acting as principal, buys and sells securities. He is a for their deals. He has a key function in the secondary market. Market makers determine the securities prices, and ensure that those who want to buy and sell securities are able to do so do not occur, that deals on a substantial scale take place, and that transactions costs are not unduly high. They are market players who provide both buy and sell quotes for a particular Market Risk: It is a risk that market price may move up or down Market Segmentation Theory: The theory which states that interest rates on securities with different maturities are effectively determined by the conditions that prevail in the different maturity segments of the market. Market Value: the market value of one share of stock is the current market price; for the corporation, it equals market price per share multiplied by the number of shares outstanding. In general, it is the value of a security which is determined by the market. Mark-to-market Margin: The amount that is deposited as a further collateral to meet daily losses. are credited to the client’s variation margin account. Maturity Gap Analysis (MGA): It is the simplest analytical technique for calculating IRR exposure. Maturity risk: It arises when the term of maturity of the security happens to be longer. Merchant Bank: An organisation that serves many needs of business enterprises such as giving Merger: It is a friendly or mutually agreed coming together of two or more companies to form one
Glossary
G.25
Monetary Base: Monetary instability: It is the instability of general prices. power to issue a single currency. The European Community’s monetary union has come monetary unit. Money Market Mutual Fund: An investment company whose assets consist primarily of treasury acceptances. Money Markets: Money markets deal in the short-term claims (with a period of maturity of one year or less). Money Multiplier: The ratio of new deposits to the original increase in reserves is called the money multiplier or credit multiplier or deposit multiplier. Money: It refers to the current medium of exchange or means of payment. Moneyness: option. Moral hazard: their obligations with respect to their performance of the contract. Mortgage Bond: Mortgages: Long-term liabilities collateralised by real property. Multicurrency Clause: The clause which gives a eurocurrency borrower the right to switch from one currency to another when the loan is rolled over. Mumbai Inter Bank Offer Rate (MIBOR):It is the interest rate at which banks can borrow funds, Mutual Fund: A trustee company which pools the resources of like minded investors (called unit
N NBFCs-ND-SI: `
G.26
Glossary
`
NBFCs-SI:
Negotiated Deal: When a trade is executed between two member brokers and then reported on the trading system, it is called a negotiated deal. Net Asset Value (NAV):The NA V per unit is basically arrived at by calculating the total market value of investments orassets of the MF, subtracting liabilities, and dividing by the number of units currently outstanding. Net Asset Value Per Share: Market value of mutual fund assets less liabilities (net assets) divided by the number of shares outstanding. Net Assets: Aggregate realisable market value of all investments less the value of liabilities outstanding for a given scheme. Net Interest Margin =
Total Interest Income – Total Interest Expenses Average Earning Assets
Net Lease: Lease in which the lessee promises to maintain and insure the equipment. Net Worth: New Issue Market: It is the market on which a company raises capital or funds by issuing primary market. New Issue Ratio: It is the ratio of primary issues to the physical capital formation which indicates New Pension System: No Load Fund: A fund with neither an entry load nor an exit load. Nominal Yield: It represents the coupon rate of a bond. Non-Banking Financial Company (NBFC): It is a company registered under the Companies
of a like nature, leasing, hire-purchase, insurance business, chit business. Non-banking institution: It is a company and has principal business of receiving deposits under any scheme or arrangement in one lump sum or in instalments by way of contributions or in Non-Competitive Bidding:
Glossary
G.27
The part of total risk of investment in a security which cannot be eliminated Non-Performing Asset: A non-performing asset shall be a loan or an advance where the interest of the Loan. Non-sterilised intervention: It occurs when the authorities purchase or sell foreign exchange, normally against their own currency, without such offsetting actions. Nostro Account: It is the working balance in foreign currency maintained by a bank in Country A Note Issuance Facility (NIF): A facility provided by a syndicate of banks that allows borrowers to usually have the right to sell their notes to the bank syndicate at a price that yields a preNovation: It is a way of selling a loan and effectively transferring both rights and obligations. In novation, the existing loan between originator and borrower is cancelled and a new agreement between the investor and borrower is substituted.
O Offshore Finance Subsidiary: haven country, whose function is to issue securities abroad for use in either the parent’s domestic or foreign business. Open ended Fund (OEF): When the units are sold and redeemed every day or continuously on an all-going basis at the price determined by the fund’s NAV,they are called OEFs. Open Interest: Open Market Operations: Open-ended Scheme: A scheme which gives the investor an option to subscribe to the units of the scheme at any time and have the units repurchased by the fund also at any time. Operating Cycle: customers, and collect proceeds of the sale in cash.
G.28
Glossary
Operating Lease: Operational Risk: inadequate or failed internal processes, people and systems or from external events’. The rate of return that could be earned if the next best alternative to cash were held by an investor, that is, the rate of return that is forgone when an investor holds cash. Opportunity Cost: The rate of return that can be earned on the best alternative investment. In general, the gain or return on the next best investment opportunity or the next best use of resources, which is forgone by putting the resources to a given use. Option Contract: An agreement that confers the right to buy or sell an asset at a set price at some future date. The right is exercisable at the discretion of the option buyer. Ordinary Shares: Ordinary shares are ownership securities which have certain advantages in favour of the issuing companies and investors depending on their attitude to risk-taking. Overdraft System: The system in which the borrower is allowed to overdraw on his current Oversubscription: When the number or the total value of the security for which investors have applied exceeds the number or the total value of security issued by the company, oversubscription is said to have occurred. Over-the-Counter (OTC) Market: It is a market which is not an organised exchange; it comprises
Overvalued Security: When the buyer or investor is willing to pay the price for the security which
P P/E Ratio: how highly a share is valued in the market. It generally tends to be high in the case of highly
in underpriced. Paid-up Capital: It is the equity capital of the company which the shareholders have subscribed to and fully paid for. Paper:
Glossary
G.29
Par Value: The value of a security when it is issued. For bonds and preferred stock, par value is equivalent to face value. Participatory Notes: They are like contract notes, and they are issued by registered FIIs to their in India which require them to make at least a minimum level of disclosure. Debt instruments backed by a portfolio of assets. Pay In: It is the process where brokers pay the clearing corporation. Pay Out: It is the process when the clearing corporation pays the brokers. Pay-As-You-Go Pension Plan (PAYGPP): as a pension that sustains the older generation Pay-Out Ratio: Pension Fund: A separate entity to which periodic (or in some cases, lump-sum) contributions are made by or on behalf of covered pension plan participants. At the time of retirement, each participant receives a distribution from the fund in the form of an annuity or a lump-sum payment. Pension Plan (PP): It is an arrangement to provide income to participants in the Plan when they retire. The hedge where the change in the value of the futures contracts is identical to the change in the value of the hedged asset or liability. Perpetuity: A perpetual annuity. Physical Delivery: It is a settlement of the contract by the supply or receipt of the asset. Portfolio: A set or group or combination of securities held by an investor. Portfolio Turnover: The ratio of the lower of annual purchase and annual sale divided by the average net asset value. Indicates the trading activity of a fund’s portfolio. Position Limit a single operator at any point of time. Position: It is market commitment by the investor. Preference Share: return (dividend) like a debenture. Preferred Stock: An equity security with an intermediate claim (between the bond-holders and the
G.30
Glossary
Premium: The difference between the face value of the security (share) and the price at which it is actually sold (issued) in the market is known as the premium. the classical gold standard whereby disturbances in the price level in one country would be Primary Dealer business. Primary Markets: markets. Prime Rate: Rate at which banks lend to their most favoured or most credit-worthy customers. Principal: Amount of debt that must be repaid. It also means a person who deals in securities on his own account and not as a broker. Private Equity: It consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet. Private Placement: When an issuer makes an issue of securities to a select group of persons not exceeding 49, and which is neither a rights issue nor a public issue, it is called a private placement. Privatisation: by individuals and private incorporated and unincorporated bodies. Property Derivative: real estate asset, usually represented in the form of an index. Prospectus: It is the document containing necessary and relevant information about the company which has to be prepared and made available when the company wants to raise fresh capital on the new issue market. Provisions for Loan Losses Provision for Loan Loss Ratio: Total Loans Prudential Regulation: It means regulation without suppression, and supervision and control without constriction.
Glossary
G.31
Public Deposit: from the public at large. Purchasing Power Parity: The concept that homogeneous goods cannot have more than one price measured in any one currency. If the price increases domestically, the domestic currency will depreciate so that the price denominated in foreign currency remains the same. This is the law of one price. Pure Insurance Premium is the present value of the expected cost of an insurance claim. Put Option: period.
Q Quick Ratio:
Quick Assets Current Liabilities
R Rally: It is a noticeable rise in the price(s) of share(s) or in the share market index after a period of stagnancy or a declining trend. Real Exchange Rate: Real Rate of Return: Realized Yield: The return actually earned on a bond as opposed to expected or promised yield. Realized Yield: The return actually earned on a bond as opposed to expected or promised yield. Recourse: Term describing a type of a loan. If a loan is with recourse, the lender has a general Redemption Price: The price per unit which the unit holder receives when the scheme is liquidated. Refunding: The issuance of new securities to retire outstanding securities. Registered Bond: The registered bond maintains the records of the owner and pays the interest directly to the owner. Registered Security: Registrar and Transfer Agent: of securities. Registrar: Financial institution appointed to record issue and ownership of company securities.
G.32
Glossary
Reinvestment Rate: Reinvestment Risk: income securities at rates equivalent to those of the maturing securities because of generally declining interest rates. Relative Valuation Models: In relative valuation, the value of an asset is derived from the pricing book value or revenues. Relative Valuation Models: In relative valuation, the value of an asset is derived from the pricing book value or revenues. Remat: Repo: Repo or ready forward contact is an instrument for borrowing funds by selling securities with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed. It is a service facility provided by the parent bank to assist MNC clients of the parent bank in dealings with the bank’s correspondents. Required Rate of Return: Rate of return required by investors on their investment. Reserve Requirement: maintain. Reserve requirements are expressed in terms of a percentage of relevant deposits. Retail Banking: Transactions with customers of smaller means; small checking accounts, consumer individuals. Retained Earnings: to shareholders as dividends, and which is held or kept with the company presumably for its reserves. Return on Assets (ROA) Return on Equity (ROE): Revaluation: An increase in the spot value of a currency. Reverse Book Building: It is a mechanism provided for capturing the sell orders on online basis be used by companies intending to delist its shares through buy back process.
Glossary
G.33
Reverse Repo: funds against buying of securities with an agreement to resell the said securities on a mutually agreed future date at an agreed price which includes interest for the funds lent. Return: It is
Right Issue: When an issue of securities is made by an issuer to its shareholders existing as on a Risk Adjusted Discount Rate: The discount rate applicable to a risky investment. It is equal to the Risk Aversion: Attitude that less risk is preferred to more risk, all other things being the same. A risk- averse investor will assume more risk only if other things are not the same, such as if he Risk Premium: The additional compensation demanded by investors above the risk-free rate of return for assuming risk—the larger the risk, the larger the risk premium. Or the difference between the expected rate of return market and the risk-free rate of return. Risk: It refers to variability of return or gain and is measured generally by standard deviation or Rolling Settlement: It is a settlement of trade or transaction in which trades executed during a day are settled on a daily basis. Rupee Gap Ratio:
Total Assets
S Sale Price: It is the price paid by investors at the time of investing in a mutual fund scheme. Savings deposits: These earn interest. Although cheques can be drawn on savings accounts, the number of withdrawals and the maximum amount that might, at any time, be withdrawn from an account without previous notice are restricted. Scrip: company and which entitles him to receive dividends (return or income). Secondary Markets: Markets in which already existing or issued or outstanding securities change hands. Secondary Markets: Secondary Security:
G.34
Glossary
Securities Lending: It occurs when a holders of securities or their agent lend eligible securities to securities traders (borrowers) in return for a fee. Securitisation: The pooling of a group of loans with similar characteristics and the subsequent sale of interests in the resulting pool to investors Security Market Line: The line representing the relationship between risk and return for individual Self-liquidating Loan: cash to repay the loan that is secured by highly liquid assets. Selling Short and Buying Long: When the party which does not have (possess or hold) the assets (shares) to deliver, sells them, it is short selling. When the buyers do not have money to pay
The semi-strong form EMH explains that Senior Debt: Debt which, in the event of bankruptcy, must be repaid before subordinated debt receives any payment. Serial Bonds: Series Bond: Settlement Price: Daily settlement price is the closing price of the futures contracts for the trading trading day. Sharpe Ratio: It is a ratio of the excess return (subtracting the risk-free rate from the rate of return of a portfolio) to the standard deviation of the portfolio returns. Short Position: A position in which the investor is obliged to deliver an asset in future. In other words, it is the position of a seller of securities. Short Sale: The sale of a stock not owned in order to take advantage of an expected decline in the price of the stock. If the decline occurs, the stock can be purchased and the short position closed. Short Selling: is done when the price of the security is expected to fall and sellers believe that they could be bought back later at a lower price. Sight Draft: Demand for immediate payment. Simple Interest: Interest calculated only on the initial investment.
Glossary
G.35
Sinking Fund: Social regulation: It comprises regulation in the area of the environment, occupational health and safety, consumer protection and labour etc. Soft Market: It refers to a market dominated by sellers with few buyers. Solvency Margin: It is the amount by which the assets of an insurer exceed its liabilities, and will form part of the insurer’s shareholder’s funds. Solvency Ratio: It means the ratio of the amount of available solvency margin to the amount of required solvency margin. Sovereign Risk: The risk that the country whose currency a bank is buying or selling will impose foreign exchange regulations which will reduce or negate the value of the contract; it also refers to the risk of government default on a loan made to it or guaranteed by it. Sovereign Wealth Fund (SWF): funded by foreign exchange assets. Special Drawing Rights (SDR): A new form of international reserve asset created by the IMF in 1967, whose value is based on a portfolio of widely used currencies. Speculation: When the investor trades on the basis of anticipated or expected price changes of the asset, he is said to be practising speculation. Spot Rate: means delivery in two days after the day of trade.
Stags: in primary markets. Standby Agreement: In a rights issue, agreement that the underwriter will purchase any stock that is not purchased by the stock-holders. Statutory Liquidity Ratio: It is the percentage of total deposits banks have to invest in government bonds and other approved securities. Sterilised Intervention: Foreign exchange market intervention in which the monetary authorities insulate their domestic money supplies from the foreign exchange transactions with offsetting sales or purchases of domestic assets. Stock Derivative: It is a derivative whose underlying is a share of some company. Stock Dividend: A payment of dividend by the corporation in the form of ordinary shares rather than in cash.
G.36
Glossary
Stock Index Futures: Futures contracts on stock indices. Stock Index Options: Stock Split: A given’ share of given face value is exchanged for more than one share with the result that the face value of a new share will be lower than that of the earlier one. Stock: company. Stress Testing: It provides an estimate of the change in the value of the portfolio due to a sudden change in the risk factors such as interest rates and exchange rates.
Structural Regulation: It concerns the regulation of the market structure. Subordinated Debt (junior debt): Debt over which senior debt takes priority. In the event of bank-ruptcy, subordinated debt-holders receive payment only after senior debt is paid off in full. A subsidiary bank is a locally incorporated bank i.e. either wholly Sub-Standard Asset: for a period less than or equal to 12 months. Sum Assured: Itis the amount that is promised by the insurance company in case of a claim either Sunk Costs: Costs which have been incurred and cannot be reversed or recovered. An economic entity whose income in a given period exceeds its
Swap: Switch: It is a mechanism by virtue of which investors can shift their investments from one scheme to others within that fund. Syndicate: Synthetic Position: It is the position created to generate desired payoffs by operating in different
Glossary
G.37
Systematic Investment Pan: It is an investment tool offered by mutual funds which helps investors to make a regular investment of small amount for a certain period of time. Systematic Risk: The variability in a security’s total return that is directly associated with the overall movements in the general market or economy is called systematic risk.
T Tangible Assets: Tap System: The system by which the government sells only those securities that the public requests.
Technical Analysis: It is a technique or method of predicting security price movements based on a study of price graphs or curves or charts over a period of time.
Temporary Investments Ratio: Total Loans Tender Offer: Term Deposits saving medium. They have different maturity periods on which depends the rate of interest. Term Loan: A loan which is generally repayable in more than one year. Term Structure of Interest Rates: The relationship between the length of maturity of loans and interest rates on them. Term to Maturity: Terminal Value: The terminal value of the asset or money is the value of today’s money at some point of time in future. Terms of Trade: The weighted average of a nation’s export prices relative to its import prices. Thin Market: The market in which there are few buyers and sellers for a security. Tick Size: The minimum amount by which the price quoted on the cash market change, and which is decided by the stock exchange in the case of derivatives trading. Time Bill Time Draft: A document which would demand payment at a stated future date.
G.38
Glossary
Total Rate of Return Swap: It is a contract between two counter parties, whereby they swap periodic payments for the period of the contract. Trade Acceptance: Written demand that has been accepted by an industrial company to pay a given sum at a future date. Trade Day: It is a transaction date on which the investor has bought or sold the security in the will be available for trading. Trading Limit: It is the maximum number of contracts that a operator can trade in a single day. Transfer Agent: Individual or institution appointed by a company to look after the transfer of newly issued securities. Treasury Bill Rate: Treasury bill rate is the rate of interest at which treasury bills are sold by the Treasury Bill: government of the country. Treasury bills (T-bills) offer short-term investment opportunities, generally up to one year. Treasury Stock: Common stock that has been repurchased by the company and held in the company’s treasury. Treynor Index: Ratio of risk premium to the beta of the portfolio. Measures the risk premium per Turnover Ratio: It is measured as the total value of shares traded on a country’s stock exchange or liquidity in the stock markets. Two-tier Foreign Exchange Market: determined exchange rate.
U It is a value of the asset like shares, debentures, commodity, livestock or some price index on which derivative contract is based. Issue of securities below their market value. The arrangement in which investment bankers undertake to ensure the full success of the issue of securities.
Glossary
G.39
services and may, thus, be engaged in securities dealing, insurance, underwriting, and the full range of more traditional banking services. Issue of a security for which there is no existing market.
risk.
V Value Additivity: Rule that the value of the whole equals the sum of the values of the parts. Value Traded Ratio: It is measured as the total value of domestic stocks traded on domestic Value-at-Risk (VaR): Vanilla Derivatives: and have simple standard features. They are also known as “plain vanilla” derivatives. Volatility Liability Dependency Ratio:
Total Volatile Liabilities – Temporary Investments Net loans and leases
Volatility: Fluctuations in a security’s or portfolio’s return or price. It refers to wide changes in the price. Vostro Accounts: Accounts of foreign banks or other foreign correspondents having rupee (foreign
W Warrant: The weak form EMH assumes that the share prices rates of return, trading volume, other market-generated information, block trades etc.
G.40
Glossary
When-Issued Market: It is the market where trading takes place in that bond before the issuer sells the securities in the primary market. A when-issued market is very active in government
Y Yield: The total of all dividends for last one year as a percentage of the month-end offer price in the case of an open-ended scheme and as a percentage of the market price in the case of a close-ended scheme. Yield Spreads: The relationships between bond yields and the particular features of bonds such as quality, callability, and taxes. Yield to Call: A better measure than yield to maturity for bonds likely to be called back, using as the time element the end of the deferred call period rather than the term to maturity. Yield Curve: The yield curve is a line that shows the relationship between yield to maturity and time to maturity for bonds of the same asset class and credit quality. Yield to Maturity (YTM): The average annual rate of return to a bond investor who buys a bond today and holds it until it matures. The YTM is that rate of return that causes the market price value).
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R.14
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R.24
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References
Weller, Paul, The Theory of Futures Markets, Blackwell, Oxford, 1992. World Bank, Finance For Growth, Policy Choices In a Volatile World World Bank, The World Development Report, Economic and Political Weekly, May 26, 1990.
R.25
Index
14-Day Treasury Bills 16.5
Asian Development Bank 22.4
91-Day Treasury Bills 16.4
Ask Price
182-Day Treasury Bill 16.5
Asset Finance Company 13.3
364-Day Treasury Bill 16.5
Asset Management 8.71
(Separate Trading of Registered Interest and Principal of Securities) 18.21
Assets of Banks
19.23
8.13
Assured Return Schemes
12.13
Atal Pension Yojana 10.27 At-the-money 20.13
A
Auction Market 19.26
Accommodation Bill 17.17 Action Plans
8.32
Actual Margin
19.28
Augmented Multiple Indicators Approach 6.10 Automatic Teller Machines 8.9
Additional Collateralised Lending Facility 6.15
Autonomous Liquidity 6.15
Additional Margin
Autonomy of the Central Bank 6.34
20.12
Autonomy of Reserve Bank of India 6.36
Adequacy of Reserves 21.35 Ad-hoc TBs
16.3
B
Agricultural Finance Consultants Ltd. 14.11 All India Financial Institutions 14.2
Backwardation 20.13 Balanced Fund 12.10
American Depository Receipts 22.7
Bank Competition 8.26
American Options 20.5
Bank Credits
Annuity 2.14
Bankers’ Bank 6.4
Arbitrage Funds
12.13
Arbitrage Pricing Theory
8.45
Banking Regulation Act 2.11
Bank Rate 6.10
5.7
I.2
Index
Basel I 8.58 Basel II 8.59 Basel III 8.60 Basic Yield 2.6 Basis 20.12 Basis Risk 8.64 Basis Swap 20.8 Bearer Bond 18.1 Beta 2.3 Bid-ask Spread 19.23 Bid Price 19.23 Bilateral Creditors 22.9 Bill Market Rates 17.19 Bill Market Scheme 17.20 Bill of Exchange 17.14 Bills of Exchange 8.8 Binomial Option Pricing Models 20.16 Biotechnology Consortium of India Limited 14.17 BIS 22.4 Black–Scholes–Merton Differential Equation 20.21 Black–Scholes Model 20.19 Black–Scholes Option Pricing Formula 20.22 Bombay Stock Exchange 19.15 Bond Swap 20.8 Bonus Issue 19.10 Bonus Issue Guidelines 7.10 Book Built Issue 19.12 Book Runner Lead Manager 19.12 Book Value 2.12 Bottom-Up Approach 2.22 Brickwork Ratings India Private Limited 13.24 Business Risk 2.4
C Call Deposits 8.13 Call Money Market 15.3 Call Money Market Proper 15.4 Call Options 20.5 Call Risk 2.5, 18.3 Capital Asset Pricing Model 2.9 Capital Conservation Buffer 8.60 Capital Gain 2.5 Capital Markets 1.6 Capital Protection-Oriented Funds 12.13 Capital to Risk (Weighted) Assets Ratio 8.24 Cash Flow Approach 8.71 Cash Management Bills 16.6 Cash Reserve Ratio 6.11 Central Institute for Rural Certainty 2.2 Chicago Theory of Regulation 5.4 Civil Servants’ Pension 10.18 Classical Theory 23.4 Clean Bills 17.17 Clearing Corporation of India Limited 18.21 Close-ended Fund 12.8 Collateralised Borrowing and Lending Obligation 15.17 Collateralised Lending Facility 6.15 Commercial Banks 8.3 Commercial Paper 17.2 Commodity Derivative 20.1 Commodity Derivatives Market 20.40 Companies Act 5.28 Company Analysis 2.23
Index
Competition Act 5.17 Competitive Bidding 16.7 Competitor 19.26 Concessional Interest Rates 24.12 Conduct Regulation 5.4 Conservative Central Banker Approach 6.34 Consumer Credit 3.21 Contango 20.12 Continuing Guarantees 17.30 Contributory Provident Fund 10.11 Convenience Yield 20.15 Conversion Premium 2.16 Conversion Price 2.16 Conversion Ratio 2.16 Conversion Value 2.16 Convertibles 20.9 Co-operative Banks 9.1 Corporate Debt 18.38 Corporate Governance 7.17 Correspondent Banks 8.27 Countercyclical Buffer 8.60 Country Risk 2.5, 8.28 Coupon 18.1 Coupon Rate 2.6 Covered Short Selling 19.28 CPs in India 17.4 Credit Analysis and Research Ltd. 13.24 Credit Authorisation Scheme 6.11 Credit Cards 8.8 Credit Creation Theory 1.15 Credit Derivatives 20.10 Credit Rating Agency 13.21 Credit Rating Framework 8.63 Credit Rating Information Services of India Ltd. 13.22
Credit Rating Methodology 13.25 Credit Rating Process 13.25 Credit Risk 8.28 Credit Risk Management 8.61 Currency Convertibility 21.27 Currency Options 20.6 Currency Risk 2.4, 8.28 Currency Swap 20.9 Current Deposits 8.13 Current Yield 2.7, 18.6
D Day Trader 19.17 Debit Cards 8.9 Debt–Equity Swap 20.9 Deen Dayal Upadhyaya Gram Jyoti Yojana 14.16 Deep Market 1.28 Default Risk 2.4, 18.2
Demand Bill 17.17 Demand Loans 8.14 Demonetisation 3.25 Deposit Insurance and Credit Guarantee Corporation 17.34 Depositories Act 5.12 Depository and Custodial Services 13.29 Depreciation 21.11 Depth 19.23 Derivatives 20.1 Determinants of Exchange Rate 21.14 Determinants of Foreign Capital 22.2 Devaluation 21.11
I.3
I.4
Index
Development Banks 14.1 Discount and Finance House of India 17.28 Discount Cash Flow Valuation 2.17 Discounting Service 17.26 Discount Rate 2.13 Discretionary Liquidity 6.16 Disintermediation 1.28 District Central Co-operative Banks 9.4
Dividend Capitalization Model 2.17 Dividend Yield 2.7 Documentary Bills 17.17 Doubtful Asset 8.23 Duration Gap Analysis 8.66
E Earnings Multiples 2.20 Earnings Yield 2.7 Econometric Techniques 8.62 Economic Analysis 2.22 Economic Instability 3.14 Effect 1.15
Market
21.8
Embedded Option Risk 8.65 Employee Pension Scheme 10.18 Employee Provident Fund 10.12 Entry Load 12.6 Equity Culture 19.1
Euro Issues 22.5 European Options 20.5 Exchange Control (EC) Authority 6.4 Exchange Rate Policy 21.15 Exchange Rates 21.9 Exchange-Traded Funds 12.12, 19.22 Exercise Date 20.13 Exit Load 12.6 Expanded Approach 3.19 Expectations Theory 23.9 Expected Return 2.6 Expert Systems 8.63 Expiration Date 20.13 Export Credit and Guarantee Corporation 17.36 Export-Import Bank of India 14.2 External Commercial Borrowings 22.9
F Face Value 18.2 FDI in the Retail Sector 22.28 Federal Funds Market 15.4 Finance 1.5 Finance Ratio 1.19 Financial Asset 1.7 Financial Derivative 20.1 Financial Engineering 1.27 Financial Guarantees 17.30 Financial Inclusion 3.18 Financial Inclusion Index 3.19 Financial Innovations 1.26 Financial Institutions 1.5 Financial Integration 3.11
Index
Financial Interrelation Ratio 1.19 Financialisation of Saving 3.7 Financial Liberalisation Theory 1.17 Financial Markets 1.6 Financial Reforms 1.29 Financial Regulation Theory 1.16 Financial Repression 1.29 Financial Revolution 1.28 Financial Risk 2.4 Financial Self-Regulation 5.33 Financial Services 1.8 Financial System 1.3 Financial Volatility 3.13 First-generation Reforms 4.3 Fixed Deposits 8.13 Fixed Exchange Rate System 21.11 Fixed Maturity Plans 12.11 Fixed Price Issue 19.12 Flat Yield Curve 18.8 Floating Rate Funds 12.10 Floating Rate Notes 22.6 Follow-on Public Offer 19.10 Foreign Bills 17.17 Foreign Bonds 22.6 Foreign Currency Non Resident (Bank) Account 22.11 Foreign Direct Investment 22.13 Foreign Exchange Management Act 5.14, 21.13 Foreign Exchange Market 21.3 Foreign Exchange Market Trading 21.7 Foreign Exchange Regulation Act 21.3 Foreign Institutional Investment 22.13 Foreign Investment 22.1
Forex Reserve Management 21.32 Forward Discount 21.10 Forward Premia 21.25 Forward Premium 21.10 Forward Rate 21.9 Forwards 20.3 Forwards versus Futures 20.4 Freight Derivatives 20.11 Full Capital Account Convertibility 21.31 Functional Approach 5.5 Functions of RBI 6.2 Functions of SEBI 7.5 Fundamental Analysis 2.22 Fund of Fund 12.13 Futures 20.3 Futures versus Options
20.7
G General Insurance 11.4 General Provident Fund 10.11 Gilt Account 18.15 Gilt Funds 12.10 Global Depository Receipts 22.7 Going Concern Approach 8.15 Going-Concern Value 2.12 Gold ETFs 12.13 Gold Monetisation Scheme 4.21 Government Banker 6.3 Government Bonds 18.9 Government Security 18.8
I.5
I.6
Index
Gross Yield Growth Fund
2.7
Industrial Reconstruction Bank of India 14.9 Industry Analysis 2.23
12.9
H Hedge Funds 12.21 Hedge Fund Strategies 12.22 High Yield Debt Funds 12.10 Hire-purchase Credit 13.3 Holding Period Yield 2.6 Household Sector Liabilities 3.8 Household Sector Saving 3.6 Housing and Urban Development Company 13.15 Housing Development Finance Corporation Ltd 13.15 Housing Finance Companies 13.12 Humped Yield Curve 18.8 Hybrid Systems 8.63
I Immediacy 19.23 Implied Interest Rate 20.11 Implied Volatility 20.12 Income Distribution Effect 1.15 Income Fund 12.9 Index-Based Market-Wide Circuit Breaker 19.30 Index Funds 12.11 Indian Railway Finance Corporation 14.18 Indira Gandhi National Old Age Pension Scheme 10.18 Industrial Financial Corporation of India 14.7 Industrial Investment Bank of India 14.9
Informal Markets 1.7 Infrastructure Debt Fund: Non-Banking Financial Company 13.7 Infrastructure Development Finance Company 14.18 Infrastructure Finance Company 13.7 Infrastructure Leasing and Financial Services Ltd. 14.10 Initial Margin 19.28 Initial Public Offering 19.10 Initiator 19.26 Inland Bills 17.17 Institutional Approach 5.6 Institutional Investors 19.17 Insurance 11.1 Insurance Policy 11.2 Insurance Premium 11.1 Insurance Regulatory and Development Authority of India Act 5.32 Insurance Regulatory Development Authority 7.20 Insurance Reserves 11.2 Insurer Solvency 11.8 Integrated Approach 5.5 Integrated Power Development Scheme 14.16 Integration 1.29 Inter-bank Call Market 15.5 Inter-bank Call Rate 15.11 InterBank Participations 8.29
Index
Interest Options
20.5
K
Interest Rate Risk 2.3, 18.2 Interest Rates for Non-Resident Deposits 24.12
Keynesian Theory 23.6 Khusro Committee 9.6 Kisan Vikas Patra 10.6
Interest Rate Swap 20.8 Interest Sensitivity 8.21 Inter-market Spread Swap 20.8 Intermediaries 1.6 Intermediate Exchange Rate Systems 21.11 Internal Rate Of Return 2.5 International Banking 8.27 International Depository Receipts 22.7 International Development Association or Agency 22.4 International Finance Corporation 22.4 Internationalisation 1.30 Interval Fund
12.9
In-the-money 20.13 Intrinsic Value
2.13
Inverted Yield Curve
18.8
Investment Company 13.5 Investment Information and Credit Rating Agency of India Ltd. 13.23 Investment Trust Company
12.1
Investors Sentiment 19.18 IPO Grading 19.11 Issue of Capital and Disclosure Requirements Regulations Act 5.24 Issue Price
18.2
J Jensen Ratio 12.16
L Large Cap Stocks 19.25 Lead Bank Scheme 8.31 Lease Finance 13.4 Letter of Offer 19.12 Leverage Ratio 8.60 Liabilities of Banks 8.12 Liability–Asset Transformation 1.14 Liability Management 8.71 Life Insurance 11.4 Life Insurers in India 11.14 Life of the Policy 11.2 Life Style Fund 12.14 Limit Price/Order 19.27 liquidation Approach 8.15 Liquidation Value 2.13 Liquidity Adjustment Facility 6.13 Liquidity Preference 23.7 Liquidity Premium Theory 23.11 Liquidity Risk 2.4, 18.3 Liquidity Risk Management 8.70 Listing of Securities 19.24 Load Fund 12.14 Loan 1.5 Loanable Funds Theory 23.6 Loan Company 13.6 Loan Ratio 8.20 Local Area Banks 8.33
I.7
I.8
Index
London Inter-Bank Offer Rate Long Position 20.1 Loss Asset 8.23
15.15
M Maintenance Margin 19.28 Management of Public Debt 6.4 Margin Account 19.28 Marginal Standing Facility 6.17 Margins 8.17 Margin-to-market 20.12 Margin Trading 19.27 Market-clearing Price 19.13 Market Design for Financial Derivatives Trading 20.31 Market Failure 5.4 Market Microstructure 19.24 Market Premium 2.10 Market Price/Order 19.27 Market Risk 2.3 Market Risk Management 8.64 Market Segmentation Theory 23.12 Market Stabilisation Scheme 6.25 Market Value 2.13 Mark-to-market Margin 20.12 Maturity Gap Analysis 8.65 Maturity Risk 2.5 Maturity Transformation 1.14 Mean Impact Cost 19.25 Measures of Autonomy 6.35 Merchant Banks 13.17 Micro 5.22 Mid Cap Stocks 19.26
Mini Contracts in Equity Indices 20.29 Minimalist Approach 3.19 Minimum Capital Requirements 8.59 Mobile Banking 8.10 Monetary Instability 3.14 Monetary Policy Corridor 24.11 Monetary Policy Framework 6.8 Money 1.5 Money Market Mutual Funds 12.10 Money Markets 1.6 Money Multiplier 8.5 Moneyness 20.13 Monthly Income Plan 12.11 Monthly Income Plans 12.6 Moral Hazard 11.2 Moral Suasion 6.13 Mortgage Guarantee Companies 13.9 Multicurrency Bonds 22.6 Multilateral Creditors 22.8 Multilateral Investment Guarantee Agency 22.4 Multiple Banking Arrangements 8.30 Multiple Price Auction 18.17 Multiple Regulator Approach 5.7 Mumbai Inter-Bank Bid Rate 15.15 Mumbai Inter-Bank Offer Rate 15.15 Mutual Fund 12.2 Mutual Savings Banks
12.2
N Naked Short Selling 19.28 National Bank for Agricultural and Rural Development 14.3
Index
National Co-operative Bank of India 9.6 National Co-operative Development Corporation 14.13 National Housing Bank 14.3 National Industrial Development Corporation 14.9 National Pension System 10.20 National Small Industries Corporation 14.11 National Stock Exchange of India 19.15 NBFC: Non-Operative Financial Holding Company 13.9 Negotiated Dealing System 18.17 Net Asset Value 12.6 Net Liquidity 6.16 Net Present Value 2.14 Net Yield 2.7 Neural Network 8.62 New Development Bank 22.5 New Economic Policy 4.1 New Issue Market 19.5 New Issue Ratio 1.19 New Pension System 10.20 NIM 8.20 NITI Aayog 4.20 Nominal Effective Exchange Rate 21.10 Nominal Exchange Rate 21.9 Nominal Return 2.7 Nominal Yield 18.6 Non-Banking Financial Company 13.1 Non-Banking Financial Company– Factors 13.8 Non-Banking Financial CompanyMicro Finance Institution 13.8
I.9
Non-Bank Statutory Financial Organisations 14.1 Non-Competitive Bidding 16.7 Non-Intermediaries 1.6 Non-Life Insurers in India 11.15 Non-performing Asset 8.23 Non-Resident (External) Rupee Account 22.10 Non-Resident Ordinary Rupee Account Non-sterilised Intervention 21.21 Normal Market 19.26 North-Eastern Development Finance Corporation Ltd. 14.18 Note Issuance Facility 22.7 Note Issuing Authority 6.2 NPS-Swavalamban 10.26 NRI Deposits 22.9
O Occupational Pension Schemes 10.18 Odd Lot Market 19.26 Offshore Banking Centre 8.28 Online Banking 8.10 Open-ended Fund 12.7 Open Interest 20.11 Open Market Operations 6.10 Operational Risk 8.69 Optimal Contract Approach 6.34 Optimisation Models 8.63 Option Premium 20.13 Options 20.5 Options on Futures 20.29
22.10
I.10
Index
Order-driven Market 19.26 Ordinary Shares 19.5 Ordinary TBs 16.3 Out-of-the-money 20.13 Overdraft Facility 8.8 Over-the-Counter Exchange of India 19.15
P Par Value 18.1 Pay-As-You-Go Pension Plan 10.15 Payment and Settlement Systems (PSS) Act 5.23 Pension Fund and Regulatory Development Authority 7.24 Pension Fund Regulatory and Development Authority Act 5.31 Pension Funds 10.15 Permanent Retirement Account Number 10.20 Perpetual Bond 1.7 Portfolio Shift 1.15 Position Trader 19.17 Post-Issue Obligations 7.9 Account
10.5
Power Distribution Schemes 14.16 Power Generation Schemes 14.15 Powers of SEBI 7.6 Power Transmission Schemes 14.16 Pradhan Mantri Awas Yojana 13.16
Pradhan Mantri Jan Dhan Yojana 4.21 Pradhan Mantri Jeevan Jyoti Bima Yojana 11.18 Pradhan Mantri Suraksha Bima Yojana 11.18 Pre-cautionary Motive 23.7 Preference Shares 19.6 Preferential Allotment 19.10 Pre-Issue Obligations 7.6 Prevention of Money Laundering Act 5.20 Price-based Auction 16.7 Price 12.6 Price Risk 2.3 Price-yield Curve 18.4 Pricing of Forward Contracts 20.13 Pricing of Future Contracts 20.15 Primary Agricultural Credit Societies 9.4 Primary Co-operative Agriculture and Rural Development Banks 9.4 Primary Corporate Market 18.45 Primary Markets 1.6 Primary Securities 1.8 Principle of Cause Proxima 11.3 Principle of Contribution 11.3 Principle of Indemnity 11.2 Principle of Insurable Interest 11.2 Principle of Loss Minimisation 11.3 Principle of Subrogation 11.3 Principle of Utmost Good Faith 11.2 Principle of Warranties 11.3 Prior Savings Theory 1.12 Private Banking 8.10 Private Equity 19.6 Private Placement 19.10 Privatisation 1.29 Process of Credit Planning 6.12
Index
Process of Money Creation 8.5 Property Derivatives 20.11 Prospectus 19.12 Provident Funds 10.10 Provision for Loan Losses Ratio 8.20 Prudential Norms 6.5 Prudential Regulation 1.29 Public Provident Fund 10.12 Public Sector Undertaking (PSU) Bond Market 18.47 Purchasing Power Risk 2.3 Pure Premium 11.2 Put Options 20.5
Q Quantitative Fund 12.13 Quote-driven Market 19.26
R Rating Symbols 13.28 Real Effective Exchange Rate 21.10 Real Exchange Rate 21.9 Real Interest Rates 24.14 Realised Return 2.6 Realized Yield 18.7 Real Return 2.7 Recommendations of Patil Committee 18.42 Recommendations of Raghuram Rajan Committee 4.18, 18.43 Redemption Value 18.2 Regional Rural Banks 8.57 Registered Bond 18.1
Regulation 5.3 Reinvestment Risk 2.3 Re-investment Risk 8.65 Relative Strength 2.25 relative Valuation 2.18 Repo 6.13 Repo Market 15.17 Re-pricing Risk 8.64 Required Rate Of Return 2.7 Reserve Bank of India 6.1 Reserve Tranche Position 21.33 Residuary Non-Banking Company 13.9 Resiliency 19.23 Retail Banking 8.24 retail investors 19.17 Return 2.5 Revenue Multiples 2.21 Reverse Book Building 19.13 Reverse Repo 6.13 Reversionary Bonus 11.5 Rights Issue 19.10 Rising Yield Curve 18.8 Risk 2.2 Risk-free Rate of Return 2.7 Risk Transformation 1.14 ROA 8.20 ROE 8.20 Rupee Debt 22.12
S Savings Deposits 8.13 Scalp Traders 19.17
I.11
I.12
Index
Secondary Equity Market 19.14 Secondary Markets 1.6 Secondary Securities 1.8 Second-generation Reforms 4.3 Sector Funds 12.11 Securities and Exchange Board Act 5.12 Securities and Exchange Board of India 7.1 Securities Contracts (Regulation) Act 5.10 Securitisation 1.30 Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act 5.19 Security Groupings 19.24 Security Market Line 2.9 Selective Credit Controls 6.11 Hypothesis 2.28 Senior Citizen Savings Scheme 10.6 Serial Obligation Bond 18.1 Service Area Approach 8.32 Settlement Cycle 19.29 Settlement Price 20.13 SGL Account 18.15 Shallow Market 1.28 Sharpe Ratio 12.15 Short Position 20.1 Short Selling 19.28 Simulation Modelling 8.67 Single Regulator 5.6 Size Transformation 1.14 Small and Medium Enterprises Act 5.22 Small Cap Stocks 19.26
Small Industries Development Bank of India 14.4 SME Rating Agency of India Ltd. 13.24 Social regulation 5.4 Society for Worldwide International Financial Telecommunications 21.4 Solvency I 11.9 Solvency II 11.11 Solvency Ratio 11.12 Sovereign Gold Bond Scheme 18.24 Sovereign Wealth Fund 22.31 Speculative Motive 23.7 Spot Rate 21.9 Standard Asset 8.23 State Co-operative Agriculture and Rural Development Banks 9.4 State Co-operative Banks 9.4 State Development Loans 18.9 State Financial Corporations 14.11 State Housing Finance Societies 13.15 State Industrial Development Corporations 14.13 State Industrial Infrastructure and Investment Corporations 14.13 State Small Industries Development Corporations 14.13 Statutory Financial Organisations 1.6 Statutory Functions of IRDA 7.20 Statutory Liquidity Ratio 6.11 Sterilised Intervention 21.21 Stock Index Options 20.5 Stockinvest Scheme 8.29 Stock Market 19.1
Index
Stock Market Indices 19.20
T
Stock Market Liquidity 19.23 Stock Price and Stock Index Quotations 19.21 Stop Loss (SL) Price/Order
19.27
Strike Price 20.13 Hypothesis 2.28 Structural Regulation 5.4 Structure and Statutory Functions of PFRDA 7.25 Sub-Standard Asset 8.23 Substitution Swap
20.8
Sukanya Samriddhi Accounts 10.7 Sum Assured 11.2 Supervising Authority 6.4 Supply Bill 17.17 Swap
20.7
Swap Deal
I.13
1.28
Swing Trader 19.17 Switch 12.6 Systematic Encashment Plan 12.6 Systematic Investment Pan 12.6 Systematic Risk 2.2 Systemically Important Core Investment Company 13.6 Systemically Important Financial Institutions 8.60 System of Administered Interest Rate 24.2 system of basket-pegging 21.13 System of Cheque Clearances 8.28
Tax Saving Funds 12.12 Tax Swap 20.8 Technical Analysis 2.23 Technical Approach 8.71 Technical Consultancy Organisations 14.16 Temporal Gap 8.51 Temporary Investments Ratio 8.20 Term Bond 18.1 Terminal Value 2.13 Term Loans 8.14 Term-Structure of Interest Rates 23.9 Term to Maturity 18.1 The Basic Indicator Approach 8.69 Theory of Forced Savings 1.15 The Standardised Approach 8.70 Tier 1 Capital 8.58 Tier 2 Capital 8.58 Time Bill 17.17 Time Value of Money 2.13 Top-Down Approach 2.22 Total Risk 2.5 Tourism Finance Corporation of India 14.10 Tracking Error 19.22 Trade Credits/Export Credits 22.9 Transactions Motive 23.7 Transfer Risk 8.28 Treasury Bill 16.1 Treasury Bill Rates 16.13 Treasury Management Funds 12.10 Treynor Ratio 12.15 Twin Peaks Approach 5.5
I.14
Index
Warrants 20.9
U Ujjwal Discom Assurance Yojana Ultimate Investors 1.12 Ultimate Savers 1.12 Uncertainty 2.2 Uniform Price Auction 18.17 Unorganised Markets 1.7 Unsystematic Risk 2.2 Urban Co-operative Banks 9.3
14.16
V Valuation of Bond 18.3 Valuation of Ordinary Shares 19.7 Valuation of Preferred Stock 19.9 Value at Risk 8.68 Venture Capital Funds 13.18 Volatility 15.13 Volatility Liability Dependence Ratio 8.20
Ways And Means Advances 6.3 Ways and Means Advances 16.6 Weather Derivatives 20.10 Weiner Process 20.19 Wholesale Debt Market 18.18 Width 19.23 Winner’s Curse
16.7
Working Funds Approach 8.71 World Bank 22.3
Y Yield-based Auction
16.7
Yield Curve 18.8 Yield Curve Risk 8.64 Yield of a Treasury Bill 16.8
W Warehousing Corporations 14.14
Yield to Call 18.7 Yield to Maturity 2.7, 18.7