UNIT II ELEMENTS OF THE FINANCIAL SYSTEM

The Indian Financial System Consists of:

The Financial Markets The Financial Intermediaries The Financial Instruments

Financial Markets:
The Indian Financial Markets can be divided into two components: a) Money Market b) Capital Market The Indian Money market is unorganized or we can say that India has an under developed money market. Therefore, it needs measures to strengthen it. Indian Money market can broadly be divided into two parts: a) Organized money market b) Unorganized money market

Financial Intermediaries:
Banking and Non-banking financial Institutions. The Reserve Bank of India which was set up in 1935, is the apex organization or institution in the Indian money market (It is the Central Bank of our country). The Reserve Bank of India set up many institutions which are supposed to help it in achieving its objectives. In April 1988, set up the Discount and Finance House of India to perform the function of stabilizing the money market.

The following diagrams can be used in order to notice the evolution and the current structure of the financial system in India.

ORGANISAITON OF THE FINANCIAL SYSTEM (1951 to 1985)

FINANCIAL INTERMEDIARIE S

FINANCIAL MARKETS

FINANCIAL ASSETS/ INSTRUMENTS

BANKS

NBFCs

MUTUAL FUNDS

INSURANCE ORGANISATION S

ASSET FINANCE COMPANIES HOUSING FINANCE COMPANIES VENTURE CAPITAL FUNDS MERCHANT BANKING ORGANISATIONS CREDIT RATING AGENCIES FACTORING AND FORFAITING ORGANISATIONS STOCKBROKING FIRMS CUSTODIAL SERVICES DEPOSITORIES

ORGANISAITON OF THE FINANCIAL SYSTEM (1951 to 1985)

FINANCIAL INTERMEDIARIES

FINANCIAL MARKETS

FINANCIAL ASSETS/ INSTRUMENTS

MONEY MARKET

CAPITAL/ SECURITIES MARKET PRIMARY/NEW

CALL MARKET T-BILLS MARKET BILLS MARKET CP MARKET CD MARKET REPO MARKET

ISSUE MARKET

SECONDARY/ STOCK MARKET/ EXCHANGE

ORGANISAITON OF THE FINANCIAL SYSTEM (1951 to 1985) FINANCIAL INTERMEDIARIES FINANCIAL MARKETS PRIMARY/ DIRECT
EQUITY/ ORDINARY SHARES

FINANCIAL ASSETS/INSTRUMENTS INDIRECT DERIVATIVES

FORWARD MUTUAL FUNDS UNITS SECURITY RECEIPTS SCRUTINISED DEBT INSTRUMENTS FUTURES OPTIONS

PREFERENCE SHARES DEBENTURES

INNOVATIVE DEBT INSTRUMENTS

CONVERTIBLE DEBENTURES NON-CONVERTIBLE DEBENTURES SECURED PREMIUM NOTES WARRANTS

ORGANISATION OF THE INDIAN FINANCIAL SYSTEM (Post 1991)

PRIVATISATION OF FINANCIAL INSTITUTIONS: BANKS MUTUAL FUNDS INSURANCE COMPANIES

REORGANISATION OF STRUCTURE MUTUAL FUNDS NBFCs DFIs/PFIs

FINANCIAL MARKETS

INVESTOR PROTECTION SEBI MONEY MARKET CAPITAL MARKET

BANKS
PRIMARY MARKET STOCK EXCHANGE

PRUDENTIAL NORMS: CREDIT/ADVANCE PORTFOLIO INVESTMENT PORTFOLIO CAPITAL ADEQUACY

MANAGEMENT OF NON-PERFORMING ASSETS: DEBT RECOVERY TRIBUNALS CORPORATE DEBT RESTRUCTURING SECURITISATION, RECONSTRUCTION OF FINANCIAL ASSETS AND ENFORCEMENT OF SECURITY INTEREST

RISK MANAGEMENT

OPERATIONAL RISK MANAGEMENT

ASSET LIABILITY MANAGEMENT

CREDIT RISK MANAGEMENT

FUNCTIONS OF FINANCIAL SYSTEM: Savings function: As already stated, public savings find their way into the hands of those in production through the financial system. Financial claims are issued in the money and capital markets, which promise future income flows. The funds, in the hands of the producers, result in the production of better goods and services and an increase societys living standards. When saving flows decline, however, the growth of investment and living standard begins to fall. Liquidity function: Money in the form of deposits offers the least risk of all financial instruments. But its value is mostly eroded by inflation. That is why one always prefers to store funds in financial instruments like stocks, bonds, debentures, etc. However, in such investments (1) a greater level of risk is involved, (2) and the degree of liquidity (i.e., conversion of the claims into money) is less. The financial markets provides the investor with the opportunity to liquidate the investments. Payment function: The financial system offers a very convenient mode of payment for goods and services. The cheque system, credit card systems et al are the easiest methods of payment in the economy; they also drastically reduce the cost and time of transactions. In India, the cheque system of payment is widely practiced. The credit card system has entered only urban India and is widely used in these areas for payment of consumption expenditure. Risk function: The financial markets provide protection against life, health and income risks. These are accomplished through the sale of life, health and property insurance policies. The financial markets provide immense opportunities for the investor to hedge himself against or reduce the possible risks involved in various investments. Policy function: India has a mixed economy. The government intervenes in the financial system to influence macroeconomic variables like interest rates or inflation. In 1996-97, by bringing about several cuts in the CRR from 12% to 10% the government, the RBI tried to force the interest rates down and increase the availability of credit-at cheaper rates to the corporate sector. Modern day economies require huge sums of money for investment in capital assets (land, equipment, factory, etc.), which are then used for providing goods and services. The funds required are so huge that it is not possible for a single government/firm to meet the requirement. By selling financial claims like stocks, bonds etc., the required can be quickly raised from a variety of investors. The business firm/government issuing such a financial claim then hopes to return the borrowed funds from expected future inflows. Indeed, we see that the financial markets within the financial system have made possible the exchange of current income for future income and transformation of savings into investments, so that production and income grow. INDIAN MONEY MARKET: Money market refers to a mechanism whereby on the one hand borrowers manage to obtain short-term loanable funds and on the other, lenders succeed in getting creditworthy borrowers for their money. In any money market, commercial banks are the most important lenders. These banks

are, however, not merely the lenders of money, they also create credit. The central banks role is important as the controller of credit. The money market as it existed in India during the pre-independence period was far more undeveloped than what it is today. Now the Indian money market in spite of all its limitations and defects is perhaps one of the most organized money markets in a Third World country. Here we will discuss the following issues: 1. The nature of the unorganized sector of the Indian money market. 2. Organised sector of the Indian money market and its various constituents. 3. Characteristics of Indian money market. 4. Measures introduced to strengthen the money market in India. THE INDIAN MONEY MARKET: The Indian money market is not an integrated unit. It is broadly divided into two parts, viz., the unorganized and the organized. There is compartmentalization between the two markets and as such the rates of interest differ in the unorganized sector from those in the organized sector. The unorganized sector of the money market comprises the indigenous bankers and the moneylenders. This, in fact, is not a homogeneous sector. The organized sector, on the other hand, is fairly integrated. Both nationalized and the private sector commercial banks constitute the core of the organized sector. The foreign banks, co-operative banks, Reserve Bank of India, Discount and Finance House of India, development finance institutions like IDBI and IFCI and investment finance companies like the LIC, GIC and UTI and Mutual Funds are the other institutions which operate in the organized sector of the Indian market. The Reserve Bank of India is the apex organization in the Indian money market. Since it is the leader and controller of the money market, it has great responsibility in respect of smooth functioning of the financial system. In April 1988, the Reserve Bank of India set up the Discount and Finance House of India to perform the function of stabilizing the money market. UNORGANIZED SECTOR OF THE INDIAN MONEY MARKET: Although some indigenous bankers and moneylenders exist even in big cities, the fact is that their banking activities, or to be more specific, lending activities are mostly confined to small towns and villages where modern banking facilities are still inadequate. Farmers, artisans and other small scale producers and traders, who do not have access to modern banks borrow from them. Lendings of the moneylenders are rather small, but some indigenous bankers do a considerable amount of business. They pursue banking business on traditional lines and combine it with other businesses. The 1. unorganized sector of the Money Market Consists of: Unregulated non-bank financial intermediaries Indigenous bankers and Money lenders

Unregulated non-bank financial intermediaries. In India, there are several types of unregulated non-bank financial intermediaries. Among these the most prominent are (i) finance companies, (ii) chit funds and (iii) nidhis. Finance companies are found in all parts of the country. The exact number of finance companies is not known. Finance companies generally give loans to retailers, wholesale traders, artisans and other self-employed persons. Since finance companies charge high rates of interest varying from 36 to

48 per cent, normally corporate firms do not borrow from these companies. The chit funds are savings institutions. They are of various types lacking any standardized form. A chit fund has regular members who make periodical subscriptions to the fund. The periodic collection is given to some member of the chit fund selected on the basis of previously agreed criterion. The chit fund business is now done in almost all the States but Kerala and Tamil Nadu account for the major part of total chit fund business . Estimates of deposits received by the chit fund companies and their annual turnover are not available. The RBI has absolutely no control over the lending activities of the chit funds. The nidhis operate particularly in South India. In their character they are like some kind of mutual benefit funds as their dealings are restricted only to the members. Since the nidhis operate in the unregulated credit market, there is hardly any information available about the amount of lending business done by them. 2. Indigenous bankers. Indigenous bankers are individuals or private firms which receive deposits and give loans and thereby operate as banks. Since their activities are not regulated, they belong to the unorganized segment of the money market. Indigenous bankers do not constitute a homogeneous group. Broadly they may be classified under four main sub-groups: Gujarati Shroffs, Multani or Shikarpuri Shroffs, Chettiars and Marwari Kayas. The Gujarati Shroffs operate in Mumbai, Kolkata, and the industrial and trading cities of Gujarat. The Marwari Shroffs are active in Kolkata, Mumbai, tea-gardens of Assam and other parts of North-East India. The Multani or Shikarpuri Shroffs are to be found mainly in Mumbai and Chennai and the Chettiars are concentrated in the South. Of the four main such groups of the indigenous bankers, the Gujarati indigenous bankers are the most important in terms of the volume of the business . Over the past three decades the indigenous bankers have faced stiff competition from the commercial and cooperative banks, yet they have survived. Money lenders. Moneylenders do not constitute one homogeneous category. Broadly they are of three types: (1) professional moneylenders whose main activity is money lending; (2) itinerant moneylenders, like Pathans and Kabulis, and (3) nonprofessional moneylenders whose main source of income is not money lending. The methods of operation of the moneylenders are not uniform. Their activities are generally localized.

3.

ORGANIZED SECTOR OF THE INDIAN MONEY MARKET: The modern sector of the Indian money market is reasonably well organized and integrated. Leaving aside some highly developed financial centres, the organized sector of the Indian money market is far more organized and developed than the money markets in most of the countries. The organized sector of the Indian money market comprises the Reserve Bank of India, commercial banks, foreign banks, cooperative banks, finance corporations, Mutual Funds and the Discount and Finance House of India Limited (DFHI). Mumbai, Kolkata, Delhi, Chennai, Ahmedabad and Bangalore are the principal centres of the organized sector of the Indian money market, of which Mumbai is the most prominent. The Mumbai money market has now become synonymous with the Indian money market. At present the Mumbai money market occupies the same position in India as the London money market in England and the New York money market in the USA. The presence of the head offices of the RBI and various commercial banks,

the leading stock exchange, well organized market of the government securities; the billion exchange and the cotton exchange have made Mumbai the most prominent financial centre of the country.

ORGANIZED SECTOR OF THE INDIAN MONEY MARKET

SUB MARKETS
Call Money Market Treasury Bill Market The Repo Market Commercial and Trade Bills Market Certificate of Deposits Market Commercial Paper Market Money Market Mutual Funds

PARTICIPATING INSTITUTIONS
Reserve Bank of India Discount and Finance House of India Banks Development Financial Institutions Investment Finance Companies Mutual Funds

INSTRUMENTS
Treasury Bills Repos Inter Bank Call Money Commercial and Trade Bills Commercial Paper Certificates of Deposits Participation Certificates

No doubt the organized sector of the Indian money market is fairly developed and organized, yet it is not comparable to the New York or the London money market. Broadly, the principal constituents of the Indian money market are: (i) The Call Money Market, (ii) The Treasury Bill Market, (iii) The Repo Market, (iv) The Commercial Bill Market, (v) the Certificate of Deposits Market, (vi) The Commercial Paper Market and (vii) Money Market Mutual Funds. FINANCIAL INSTITUTIONS: Financial institutions are vital to the economic well-being and future growth of a market-oriented economy. In most industrialized economies today, the liabilities of financial institutions are the principal means for making payments for goods and services, and their loans are the chief source of credit for all economic units in society-business, households, and governments. Moreover, the financial institutions sector, along with the services sector as a whole, has been one of the most rapidly growing

components of the global economy, creating challenging businesses and career opportunities for the future. For all of these reasons, an understanding of the lending and borrowing activities, the portfolio behaviour, the management policies and the regulatory environment of the financial institutions is essential. Financial Institutions & Environment in India : Thanks to the initiatives taken by the government, a large number of other financial institutions have also come up in the post Independence period. The wide variety of financial institutions existing in India can be broadly classified into all-India financial institutions, State level institutions and other institutions. The financial institutions within these groups can be further categorized according to their main activities/functions into: 1. All India Development Financial Institutions (DFIs): Industrial Finance Corporation of India Ltd (IFCI), Industrial Development of India (IDBI), Small Industries Development Bank of India (SIDBI) and Industrial Investment Bank of India (IIBI). Industrial Credit and Investment Corporation of India Ltd. (ICICI Ltd) has ceased to be a development bank after its merger with ICICI Bank with effect from March 30, 2002. Specialized Financial Institutions: Export-Import Bank (EXIM Bank), IFCI Venture Capital Funds (IVCF, formerly RCTC) Ltd., ICICI Venture Ltd. (formerly TDICI Ltd), Tourism Finance Corporation of India (TFCI) Ltd., and Infrastructure Development Finance Company (IDFC) Ltd. Investment Institutions: Life Insurance Corporation of India (LIC), Unit Trust of India (UTI), and General Insurance Corporation of India (GIC) and its four erstwhile subsidiaries. Refinance Institutions: National Housing Bank (NHB) and National Bank for Agriculture and Rural Development (NABARD). State level Institutions: State Financial Corporations (SFCs) and State Industrial Development Corporations (SIDCs). Other Financial Institutions: Some other financial institutions are Export Credit and Guarantee Corporation of India Ltd. (ECGC) and Deposit Insurance and Credit Guarantee Corporation (DICGC).

2.

3. 4. 5. 6.

Of all the above financial institutions, only nine (IDBI, IFCI, EXIM Bank, NABARD, SIDBI, IDFC, IFCI, IIBI and NHB) fall within the regulatory and supervisory domain of Reserve Bank of India.

FINANCIAL INSTITUTIONS
FINANCIAL INTERMEDIARIES COMMERCIAL BANKS CREDIT UNIONS SAVING BANKS SAVINGS AND LOAN ASSOCIATIONS LIFE INSURANCE COMPANIES INVESTMENT COMPANIES FINANCE COMPANIES PENSION FUNDS REAL ESTATE INVESTMENT TRUSTS LEASING COMPANIES

OTHER FINANCIALINSTITUTIONS SECURITIES BROKERS AND DEALERS INVESTMENT BANKERS MORTGAGE BANKERS MISCELLANEOUS INSTITUTIONS

The all-India financial institutions have been fast losing ground in recent years. This situation has come about as a result of the distinction between development and commercial banking getting blurred , high cost of funds and asset-liability mismatches. With reforms in the financial sector, the facility of low cost funds under long-term operations funds, funds from bilateral and multilateral agencies and bond issues under statutory liquidity ratio is no more available. Now the financial institutions are raising funds at market rates of interest. The Narasimham Committee II had recommended that with the convergence of activities between banks and development financial institutions, the development financial institutions should, over a period of time, convert themselves into banks paving the way for only two forms of intermediaries, viz., banking companies and non-banking financial institutions. The Reserve Bank of India had advised financial institutions to chart a path for their evolution into universal banks. The merger of ICICI had accounted for a substantial part of the sanctions and disbursements of all India financial institutions. With its merger with ICICI Bank, the role of all-India financial institutions has subsided further. Similarly, in order to pave the way for conversion into a universal bank, IDBI had approached the government to corporatize it by repealing the IDBI Act. Accordingly the government announced the proposal for corporatizing IDBI by introducing the necessary legislative changes. The Call Money Market: The call money market consists of overnight and money at short notice for periods upto 14 days. It is meant to balance the short-term needs of banks. The call money market exists in almost all developed money markets. It is generally the most sensitive part of the financial system. Any change in flow of funds and the demand for them is clearly reflected in it. The response is generally quick. In India, the call money market is centred at Mumbai, Kolkata and Chennai. Among these, the market at Mumbai is the most important. During the 1980s the call money rate was an administered one. Its ceiling at 10 per cent was fixed by the Indian Banks Association. This was the time when there were a few large lenders and a large number of borrowers in the call money market. Since in this period there were not many participants who alternated as both lenders and borrowers, the call money market failed to develop adequately. The UTI and the LIC were large lenders. They were not allowed to operate as borrowers. These investment institutions had a sizeable short-term float which they could profitably deploy in the call money market. The commercial banks were usually the borrowers. Their needs for short-term funds often coincided. Among the banks the State Bank of India was sometimes on the lenders side of the market on account of its strong liquidity position. On the recommendations of the Vaghul Committee the Discount and Finance House of India (DFHI) was set up in April 1988. In July 1988 the DFHI was allowed to operate both as lender and borrower in the call money market. The operations of the DFHI were exempted from the ceiling rate set by the Indian Banks Association. These measures helped in the development of the call money market as they corrected imbalances in the supply and demand for funds in the market. With the participation of DFHI in the call money market there was a significant increase in its annual turnover. In May 1989, the ceiling on the call money rate was withdrawn. In May 1990, the Reserve Bank of India allowed IDBI, GIC and NABARD to

participate in the call money market as lenders. In October 1993, the participating development banks and the financial institutions were allowed to borrow up to an aggregate limit of Rs.1,000 crore with individual limits to be fixed for borrowing from time to time. Since the withdrawal of ceiling on the call money rate there have been sharp fluctuations in it due to imbalances in the demand and supply of bank reserves. The imbalances in the demand and supply of bank reserves arose on account of several factors. The most important of these has been a branching up of the banks needs for short-term funds in order to meet cash reserve ratio (CRR) requirements. Another contributing factor has been the unsound policy of some large banks to invest in medium and longterm assets by borrowing from the call money market. Finally, the occasional withdrawal of liquidity from the banking system by the government led to imbalances in the demand and supply of bank reserves. According to Kunal Sen and Rajendera R. Vaidya, instability in the call money rates in the post-1990 period notwithstanding, with the deregulation of the interest rate and the widening of the market through the participation of more non-bank financial institutions as both lenders and borrowers, the call money market has been playing an increasingly important role in equilibrating the banking systems demand and the supply of the short-term funds. Clearly, with the growth in the size of the call money market (as evident by the increase in DFHIs annual turnover), the need for commercial banks to hold on to excess reserves to meet any unanticipated deposit withdrawals by bank customers has been greatly reduced thereby lowering bank intermediation costs. The setting up of DFHI in 1988 and its emergence as a major force in the call money market have also contributed to the development of the market. Call money rates were stable during the first-half of 2004-05, reflecting the substantial overhang of liquidity in the system. The scenario began changing in October 2004 and the call money market once again stabilized in November 2004. However, the average call rate had risen to 5.62 per cent as against below 4.5 per cent in the first-half of 2004-05. The Treasury Bill Market The market which deals in treasury bills is known as the treasury bill market. In India, treasury bills are short-term liability of the Central government. Theoretically treasury bills should be issued for meeting temporary deficits which a government faces due to its excess of expenditure over revenue at some point of time. However, in India till recently they were a permanent source of funds for the Central government, as every year more new bills were issued than those retired. Further, every year a part of treasury bills held by the Reserve Bank of India was converted into long-term bonds. The treasury bill market in India is very much undeveloped. Except the RBI, there are no major holders of treasury bills. In fact, even the RBI is a passive or captive holder of these bills which implies that it is under an obligation to purchase all the treasury bills which are being offered to it by the government. It is also required to rediscount whatever treasury bills are presented to it by banks and others for this purpose. This has resulted in the monetization of public debt and has become a major source of inflationary expansion of money supply. At present the RBI holds most of the outstanding treasury bills. Other holders, such as commercial banks, State governments and semi-government bodies do not hold them in large quantities. Non-bank financial intermediaries, such as the LIC and the UTI and corporate and non-corporate firms do not hold

treasury bills. In contrast, in the U.S.A. and the U.K., treasury bills are the most important money market instrument, and as a result the open market operations of the central bank in these countries are quite effective. Since April 1, 1997, ad hoc and on-tap treasury bills have been replaced by Ways and Means Advances for financing the Central governments temporary deficits. It is hoped that this measure would prevent monetization of public debt and inflationary expansion of money supply.

At present the following types of treasury bills are in use:

14-Day Intermediate Treasury Bills: With the discontinuance of tap treasury bills, the Central government had introduced the scheme of 14day treasury bills to provide the State governments, foreign central banks and specified bodies with an alternative arrangement to invest their surplus funds. These treasury bills were to be sold only to the State governments, foreign central banks and other specified bodies with whom the RBI has an agreement for investing their temporary surplus funds. Auction of these treasury bills was discontinued from May 14, 2001. 14-Day Auction Treasury Bills: The Reserve Bank of India introduced 14-day auction treasury bills on a weekly basis with effect from June 6, 1997. The dual purpose of introducing these treasury bills was to facilitate the cash management requirements of various segments of the economy and to help in forming a complete yield curve for aiding in the pricing of debt instruments. The 14-day auction treasury bills did not devolve on the Reserve Bank unlike the 91-day treasury bills. Auction of these treasury bills was discontinued from May 14, 2001. 91-Day Treasury Bills: Earlier there were two types of 91-day treasury bills ordinary and ad hoc. With effect from April 1, 1997 ad hoc treasury bills were discontinued. On this day 91-day ad hoc treasury bills amounting to Rs.38,130crore were converted into special securities without any specific maturity. The interest on these securities was fixed at 4.6 per cent per annum. In 1992-93 a scheme for the issue of 91-day treasury bills with the RBI of India participation was introduced. The cut off yields on these treasury bills were higher than the fixed discount rate of 4.6 per cent per annum on 91day treasury bills sold on tap. 182-Day Treasury Bills: 182-day treasury bills were reintroduced with effect from May 26, 1999. As per the calendar, notified amount for 182day treasury bills remained constant at Rs.100 at the fortnightly auctions held on Wednesdays preceding non-reporting Fridays. Auction of these treasury bills was discontinued from May 14, 2001. 364-Day Treasury Bills: 364-day treasury bills were introduced in April 1992. Since then these treasury bills are auctioned on a fortnightly basis in a regular manner. These treasury bills are not rediscountable with the RBI. However, they offer short-term investment opportunities to banks and other financial institutions. Since 364-day treasury bills constitute a safe avenue for investment, the auction of these treasury bills have evoked good response. The Repo Market Repo is a money market instrument which helps in collateralized short-term borrowing and lending through sale/purchase operations in debt instruments. Under a repo transaction, securities are sold by their holder to an investor with an agreement to repurchase them at a predetermined rate and date. Under reverse repo transaction, securities are purchased

with a simultaneous commitment to resell at a predetermined rate and date. Initially repos were allowed in the Central government treasury bills and dated securities created by converting some of the treasury bills. In order to make the repos market in equilibrating force between the money market and the government securities market, the Reserve Bank of India generally allowed repo transactions in all government securities and treasury bills of all maturities. Lately State government securities, public sector undertakings bonds and private corporate securities have been made eligible for repos to broaden the repo market. Explaining the usefulness of repos, Report on Currency and Finance 19992000 notes that repos help to manage liquidity conditions at the short-end of the market spectrum. Repos have been used to provide banks an avenue to park funds generated by capital inflows to provide a floor to the call money market. During time of foreign exchange volatility, repos have been used to prevent speculative activity as the funds tend to flow from the money market to the foreign exchange market. The Commercial Bill Market: The commercial bill market is the sub-market in which the trade bills or the commercial bills are handled. The commercial bill is a bill drawn by one merchant firm on the other. Generally commercial bills arise out of domestic transactions. The legitimate purpose of a commercial bill is to reimburse the seller while the buyer delays payment. In India, the commercial bill market is highly undeveloped. The two major factors which have arrested the growth of a bill market are: (i) popularity of cash credit system in bank lending, and (ii) the unwillingness of the larger buyer to bind himself to payment discipline associated with the commercial bill. Among other factors that have prevented growth of genuine bill market are, lack of uniformity in drawing bills, high stamp duty on usance or time bills and the practice of sales on credit without specified time limit. Commercial bills as instruments of credit are useful to both business firms and banks. In addition, since the drawees of the bill generally manage to recover the cost of goods from their resale or processing and sale during the time it matures, the bill acquires a self liquidating character. Finally, it is easier for the central bank to regulate bill finance. Keeping in view these considerations, the Reserve Bank of India has made efforts to develop a bill market in this country and popularize the use of bills. Its two specific bill market schemes, however, had limited success. The old bill market scheme introduced in January 1952 was not correctly designed to develop a bill market. It merely provided for further accommodation to banks in addition to facilities they had already enjoyed. The scheme had, in fact, provided for obtaining loans on the security of bills rather than for their rediscount. In order to encourage use of bills the RBI offered loans at a concessional rate of interest and met half the cost of stamp duty incurred by banks on converting demand bills into usance bills. This scheme, however, failed to make any impact. Not satisfied with the old scheme, the RBI introduced a new bill market scheme in November 1970. It has been modified from time to time. The two noteworthy features of the new scheme are: (i) the bills covered under the scheme are genuine trade bills; and (ii) the scheme provides for their rediscounting. Even this scheme which really aimed at developing a bill market in the country has not been very successful. The major obstacle to the development of bill finance in this country is the dominant cash credit

system of credit delivery where the onus of cash management rests with banks. The outstanding amount of commercial bills rediscounted by the banks with various financial institutions stay often below Rs.1,000crore. The Certificate of Deposit Market: A Certificate of Deposit (CD) is a certificate issued by a bank to depositors of funds that remain on deposit at the bank for a specified period. Thus CDs are similar to the traditional term deposits but are negotiable or tradeable in the short-term money markets. In the mid-eighties, the shortterm bank deposit rates were much lower than older comparable interest rates. The Vaghul Committee thus felt that the CD as a money market instrument could not be developed in this country until the situation remained unchanged. The Committee stressed that it was necessary for the introduction of the CD that the short-term bank deposit rates were aligned with the other interest rates. In 1988-89, the RBI, as a corrective measure, revised the rate of interest upward on term deposits of 46 to 90 days. Once this was done in March 1989, the RBI introduced CDs with the objective of widening the range of money market instruments and providing investors greater flexibility in the deployment of their short-term surplus funds. The CDs could initially be issued only by scheduled commercial banks in multiples of Rs.25lakh (later lowered to Rs.10lakh) subject to the minimum size of an issue being Rs.1crore. Their maturity varied between three months and one year. In 1993 six financial institutions, viz., Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI), Industrial Finance Corporation of India (IFCI), the Industrial Reconstruction Bank of India, Small Industries Development Bank of India (SIDBI) and Export-Import Bank of India were permitted to issue CDs with a maturity period of more than one year and upto three years. CDs are issued at discount to face value and the discount rate is market determined. They are further freely transferable by endorsement and delivery. Banks pay a high interest rate on CDs. Hence, holders of CDs prefer to hold them till maturity and thus secondary activity in CDs has been non-existent. To begin with there was a lack of interest among banks in issuing fresh CDs. The stringent conditions in the money market, however, induced banks to mobilize resources on a large scale through CDs. The outstanding amount of CDs issued by the banks rose from Rs.4,485 crore as at end April 2003 to Rs.4,460 crore on March 31, 2004 and further to Rs.5,425 crore as on November 12, 2004. Due to the tight money market conditions, the discount rates on CDs increased sharply during 1995-96. However, since July 1996 the average discount rate on CDs has steadily declined. By early November 2004 typical discount rate was 4.0 per cent per annum. To bring CDs at par with other instruments such as CPs and term deposits, the minimum maturity of this instrument was reduced to 15 days in April 2003 from 3 months earlier. Commercial Paper: Commercial Paper (CP) is a short-term instrument of raising funds by corporates. It is essentially a sort of unsecured promissory note sold by the issuer to the investor or via some agent like a merchant banker or a security house. The issuance of commercial paper is not related to any underlying self-liquidating trade. Therefore, maturity of this instrument is flexible. Usually borrowers and lenders adopt a maturity of a CP to their needs. Highly rated corporates which can obtain funds at a cost lower than the cost of borrowing from banks are particularly interested in issuing CPs. Institutional investors also find CPs an attractive outlet for the shortterm funds. The Vaghul Committee had strongly recommended the

introduction of CPs in the Indian money market. In its observations on this instrument, the Committee had stated the issue of commercial paper imparts a degree of financial stability to the system as the issuing company has an incentive to remain financially strong. The possibility of raising short-term finance at relatively cheaper cost would provide an adequate incentive for the corporate clients to improve the financial position and in the process the financial health of the corporate sector should show visible improvement. Following the recommendations of the Vaghul Committee, the CP was introduced in the Indian money market in January 1990. The CP can be issued by a listed company which has a working capital of not less than Rs.5 crore. With maturity ranging from three months to six months they could be issued in multiples of Rs.25 lakh (later reduced to Rs.5 lakh) subject to the minimum size of an issue being Rs.1crore (later reduced to Rs.25 lakh). The company wanting to issue CP would have to obtain every six months a specified rating form an agency approved by the RBI. CP would be freely transferable by endorsement and delivery. According to the RBIs guidelines for the issue of CP, a company will have to obtain P2 rating from Credit Rating Information Services of India Ltd. (CRISIL) or A2 rating from Investment Information and Credit Rating Agency of India Ltd. (ICRA). Minimum maturity period of CP was reduced to 7 days. The effective interest rates were in the range of 9.35 to 20.9 per cent per annum. Easy liquidity conditions gave fillip to the issue of CPs since 199899 and the outstanding stocks of CPs rose from a low level of Rs.1,030 crore in April 1998 to Rs.10,848 crore as on July 31, 2004. The discount rate on commercial paper remained in the range of 4.61-5.50 per cent per annum during April 2004. Money Market Mutual Funds: A scheme of Money Market Mutual Funds (MMMFs) was introduced by the RBI in April 1992. The objective of the scheme was to provide an additional short-term avenue to the individual investors. As the initial guidelines were not attractive, the scheme did not receive a favourable response. Hence, with a view to making the scheme more flexible, the RBI permitted certain relaxations in November 1995. The new guidelines allow banks, public financial institutions and also the institutions in the private sector to set up MMMFs. The ceiling of Rs.50 crore on the size of MMMFs stipulated earlier, was withdrawn. The prescription of limits on investment in individual instruments by MMMFs was also deregulated. Since April 1996, MMMFs are allowed to issue units to corporate enterprises and others. During 1996-97 the scheme of MMMFs was made more flexible by bringing it on par with all other mutual funds by allowing investment by corporates and others. The scheme was later on made more attractive to investors by reducing the lock-in period from 45 days to 15 days. The scheme was further liberalized in 1997-98 and the MMMFs were permitted to make investments in rated corporate bonds and debentures with residual maturity of up to one year. Resources mobilized by the MMMFs could earlier be invested exclusively in call/notice money, treasury bills, CDs, CPs, commercial bills arising out of genuine trade/commercial transactions and government securities having an unexpired maturity up to one year. The prudential measure that the exposure of MMMFs to CPs issued by an individual company should not exceed 3 per cent of the resources of the MMMFs has been retained. The MMMFs have been brought under the purview of the SEBI regulations since

March 7, 2000. Banks are now allowed to set up MMMFs only as a separate entity in the form of a trust. Currently there are three MMMFs in operation. HALLMARKS OF A DEVELOPED MONEY MARKET

The Characteristics of a developed money market are as following:

1. 2. 3. 4. 5. 6. 7. Existence of a well-developed and highly organized commercial banking system. Existence of a strong central bank as the money market regulator. Availability of a wide variety of financial instruments for both borrowers and lenders. Existence of a number of highly developed and specialized submarkets, which are closely integrated. Existence of a large number of players in a competitive environment. Prevalence of a developed information and communication network. Minimum government intervention and restrictions in the money market.

CHARACTERISTICS OF INDIAN MONEY MARKET In its organization and development, the Indian money market is not comparable to either the London money market or the New York money market. It suffers from a number of defects of which the following are more prominent: 1. Lack of integration: As already stated, the Indian money market is divided into two sections, viz., the unorganized sector and the organized sector. As the two sectors are completely separate from each other, their financial operations are quite independent, and whatever goes on in one sector has little effect on the other. Some financial operations are quite independent, and whatever goes on in one sector has little effect on the other. Some experts assert that the country has no national money market. There are reasonably well developed local money markets; the Mumbai and the Kolkata money markets being the most prominent. The Mumbai money market, however, has been showing a tendency for quite some time to emerge as the national money market. 2. Lack of rational interest rates structure: For a long time a major defect of the Indian money market was the lack of rational interest rates structure in it. This was particularly due to lack of adequate co-ordination between different banking institutions. Lately, situation has improved somewhat due to the authority of the Reserve Bank of India. Further, standardization of interest rates has also introduced some rationality in the structure of interest rates. However, the system of administered interest rates suffered in the past from various defects such as: (1) relatively low yield on government securities, (2) too many concessional rates of interest, and (3) inappropriate deposit and lending rates of commercial banks. These defects in administered interest rates has led to a situation in the past in which there had always been excess demand for credit and the Reserve Bank of India had to rely often on cash reserve ratio (CRR) changes to combat inflationary pressure. The number of administered rates on bank advances was reduced to 2 from 20 in 1989-90. Further, interest rate structure has now been deregulated. The RBIs efforts to introduce rationality in the interest rate structure notwithstanding, the situation in the Indian money market is still not

comparable to that in the London money market where the discount rate is sufficiently effective and market rates immediately respond to changes in it. In India not only the lending rates of the State Bank of India and the commercial banks differ from those of the co-operative banks and the indigenous bankers, but their bill finance rates also differ from the Hundi rate. 4. Absence of an organized bill market: Though both inland and foreign bills are being purchased as well as discounted by the commercial banks, yet it cannot be said that an organized bill market exists in the country. Only a limited bill market that has been created by the RBI under its schemes of 1952 and 1970 now exists but it has failed to popularize bill finance in this country. Some experts contend that the popularity of cash credit and lack of uniformity in commercial bills proved to be serious obstacle in the development of a bill market. Moreover, due to the presence of inter-bank call money market, commercial banks never felt the real necessity of an organized bill market. Interestingly, the bill finance has fallen since the second scheme was introduced. 5. Shortage of funds in the money market: The Indian money market is characterized by shortage of funds. Invariably demand for loanable funds in the money market far exceeds its supply. This is attributed to a variety of factors. In the first place, savings are small due to low per capita income. Because of widespread poverty, a vast multitude of population has virtually no ability to save. Those of the people who have the ability to save often indulge in wasteful consumption. Secondly, inadequate banking facilities, lack of banking habit among the people and absence of ample and diversified investment opportunities had also contributed in the past to shortage of funds. As in the countryside banking facilities are still lacking, people have little option but to hoard their savings. Failure to mobilize them is a factor that must not be ignored, if the supply of loanable funds is to be augmented. Finally, emergence of a parallel economy and vast amount of black money in the country have also caused shortage of financial resources in the money market. In the recent past, the development of banking, particularly the opening of branches of commercial banks in the rural sector and expansion of co-operative banking have, however, improved the mobilization of funds. This has helped in overcoming the stringency of funds to an extent, but no remedial measures are possible to remove scarcity of loanable funds in the money market caused by the acute poverty of the mass of population. Seasonal stringency of funds and fluctuations in interest rates: India being essentially an agricultural country, farm operations have also some bearing on the demand as well as the supply of funds in the money market. From October to June when farm operations and trading in agricultural produce require additional finance, a monetary stringency is created in the money market. Had the money market been sufficiently elastic and had it been possible to augment the supply of funds more or less automatically in response to the seasonal rise in demand, interest rates would have been very much stable. But until recently this did not happen in this country. Inadequate banking facilities: Though lately commercial banks have opened their branches on an unprecedented scale, yet banking facilities in the country are still somewhat inadequate. The coverage of the rural sector by the modern banks leaves much scope for further development. Compared to the U.S.A. where per 1,00 persons there is

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a branch of a commercial bank, in India, we have a branch on an average for roughly 15,000 persons. This difference is probably due to the difference in the levels of development in the two countries. An overwhelming majority of the people in this country is either below the poverty line or just at the subsistence level and does not require any banking facility. At the same time lots of people, particularly those in the countryside whose savings are small, have no access to banking facilities. Mobilization of small savings is both difficult and uneconomic, but in an underdeveloped country like ours, where every bit of saving is to be used for productive purposes, banking facilities have to be expanded. DEFECTS OF INDIAN MONEY MARKET 1. Unorganized Sector still beyond Control: Now we proceed to take up the defects from which the Indian money market suffers today. We have earlier stated that the Indian money market suffers mainly because of lack of relationship between its different segments. Although, prior to the establishment of the Reserve Bank of India, the Indian money market was divided into various sections and units and all these units, say for example, the Imperial Bank of India, the foreign exchange banks, the joint-stock banks, the co-operative banks, etc. confined their activities to their own areas and to a particular class of business, their relations were more competitive then co-operative. After the establishment of the Reserve Bank, these separatists tendencies have no doubt, to a great extent disappeared, more particularly after the passing of the Banking Regulation Act, 1949. The co-operative banks have now also come within the jurisdiction of the reserve Bank and so it can be said that the organized sector of the money market is now under the effective control of the Reserve Bank. The reliance of the commercial banks for rediscounting and borrowing facilities on the Reserve Bank has considerably increased. The Reserve Bank also undertakes regular inspections of the books of these banks and issues guidelines for their lending operations, from time to time. But the major drawback is the absence of control of the Reserve Bank on the unorganized sector. The indigenous bankers are even today outside the control of the Reserve Bank, despite frantic efforts made by it. Very recently, signs have started developing for the increasing control of the Reserve Bank of India on the indigenous bankers, since the bigger indigenous bankers have started forming themselves into joint-stock companies. 2. Competition within the Same Sector: Again, one finds that even in these two sectors, there is tough competition among the members of the same sector, e.g., the State Bank of India and other commercial banks compete with each other. Similarly, the members of the unorganized sector compete among themselves. This sort of competition is not only wasteful but is also detrimental to the interests of the poor agriculturists, specially small and marginal farmers and also endangers the speedy economic development of the country. 3. Fragmentation: One also finds that the Indian money market suffers from fragmentation. In other words, it would not be correct to call the money market in India as an All India Market in the true sense of the term. There is hardly any contact between the money markets in smaller towns and those in the bigger towns like Mumbai, Kolkata, Delhi, Chennai, etc.

4. Large Variety of Money Rates: As a consequence of this competition between the various constituents of the money market and intrasectoral competition a large variety of money rates prevail in the country. This creates confusion and chaos. The confusion is worse confounded when one finds that there are different rates of interest in bigger and smaller towns, in rural and urban areas, in different localities of the same town and in different seasons in the country. Such sort of diversity in the rates of interest is hardly to be seen in any of the money markets of developed countries of the West. Nearly 50 years ago, the Central Banking Enquiry Committee had remarked: The fact that a call rate of .75 per cent, a hundi rate of 4 per cent, a bank rate of 4 per cent, a bazaar rate for bills of small traders of 6.38 per cent and a Calcutta bazaar rate for bills of small traders of 10 per cent can exist simultaneously indicates extraordinary sluggishness of the movement of credit between the various markets. And the situation has not changed much in these years. The result of such a situation is that changes in the bank rate do not produce the desired result. 5. Undeveloped Bill Market: As stated already, the existence of an undeveloped and unorganized bill market is the greatest defect of the Indian money market. In fact the Indian money market has not been able to function properly and effectively only because of this reason. Although, hundies have been in use since time immemorial, there is a general shortage of hundies in the market. That is why, the commercial banks have not been able to invest more than 6 per cent of their deposits in hundies. This can also be the reason for compelling the businessmen and traders to conduct their business in cash. Whatever may be the position, the absence of a developed bill market has certainly marred the efficient functioning of the Indian money market. It is, therefore, essential that the Reserve Bank of India should take steps to popularize the use of hundies among Indian businessmen and offer facilities for rediscounting them. The position now stands very much improved in this respect butit cannot be considered satisfactory at all. 6. Seasonal Variations in Interest Rates: Another defect from which the Indian money market suffers today is the lack of synchronization between the demand for and supply of credit facilities during various seasons of the year. As already stated, during the busy season the supply of credit does not increase proportionately, while during the slack season there is a general fall in the demand for credit facilities. The supply of money being generally elastic, there is a wide variation in the rates of interest during these two parts of the year. Despite sincere efforts of the Reserve Bank, it has not been possible to eliminate these seasonal variations in the rates of interest. Ultimately, it affects the economic development of the country. 7. General Shortage of Capital: There is a general shortage of capital in the Indian money market. Firstly, the per capita income of the people in the country is quite low and therefore, the saving capacity of the people is rather limited. Secondly, the banking services in the rural areas are hardly adequate and hence the rural savings are not being mobilized, to the desired extent. Consequently, the rate of capital formation is low and mobility of the capital is also at a low ebb. 8. Lopsided and Unbalanced: The Indian money market is rather lopsided and unbalanced. The rural areas which cover the major

portion of the country are inadequately served by commercial banks. The indigenous bankers are, therefore, in a very large number and they provide a large amount of credit to trade and business. It would not be wrong to say that in certain parts of the country, they enjoy monopoly in the moneylending business. On the other hand, one finds that specialized banking institutions are conspicuous by their absence. These specialized institutions are the industrial banks, discount houses, Indian-owned foreign exchange banks, etc. The above defects have been considerably reduced during recent decades by the Reserve Bank. The different parts of the money market stand today very much interlinked, the discrimination between foreign and Indian commercial banks has virtually disappeared, the money rates indifferent parts of he country are not very much uniform; the seasonal monetary stringency stands very much reduced and the bill market in the country is now on its way to development. In this respect, the nationalization of major commercial banks has no doubt been a great step in the direction. REFORM MEASURES OF MONEY MARKET 1. Remitting the stamp duty: In August 1989, the government remitted the stamp duty on usance bills which was considered a major administrative constraint in the use of bill system. However, this measure has failed to induce use of commercial bills. Experts assert that unless effective measures are undertaken to discourage cash credit system, the governments decision to remit the stamp duty alone would not alter the situation in the favour of the use of bill system. Deregulation of money market interest rates: With effect from May 1, 1989 the RBI deregulated money market interest rates which proved to be a significant step towards the activation of the money market. This was expected to make interest rates flexible and lend transparency to transactions in the money market. Earlier the call/notice money was subject to interest rate ceiling of 10.0 per cent. Likewise interest rate on interbank term money was subject to a ceiling of 10.5-11.5 per cent, and on rediscounting of commercial bills and inter-bank participations without risk was subject to a ceiling of 12.5 per cent. Introducing new money market instruments: Over the past fifteen years four major money market instruments have been introduced. These are 182-day treasury bills, 364-day treasury bills, Certificates of Deposits (CDs) and Commercial Paper (CP). 182-day treasury bills were systematically promoted by the Discount and Finance House of India and were the first security sold by auction for financing the fiscal deficit of the Central government. The Discount and Finance House of India also developed a secondary market in these bills and they became popular with the banks. In 1992-93 it was decided to introduce 364-day treasury bills and the auction for 182-day treasury bills were discontinued. 182-day treasury bills were, however, reintroduced in May 1999. Like 182-day treasury bills, 364-day treasury bills can be held by the commercial banks for meeting Statutory Liquidity Ratio. CDs gained a considerable market in 1996-97. The volume of outstanding CDs rose from Rs.6,385crore on January 6, 1995 to Rs.20,815crore on July 5, 1996. However, due to improvement in the liquidity conditions later on, the outstanding amount of CDs issued by banks increased in 2004-05 and amounted to Rs.5,438crore on June 25,

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2004. Now private banks account for the largest share of outstanding CDs. An encouraging development is that the top banks get their CDs rated for better access to the market. CPs as money market instrument are now more than ten years old. The Indian CP market is driven by the demand for CP by scheduled commercial banks which, in turn, is determined by bank liquidity. The secondary activity is subdued in the Indian CP market due to most investors preference to hold the instrument on account of higher riskadjusted return relative to those of other instruments. 4. Introduction of repos: An important development in the government securities market is introduction of repos in December 1992. A repo is an instrument of repurchase agreement between the RBI and the commercial banks. This is an asset which banks use for short-term liquidity management. The repo rates are market determined and often fluctuate steeply. The period of repo has stabilized since August 1993 at 14 days. The repo has now become popular with banks. It can now also be effected between banks and financial institutions and banks themselves. To further develop and widen repos, in April 1999. the RBI introduced regulatory safeguards. Setting the Discount and Finance House of India: The Discount and Finance House of India (DFHI) was set up on April 25, 1998. Its major function is to bring into the fold of the Indian money market the entire financial system comprising of the scheduled commercial banks, foreign banks, co-operative banks and all-India financial institutions in the public and private sectors, so that their shortterm surpluses and deficits are equilibrated at market related rated/prices through inter-bank transactions in case of bank and through money market instruments in the case of banks and others. In DFHI operations, the emphasis is placed on a high turnover in the money market instruments rather than on being their repository. Introducing money market mutual funds: Money market mutual funds (MMMFs) were introduced in India in April 1991. MMMFs provide an additional short-term avenue to investors and bring money market instruments within the reach of individuals. The portfolio of MMMFs consists of short-term money market instruments. The growth of MMMFs has been far less than expected. While in principle approvals have been granted to ten MMMFs, only there have been set up one each by the IDBI and UTI and one in the private sector. It is hoped that with the growth of the money market in volume and depth more MMMFs would be set up. Developing call/notice money market: The call/notice money market was mainly an interbank market until 1990. Only the Unit Trust of India and the Life Insurance Corporation were allowed to operate as lenders since 1971. During the 1990s the RBIs policy relating to entry into the call/notice money market was liberalized to provide more liquidity despite the recommendation of the Vaghul Committee that the call money market should be restricted to banks. As of now, broadly speaking banks and primary dealers (PDs) are operating as both lenders and borrowers while a number of non-bank financial institutions and mutual funds are operating only as lenders. Removing constraints on development of the term money market: The term money market in India has always been dormant. Statutory pre-emptions on inter-bank liabilities, cash credit system of financing, the regulated interest rate structure, the high

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degree of bolatility in the call money rates, availability of sector-specific refinance, the scarcity of money market instruments of varying maturities and the inadequate assets liability management (ALM) discipline among banks were the factors that inhibited the development of the term money market. Most of these constraints have been gradually removed by the RBI in recent years and, as a result, there is some activity in the term money market. However, despite the foregoing reforms the volumes of operations still remain rather small. 9. Sector specific refinance facilities: Refinance is used by central banks to meet liquidity shortage in the system, to control monetary and credit conditions and direct credit to selective sectors. The RBI has used in the past a number of sector specific refinance facilities of which export credit refinance and food credit refinance were the most prominent. Currently there are only two refinance schemes in operation export credit refinance and general refinance. Lately with the emergence of the bank rate as the signaling rate of monetary policy stance, the RBIs policy has been to keep the refinance rate linked to the bank rate. The Indian money market has been characterized by ample liquidity since 2002-03. Mirroring the comfortable liquidity conditions, the interest rates softened across the various segments of the money market. The RBI continued to appropriately manage liquidity conditions through open market operations.

SUGGESTIONS FOR IMPROVING THE INDIAN MONEY MARKET: The following suggestions are offered for improving the Indian money market: 1. Control over Non-Bank Financing Companies: During recent months a number of cases have come to light where public limited finance companies have cheated the general public by inviting deposits to the tune of crores of rupees. The Reserve Bank of India has not been able to protect the depositors from exploitation and cheating of such finance companies. Similarly, a number of chit funds have also been cheating the general public. The Reserve Bank of India should, therefore, insist on a uniform legislation for regulating the activities of chit funds and financing companies. The legislation should specially incorporate a provision that at least 25 per cent of deposits accepted from the public would be deposited by such companies with the State Bank of India or the Reserve Bank of India; and also that such companies will have to submit every quarterly a statement indicating the names of the depositors, the amounts of deposit and the period of such deposits to the Reserve Bank of India. 2. Standard Forms of Hundies: The Banking Commission (1972) recommended that standard forms of hundies should be prescribed and the Negotiable Instruments Act be made to apply to such hundies, but so far nothing in particular seems to have been done in this regard. It is a well-known fact that in the organized sector of the Indian money market large transactions are performed by discounting hundies by the indigenous bankers. The commercial banks, however, do not accept these hundies. It is therefore necessary, that suitable action may be taken immediately by the Reserve Bank of India to implement the recommendation of the Banking Commission. 3. Regulation of the Activities of the Indigenous Bankers: The situation of the banking services now available in the rural areas is

far more improved than what it was in the early1960s of this century. A number of branches have been opened by commercial banks, lead banks, regional rural banks and cooperative banks in the rural areas after 1969. Despite the expansion of banking facilities in the rural areas indigenous bankers continue to occupy an important position. As early as 1972 the Banking Commission has recommended the regulation of the activities of indigenous bankers through commercial banks but unfortunately no progress has been made in this direction so far. 4. Development of Bill Market: A developed bill market is very essential for the growth of Indian money market. Despite the efforts made in this direction by the Reserve Bank of India the situation does not appear to have improved to a satisfactory extent. The government should, therefore, at least in its own departments and public sector undertakings make it compulsory that payments for all credit purchases should be in the form of bills which should be honoured on due date. Besides, Reserve Bank of India should lay down simpler procedure for rediscounting of bills. These steps will go a long way to develop bill culture in the country. 5. Development of Money Market in Other Centres: At present the money market is confined to four major cities in the country. For the proper growth of the money market it is necessary that adequate banking and clearing house facilities are provided on a large scale, discount and acceptance houses are established and cheap remittance facilities are extended throughout the country to facilitate the mobilization of funds. 6. Creation of Secondary Market: For imparting adequate linking in the Indian money market it is essential that an active secondary market is created by developing new sets of institutions. This step will certainly improve the functioning and growth of the Indian money market.

COMMERCIAL BANKING:
TYPES OF BANKS 1. Commercial Banks 2. Industrial Banks 3. Agricultural Banks 4. Foreign Exchange Banks On the basis of proprietorship 5. Public sector and Private sector Banks On the basis of ORGANIZATION 1. Branch Banking 2. Unit Banking The public sector bank is a Government of India undertaking while a private sector bank is owned by the shareholders. Both these types of banks perform the same functions, and their interest rate structure and salary and allowance structure are the same except the non-scheduled banks. State Bank of India was the first public sector bank established on 1 July, 1995, after nationalization of Imperial Bank of India. It had 7 subsidiaries which were nationalized in 1959. These are State Bank of Hyderabad, State Bank of Bikaner and Jaipur, State Bank of Travancore, State Bank of Mysore, State Bank of Patiala, State Bank of Indore and State Bank of

Saurashtra. 14 major scheduled banks were nationalized on 19 July, 1969. These were Allahabad Bank, Bank of Baroda, Bank of India, Bank of Maharashtra, Canara Bank, Central Bank of India, Dena Bank, Indian Bank, Indian Overseas Bank, Punjab National Bank, Syndicate Bank, Union Bank of India, United Bank of India and United Commercial Bank. On 15 April,1980, 6 more scheduled banks were nationalized. They were Andhra Bank, Corporation Bank, New Bank of India, Oriental Bank of Commerce, Punjab and Sind Bank and Vijaya Bank. Later on 4 September, 1993, New Bank of India was merged with Punjab National Bank. The regional rural banks are also public sector banks and their number is 196. Hence there are in all 223 public sector banks comprising State Bank of India and its 7 subsidiaries, 19 nationalized banks and 196 regional rural banks. FUNCTIONS OF COMMERCIAL BANKS: Prof. Sayers has described the functions of a modern bank in the following words, Ordinary banking business consists of changing cash for bank deposits and bank deposits for cash: transferring bank deposits from one person or corporation to another, giving bank deposits in exchange for bills of exchange, government bonds, the secured promises of businessmen to repay, and so forth. The modern bank performs a large variety of functions and services. The fundamental functions performed by the bank are: 1. Acceptance of Deposits: The bank accepts three types of deposits from the public. (i) Fixed Deposit Account: Money is this account is accepted for a fixed period, say, one, two or five years. The money so deposited cannot be withdrawn before the expiry of the fixed period. The rate of interest on this account is higher than that on other accounts. The longer the period, the higher is the rate of interest. In technical language, this type of deposit is known as time or time deposit. It matures at a definite date and entails an interest penalty if it is withdrawn earlier due to some emergency by the depositor. (ii) Current Account: The depositor can withdraw the money from his current account whenever he requires it. Generally speaking, the bank grants no interest on this account because it has to keep the cash ready at all times to meet the requirements of the depositor. This account is generally opened by businessmen who may have to withdraw money several times a day. The bank, however, levies certain incidental charges on the customer for the services rendered by it. In technical language, it is known as demand deposit or checking deposit. The debtor (i.e., bank) has to pay off the debt on demand either to the depositor himself or to anyone else whom he authorizes by writing a cheque. The money represented by demand deposits is the debt of the bank. It is a liability for the bank but an asset for the depositor. Savings Bank Account: Some restrictions are imposed on the depositor under this account. For example, he can withdraw only a specified sum of money in a week. Of course, the depositors are given cheque facility to withdraw money from this account. The rate of interest allowed on this

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account is rather low. This type of deposit account encourages small savings in the country. According to banking terminology, the bank deposits are divisible into two categories: (a) Demand Deposits or Demand Liabilities: These deposits refer to those deposits which are repayable by the banks on demand. These include current deposits and a major portion of the savings deposits. (b) Time Deposits or Time Liabilities: Time deposits are accepted by the banks for fixed time-periods and are not repayable before the expiry of the stipulated period. They include fixed deposits, recurring deposits and a part of the savings deposits. Greater the volume of demand deposits, greater shall be the proportion of the liquid assets which the banks will be required to keep with themselves to meet their liabilities. In addition to the commercial banks, there are certain other institutions as well which specialize in the acceptance of both time and savings deposits. They are savings and thrift associations, mutual savings banks and Credit Unions etc. 2. Advancing of Loans: The deposits received by the bank are not allowed to lie idle in the cash box of the bank. After keeping certain cash reserves, the balance is given by the bank to the needy borrowers in the form of loans and advances. Before advancing loans to the borrowers, the bank satisfies itself fully about their creditworthiness. The various types of loans and advances are as follows: (i) Making Ordinary Loans: Here the bank gives a specified sum of money to a person or a firm against some collateral security. The loan money is credited to the account of the borrower and the borrower can withdraw the money from the account according to his requirements. The bank can recall such loans at its option. Cash Credit: Under this account, the bank gives loans to the borrowers against certain society. But the entire loan is not given at one particular time. What the bank does is that it opens the account in the name of the debtor and allows him to withdraw the money from time to time up to a certain limit determined by the value of the stocks kept in the debtors godown. The godown remains in the possession of the bank. The debtor continues to withdraw small sums of money according to his requirements, but he cannot exceed the credit limit allowed to him. The bank, however, charges interest only on the amount withdrawn from the account. This type of loan is very popular with the Indian businessmen. Overdraft: Sometimes the bank grants overdraft facilities to its respectable and reliable customers. The bank allows such customers to overdraw their accounts through cheques. The customers, however, pay interest to the bank on the amount overdrawn by them. Discounting of Bills of Exchange: This is another type of lending which is very popular with the modern banks. If the

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holder of an exchange bill needs money immediately he can get it discounted by the bank. After deducting its commission, the bank pays the present price of the bill to the holder. When the exchange bill matures, the bank can secure its payment from the party which had accepted the bill. 3. Investment of Funds: Besides loans and advances, a modern commercial bank also invests a part of its surplus funds in government securities and earns interest on them. In India, the commercial banks are requirement under statute to invest a part of their funds in government and other approved securities. Though the return from such securities is not very attractive, the funds invested in them are not only near liquid, but also secure from the risk of loss. 4. Promote the Use of Cheques: The commercial banks render an important service by providing to their customers a cheap medium of exchange like cheques. It is found much more convenient to settle debts through cheques rather than through the use of cash. The cheque is the most developed type of credit instrument in the money market. 5. Agency Functions of the Bank: In addition to the above functions, the bank performs certain agency functions for its customers. For these services, the bank charges a certain commission from its clients. The various agency services rendered by the bank are as follows: (i) Transfer of Funds: The bank helps its customers in transferring funds from one place to another. The instrument used for this purpose is known as the Bank Draft. For this service rendered, the bank charges a small commission from the customers. Collecting Customers Funds: The bank collects the funds of its customers from other banks and credits them to their accounts. Purchase and Sale of Shares and Securities for its Customers: The bank buys and sells stocks and shares of private companies as well as government securities on behalf of its customers. Collecting Dividends on the Shares of the Customers : The bank collects dividends as well as interest on the shares and debentures of its customers and credits them to their accounts. Payment of Premia: The bank pays premia to the insurance companies on behalf of its customers. It may also pay certain bills of the customers as per their directives. The Bank acts as the Trustee and the Executor : The bank preserves the Wills of the customers and executes them after their death.

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(vii) Income-Tax consultant: The bank may also give advice to its customers on income-tax matters. It may even prepare

the income-tax returns of its customers on payment of its fee. (viii) Acts as Correspondent: The bank may also act as a correspondent, agent, or representative of its customers. The bank may obtain passports, travellers tickets and even secure air and sea passages for its customers. 6. Purchase and Sale of Foreign Exchange : The bank also carries on the business of buying and selling foreign currencies. Ordinarily, the sale and purchase of foreign currency is done by the Foreign Exchange Banks. But in India, some commercial banks, in addition to their other functions, also do business in foreign exchange. 7. Financing Internal and Foreign Trade : The bank finances internal and foreign trade through discounting of exchange bills. Sometimes, the bank gives short-term loans to traders on the security of commercial papers. This discounting business greatly facilitates the movement of internal and external trade. 8. Other Functions of the Bank: They are as follows: (i) Safe Custody of Valuable Goods: The modern bank provides locker facilities to its customers. The customers can keep their valuables, such as, gold and silver ornaments, important papers, shares and debentures in these lockers. The bank charges an annual rental for this service. (ii) Issuing of Travellers Cheques: The bank also issues travellers cheques or circular letters of credit for the benefit of its customers. The customers are saved the botheration and the risk of carrying cash during their travels. Giving Information about its Customers : Since the bank is closely acquainted with its customers, it can pass on reliable information about their credit-worthiness to other parties at other places. The businessmen often make use of this service to know about the credit-worthiness of other parties at other places. Collection of Statistics: The modern bank collects statistics about money, banking, trade and commerce, and publishes them in the form of pamphlets and hand-outs. This helps the banks customers in acquiring knowledge about the latest economic situation on the basis of which they can formulate their business policy. Underwriting of Company Debentures : Sometimes private companies issue debentures for public sale. But the public may hesitate in buying these debentures unless they are underwritten by the banks. The public has full confidence in the banks. If the debentures carry the signatures of a bank, the public would not hesitate in buying them. For under-writing these debentures, the bankers charge a small underwriting commission from the companies. Accepting Bills of Exchange on behalf of Customers : Sometimes, the banks accept exchange bills on behalf of

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their trusted customers. This benefits the customers because when the bank signifies its acceptance on the exchange bill, it becomes readily discountable in the money market. (vii) Giving Advice on Financial Matters: Since the bank is fully acquainted with the economic situation in the country, it is in a position to render useful advice to its customers on financial matters. 9. Creation of Credit: As pointed out above, granting of loans and advances is an important function of the bank. But the process by which the bank grants loans and advances has special significance for the modern economy. As is well-known, when the bank grants a loan to its customers, it generally does not lend out cash, equal to the amount of the loan, to the customer as an individual money-lender does, but, on the contrary, opens an account in his (borrowers) name and credits the amount of the loan to his account. Thus, whenever a bank grants a loan, it creates a deposit or a liability against itself. Since the deposits of the bank circulate as money, the creation of such deposits leads to a net increase in the money stock of the economy. This is known as creation of money or creation of credit by the bank. A modern bank, during its operations, creates quite a good deal of money which has a far-reaching influence on the course of economic activity in the country. 10. Fulfillment of Socio-economic Objective: In recent years, commercial banks, particularly in developing countries, have been called upon to help achieve certain socio-economic objectives laid down by the State. For example, the nationalized banks in India (representing 85 per cent of the total banking business in the country) have framed special innovative schemes of credit to help small agriculturists, village and cottage industries, retailers, artisans, the self-employed persons through loans and advances at concessional rates of interest. Under the Differential Interest Scheme (D.I.S) the nationalized banks in India advance loans to persons belonging to scheduled tribes, tailors, rickshaw-walas, shoe-makers at the concessional rate of 4 per cent per annum. This does not cover even the cost of the funds made available to these priority sectors. Banking is, thus, being used to subserve the national policy objectives of reducing inequalities of income and wealth, removal of poverty and elimination of unemployment in the country. From the above discussion, it is evident that a modern bank plays a very vital role in the economic activity of the country. It plays the role of a financial intermediary it accepts deposits, makes loans and advances and buys negotiable securities. Without it, the individual saver-investor would have to deal directly with individual borrowers. The modern bank acting as an intermediary enables the individual saver to secure reasonable return without undergoing the botheration of confronting a borrower. It is on account of this that a well-developed banking system provides a firm and durable foundation for the economic development of the country. In addition to the above, the commercial banks have also started performing a number of other functions during recent years, such as issuing credit cards, establishing mutual funds, engaging in merchant banking, giving loans to priority sectors, consumption loans, education loans, housing loans, etc.

CENTRAL BANKING (RBI) Defining a Central Bank is not easy. There has been a great diversity of opinions in regard to its definition. Each writer has defined it in his own way emphasizing either on one or more functions performed by it. According to Kent: It is an institution which is charged with the responsibility of managing and expanding and contracting of the general public welfare. According to Verasmith: The primary definition of Central Banking is a banking system in which a single bank has either complete or residuing monopoly in the note issue. It was out of monopoly in the note issue that were derived the secondary functions and characteristics of are modern central banking. According to Shaw A Central Bank is a bank which controls Credit and According to Hawtrey: a Central Bank is a lender of the last resort. According to M.H.de Kock: A Central Bank is a bank which constitutes the apex of the monetary and banking structure of its country which performs as best as it can in the national economic interest. The Central Bank occupies a pivotal position in the monetary and banking structure of the country. The Central Bank is the undisputed leader of the money market. As such it supervises, controls and regulates the activities of the commercial banks affiliated with it. The Central Bank is also the highest monetary institution in the country charged with the duty and responsibility of carrying out the monetary policy formulated by the government. NECESSITY OF CENTRAL BANK The need for a Central Banking Institution in a country arises from the following: 1. Control of Credit: As already pointed out, every commercial bank creates credit during its daily operations. In fact, credit creation is supposed to be the major function of the commercial banks. But this credit creation sometimes poses serious dangers for the economy of the country. For example, if the commercial banks in the country are creating excessive credit, it can be a source of serious danger for the economy of the country. Hence, the need arises of some institution which can exercise control on credit creation of the commercial banks. This function can be befittingly performed by the Central Bank. The Central Bank should see to it that the credit created by the commercial banks remains within limits. Issue of Paper Currency: A Central Bank is also required to issue paper currency. The reason in that the note-issue by the Central Bank satisfies the requirement of elasticity. Moreover, the

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note-issue of the Central Bank is based strictly on economic considerations. As against this, the system of note-issue of the government lacks elasticity. It may also be influenced by political considerations. 3. Economic Help to the Commercial Banks: A Central Bank is also required to help the commercial banks to tide over economic crisis. In the absence of the Central Bank, the commercial banks are likely to fail at the slightest crisis in the economy. Implementation of the Governments Monetary Policies: Since the Central Bank exercises full control over the banking system of the country it is in a position to implement successfully the monetary and financial policies of the government.

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PRINCIPLES OF CENTRAL BANKING Following are the three main principles of Central Banking: 1. The Central Bank is always inspired by the Spirit of National Welfare: The commercial banks are generally guided almost exclusively by the profit motive. As against this, the Central bank is always inspired by the spirit of national welfare. According to De Kock, the directive principle of a Central Bank is that it should work exclusively in the interest of public welfare. It should not consider profit as the primary motive. This, however, does not mean that the Central Bank should suffer losses while working in national interest. What it implies is hat the profit-motive for the Central Bank should only be a secondary consideration. 2. Monetary and Financial Stability: Another important principle of Central Banking is that the Central Bank should help in the maintenance of monetary and financial stability in the country. There are several weapons in the armoury of the Central Bank which it can utilize for the achievement of this objective. 3. Freedom from Political Influence : The Central Bank should remain free from all political influences. In other words, it should not allow itself to be dominated by the ideology of a particular political party. On the contrary, it should work strictly in accordance with the well-known principles of Central Banking. At the same time, it is also necessary that there should be perfect co-operation between the Central bank and the government of the country. The reason is that the economic problems of the country cannot be satisfactorily solved without the fullest co-operation between the government and the Central Bank. 4. No Competition with Member-Banks: The Central Bank is a parent bank. Just as the parents do not compete with children, the Central Bank should, under no circumstances, compete with the member-banks in receiving deposits from the public or extending loans to the needy borrowers. If it competes with the member banks, this will conflict with its important functions of being a bankers bank, controller of credit and lender of the last resort. COMPARISON BETWEEN CENTRAL BANKING AND COMMERCIAL BANKING: There are similarities as well as dissimilarities between Central Banking and Commercial Banking. The similarities are as follows:

1. Both deal in money: Both the Central Bank as well as the commercial banks are basically monetary institutions. They deal in money in some form or the other. The Central Bank creates money, whereas the commercial banks deal in money. 2. Both create credit: The Central Bank as well as the commercial banks are both engaged in the creation of credit. The Central Bank, in reality, creates credit when it issues paper currency without keeping equivalent securities in the reserves. Likewise, the commercial banks also create credit on the basis of their derivative deposits. 3. Non-acceptance of immovable properties as securities: Both the Central Bank as well as the commercial banks decline to extend loans against immovable properties because this results in creating non-liquidity in their assets. 4. Both extend short-term credits: Both the Central Bank as well as the commercial banks extend short-term loans only because this helps them in maintaining liquidity in their resources. The Central Bank should, under no circumstances, extend long-term loans because this will make its assets non-liquid. Following are the differences between Central banking and Commercial Banking: 1. The Central Bank is the top-most bank and it exercises control over the entire banking system of the country. The commercial bank, on the contrary, is only a constituent unit of the banking system. 2. The Central Bank is normally owned by the State while the commercial banks are, generally, privately-owned institutions. 3. The Central Bank is not a profit-hunting institution. In fact, profit is its secondary objective. The primary objective of the Central Bank is to stimulate the economic growth of the country in an environment of economic stability. As against this, profit-earning is the primary objective of the commercial banks. Hence, they are prepared to invest their funds even in risky enterprises for the sake of earning profits. 4. The Central Bank does not deal directly with the public. As against this, the commercial banks deal directly with the general public. The Central Bank is not only the banker to the government; it is also the bankers bank. Hence, it cannot undertake the functions normally performed by the commercial banks. 5. The Central Bank does not compete with the commercial banks, because if it competes with them it will be doing so with the funds which the commercial banks are obliged to keep with it. Moreover, if the Central Bank completes with the commercial banks, it will be deviating from its major function as the bankers bank and as the lender of the last resort. 6. The Central Bank has special relationship with the commercial banks affiliated with it. The Central Bank is generally given statutory powers to exercise check on the activities of the commercial banks. 7. Another distinctive feature of the Central Bank is that it possesses the monopoly of note-issue. This right is no longer enjoyed by the commercial banks. 8. The Central Bank is the custodian of the foreign exchange reserves of the country. As such, it is responsible for maintaining the stability of foreign exchange rates. While commercial banks do deal in foreign

exchange, they are neither the custodians of the foreign exchange reserves nor do they have any responsibility for the maintenance of stability in foreign exchange rates. 9. The Central Bank acts as the banker to the government. It accepts deposits on behalf of the government and also gives short-terms loans to it. Commercial banks, on the other hand, act as bankers to the general public. They accept not only deposits from their customers but also extend loans and advances to them. 10. The Central Bank also functions as the bankers bank. The commercial banks are required by law to maintain a certain percentage of their cash reserves with the Central Bank. The Central Bank, acting as the lender of the last resort, grants credit to the commercial banks in times of emergency by rediscounting their commercial bills. The Central Bank also acts as the clearing house for the commercial banks. No such functions are performed by any commercial bank. The Central Bank is the top-most institution which controls and regulates the monetary and the banking system of the country. No such responsibility rests on the commercial banks. FUNCTIONS OF THE CENTRAL BANK The functions of the Central Bank differ from country to country in accordance with the prevailing economic situation. But there are certain functions which are commonly performed by the Central Bank in all countries. According to De Kock, there are six functions which are performed by the Central Bank in almost all countries. They are: 1. The Central Bank enjoys Monopoly of Note-issue . As already pointed out, the commercial banks in the 19 th century had the right of note-issue, but the notes issued by them suffered from a number of drawbacks. Firstly, there was lack of uniformity in the notes issued by the commercial banks. Secondly, every commercial bank was required to issue notes according to its reserves which were bound to be of a limited size. As such, the notes issued by them were in limited quantity. Thirdly, sometimes the commercial banks failed to convert their notes in cash on public demand. Hence, it was realized that the note-issue system by the commercial banks was not satisfactory. After sometime, the government took the issue of paper currency in its own hands. But even this system proved unsatisfactory in the long run. The reason was that the system of note-issue by the government suffered from lack of elasticity. The government was not in a position to estimate accurately the money requirements of the economy. Hence, it came to be realized, in course of time, that the Central Bank was the most appropriate institution to undertake the issue of paper currency. The Bank of England was, thus, given the monopoly of note-issue in 1884. in other countries also the right of note-issue was conferred upon the Central Bank, following the example set by the British Government. The following advantages have accrued from the system of note-issue by the Central Bank: (a) Uniformity in the Monetary System: It has been possible to bring about uniformity in the monetary system on account of the system of note-issue by the Central Bank. Along with this, it is also possible now to exercise proper control over the supply of money in the country. (b) Greater Public Confidence: The method of note-issue strengthens public confidence in the monetary system because the Central Bank enjoys a high status in the estimation of the public. (c) Elasticity in the Monetary System: The system of note-issue tends to introduce elasticity in the monetary system of the country.

In its capacity as the top-most bank, the Central Bank has full information about the money requirements of the economy. It is on the basis of this information that the Central Bank manages the paper currency system. It can vary the quantity of paper currency in accordance with the varying requirements of the economy. (d) Control on Credit Creation: This method helps the Central Bank to exercise control on the creation of credit by the commercial banks, because the creation of credit by the commercial banks ultimately depends upon the volume of paper currency issued by the Central Bank. Thus, through the medium of paper currency, the Central Bank controls and regulates the creation of credit by the commercial banks. (e) Profit for the Government: As is well-known, the Central Bank earns profit out of the issue of paper currency. A part of this profit goes to the government. (f) Stability in the Internal and External Value of Money: With its monopoly of note-issue, the Central Bank can maintain stability in the internal and the external value of home currency. Consequently, there do not occur wide fluctuations in the exchange rates. The internal price-level also remains stable. If the right of note-issue is granted to the commercial banks, they would not be able to maintain stability in the internal and external value of the home currency. it is on account of the above advantages that the right to issue notes has been granted to the Central Banks in all the countries of the world. In India also the right to issue notes has been conferred on the Reserve Bank of India. The right to issue notes is regulated by law. According to this law, every note issued by the Central Bank has to be backed up by an asset of equal value, like foreign currencies, government securities, other securities and metallic reserves. This becomes necessary to inspire public confidence in paper currency. 2. The Central Bank acts as the Banker, Agent and Adviser it to the Government. As the governments banker, the Central Bank keeps the accounts of various government departments and institutions. It performs the same functions for the government as the commercial banks ordinarily perform for their customers. The Central Bank accepts deposits from the government; it undertakes the collection of cheques and drafts deposited in the government account: it transfers government funds from one place to another or from one account to another account. The Central Bank also provides short-term loans (ways and means advances) to the government when requested by it. In addition, the Central Bank also provides to the government foreign exchange resources to enable it to meet its external debt or for the purchase of foreign goods, or for making other payments, etc. The Central Bank in its capacity as agent to the government, accepts loans and manages the public debt on behalf of the government. The timing of government loans is also decided by the Central Bank, keeping in view the overall liquidity conditions in the market. In fact, the new loans and the treasury bills are issued by the Central Bank on behalf of the government. The Central Bank receives taxes and other payments from the public on behalf of the government as its fiscal agent. As financial adviser, the Central Bank tenders useful advice to the government on important economic problems like those of

devaluation of currency, commercial policy, foreign exchange policy and the budgetary policy, etc. Since the Central Bank possesses full information about the working of the economy, it is in a position to offer useful advice to the government on economic financial problems. The Central Bank is also the custodian of the nations gold and foreign exchange reserves, and in that capacity manages the countrys relations with the international financial institutions. 3. The Central Bank acts as the Bankers Bank. Broadly speaking, the Central Bank acts as the bankers bank in three different capacities: (ii) The Central Bank is the Custodian of the Cash Reserves of Commercial Banks. The Central Bank is the top-most bank of the country. The commercial banks are affiliated with it. As such, every commercial bank has to keep a certain percentage of its liabilities with the Central Bank in the form of cash reserves. The commercial bank, no doubt, keeps a certain percentage of its liabilities in the form of cash reserves with itself. These cash reserves are kept by the commercial banks in two forms: (i) Cash reserves kept with itself; and (ii) Cash reserves kept with the Central Bank. The commercial banks make use of their reserves with the Central Bank in times of emergency. In every country, the commercial banks are required by law or by tradition to maintain a certain percentage of their liabilities with the Central Bank. Since the Central Bank holds the cash reserves of commercial banks, it is named as the reserve bank of the country. This centralization of cash reserves results in several advantages for the country: (a) The centralization of cash reserves with the Central Bank reinforce the confidence of the public in the strength of the banking system of the country. (b) This system of centralization results in a more effective utilization of the cash reserves of the country. It is evident that when the cash reserves are centralized in one institution, they can be used in a more effective manner during periods of seasonal and financial stringency. (c) The system of centralized cash reserves enables the Central Bank to extend accommodation to those commercial banks which find themselves in temporary difficulties. In fact, it is this system of centralized cash reserves which enables the Central Bank to function as the lender of the last resort. (d) This system of centralization ensures elasticity in the credit structure of the country. When a commercial bank maintains reserves with the Central Bank, then it can create credit to the maximum extent possible on the basis of its cash reserves. The bank knows that it can make use of its cash reserves with the Central Bank in times of emergency. (e) When the cash reserves accumulate with the Central Bank, it can make use of them in the interests of national welfare. (f) Since the Central Bank is the clearing-house of the country, the various commercial banks can settle their claims and counter-claims through its medium. This

reduces the use of cash to the minimum, because the cheques and drafts drawn upon the banks are settled through the medium of the Central Banks. (g) The centralization of cash reserves also enables the Central Bank to control the creation of credit by the commercial banks through increasing or decreasing their cash reserves. In other words, the Central Bank controls the creation of credit by using the technique of variable reserve ratio. (iii) The Central Bank is the Lender of the Last Resort. This means that if the commercial banks are not able to secure financial accommodation from other sources, then as a last resort, they can approach the Central Bank for the necessary credit facilities. The Central Bank in such a case will be prepared to grant accommodation to the commercial banks against eligible securities. The commercial banks can also get their eligible securities and exchange bills re-discounted by the Central Bank. This practice greatly benefits the commercial banks. They can fall back upon the Central Bank in times of emergency. This results in the following advantages: (a) The commercial banks can carry on their activities on the basis of smaller cash reserves. They know that they can get their eligible paper re-discounted by the Central Bank in times of emergency. Hence, the commercial banks need not keep large cash reserves to meet he cash requirements of the depositors. (b) The commercial banks can secure financial help from the Central Bank at a time of crisis. This strengthens public confidence in the banks because the people know that in case of emergency, the Central Bank will come to the rescue of the commercial banks. In fact, the Central Bank is the parent bank. When the children are in difficulties, the parents invariably rush to help them out. Likewise, the Central Bank also comes to the rescue of the commercial banks when they are confronted with financial difficulties. (c) This system helps the commercial banks to maintain the liquidity of their financial resources. The commercial banks are assured of financial accommodation through the grant of re-discounting facilities by the Central Bank. (d) This function of the Central Bank as the lender of the last resort, offers an opportunity for the Central Bank to establish its control over the banking system of the country. When the commercial bank applies to the Central Bank for financial accommodation, the latter automatically acquires the right to examine the financial condition of the former. The Central bank not only studies the financial condition of the concerned bank, but also offers suggestions from its own side for its improvement. The suggestions made by the Central Bank are invariably accepted by the commercial bank concerned. This helps the Central Bank to establish its control over the banking system of the country. As said above, according to the traditional concept of central banking, this function, namely, the lender of the last resort, is performed when the commercial bank concerned has exhausted all the liquidity in the money market before approaching the Central Bank for financial accommodation. But in India, this power of the Central Bank (to act as lender of the last

resort) is being utilized since the late sixties to persuade the memberbanks to lend to certain priority sectors which normally they would not care to accommodate. The Reserve Bank of India provides refinance facilities to scheduled commercial banks to encourage them to increase their lendings to the priority sectors, such as, agriculture, village and cottage industries, artisans, exports, food procurement, etc. Strictly speaking, this promotional role of the Central Bank is not in conformity with its function as lender of the last resort according to which the Central Bank should lend to a member-bank only when the latter had exhausted all other sources of financial accommodation. But in a developing country like India, the function (lender of the last resort) has been considerably watered down with a view to providing institutional credit to those sectors which figure high in our development priorities. (iv) The Central Bank is the Bank of Central Clearance, Settlement and Transfers. Clearing, it must be admitted, is one of the main operations of central banking. The Central Bank acts as the clearing-house for the commercial banks. Since it holds the cash reserves of the commercial banks, it becomes easier and more convenient for it to act as the clearing-house of the country. All the commercial banks have their accounts with the Central Bank. Consequently, the Central Bank can settle the claims and counter-claims of the commercial banks with the minimum use of cash. Thus, the clearing-house function of the Central Bank economizes the use of cash by the banks. Another advantage accruing from the Central Bank in its capacity as the clearinghouse is that it helps the commercial banks to create credit on a large scale because the demand for cash is automatically reduced consequent upon the functioning of the clearing-house system in the country.

4. The Central Bank is the Custodian of the Nations Gold and Foreign Exchange Reserves. This is an important function of the Central Bank. If there are fluctuations in foreign exchange rates, then the Central Bank, in order to minimize them, may have to buy and sell foreign currencies in the market. For example, if the price of a certain foreign currency rises up, the Central Bank will start selling that currency in the market. This will automatically reduce the price of that currency in the market. Likewise, if the price of the foreign currency declines, the Central Bank will try to raise it up by purchasing that currency from the market. It is, therefore, the responsibility of the Central Bank to maintain stability in the rates of foreign exchange. In case of emergency, the Central Bank may even impose control on the buying and selling of foreign currencies in the market. 5. The Central Bank publishes Economic Statistics and other Useful Information. In almost every country, the Central Bank collects and publishes statistics about the various aspects of the functioning of the national economy. This provides valuable information on the basis of which the Government can formulate and implement its economic policies. 6. The Central Bank acts as the Controller of Credit. This is by far the most important function performed by the Central Bank. According to De Kock, It is the function which embraces the most important question of Central Banking policy, and the one through which practically all the other functions are united and made

to serve a common purpose. The credit money produces a deep impact on the economy. If the Central Bank is able to keep the creation of credit within limits, it can prove a blessing for the country. But if credit is not effectively controlled and kept within limits, it can have dangerous consequences for the economy. Hence, it is essential that the creation of credit is kept within reasonable limits by the Central Bank. And there is no other institution which can control credit more effectively than the Central Bank. By controlling credit in an effective manner, the Central Bank can help to bring about not only stability in the internal price-level but can also check fluctuations in the foreign exchange rates. Hence, it is important for the Central Bank to exercise an effective control on the creation of credit by the banking system. The Central Bank is in a position to control credit in its capacity as the bank of issue and the custodian of the cash reserves of the commercial banks. Before 1931, the control of credit by the Central Bank necessary to maintain the stability in the foreign exchange the objective of credit control is to eliminate internal price to maintain a high level of employment and at the same the objective of international exchange stability. was considered rates, but today fluctuations and time to achieve

In order to control credit, the Central Bank uses several weapons, such as, the bank rate, open market operations, changes in the reserve ratios and selective methods of credit control. Conclusion: In addition to the above functions, there are certain other minor functions as well which are being performed by the Central Banks in various countries of the world. In fact, the functions of the Central Bank are expanding these days. The Central Banks in western countries now perform a large variety of functions. The question now arises: Which function is the most important? In fact, this question is not easy to answer. There are wide differences of opinion amongst the economists with regard to this issue. According to Hawtrey, the most important function of the Central Bank is its function as the lender of the last resort. Prof. Smith on the contrary, considers note-issue as the most important function of the Central Bank. Prof. Shaw thinks that control of credit occupies the pride of place amongst the functions of the Central Bank. Kisch and Elkin look upon the maintenance of the stability of the monetary standard as the most important function of the Central Bank. In fact, there is hardly any unanimity amongst the economists as to which function of the Central Bank is the most important function. Prof. De Kock considers this controversy as useless and enumerates the important functions of the Central Bank in the following order: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) It enjoys the monopoly of note-issue. It acts as the banker, the agent, and adviser to the government. It maintains the cash reserves of the commercial banks. It is the custodian of the metallic reserves of the nation. It re-discounts exchange and treasury bills for the commercial banks. It acts as the lender of the last resort. It settles the claims and counter-claims of the affiliated banks through its clearing-house function. It controls credit creation by the member-banks.

To the list of Central Banking function enumerated by De Kock, we may add still another important function of the Central Bank. The Central Bank is acting more and more these days as the promoter of economic growth in several countries of the world.

MONEY MARKET ORGANIZATION IN INDIA

RBI

SUB-MARKETS

MONEY MARKET ORGANIZATION INSTITUTIONAL DEVELOPMENT PRIMARY DEALERS MONEY MARKET MUTUAL FUNDS

ROLE

FUNCTION S

CALL MARKET COMMERCIAL BILL MARKETS T-BILLS MARKET COMMERCIAL PAPERS MARKET CERTIFICATES OF DEPOSIT MARKET PROMOTIONAL ROLE

NOTE ISSUE AUTHORITY/ ISSUER OF CURRENCY

GOVERNMENT BANKER BANKERS BANK

EXCHANGE CONTROL AUTHORITY

SUPERVISING AUTHORITY/ REGULATOR AND SUPERVISOR

CASH RESE RVE RATIO

REGULATOR OF MONEY ANDCREDIT/ MONETARY AUTHORITY

OPEN MARKET OPERATIO NS

BANK RATE

REFIN ANCE

STATUTOR Y LIQUIDITY

RATIO

REPO AND REVERSE REPO

MARKET STABILIZ ATION SCHEME

FACILITY

LIQUIDITY ADJUST MENT

INDIAN CAPITAL MARKET

All those institutions and mechanisms through which medium and long term funds are pooled and chanalised to individuals, businesses and the government constitute the Capital Market. It deals with the long term securities of different types, which serve the requirements purchasers and sellers of those instruments. The Indian Capital Market constitutes of the Unorganised and Organised sectors. The Unorganised Money Market is the most unsystematic. There is no uniform policy regarding interest rates, maturity of financial assets, etc. Despite all the measures taken by the government and the RBI, this sector is still out of their control.

The Organised Sector of the Capital market consists of a number of financial institutions like: Unit Trust of India (UTI) Industrial Finance Corporation of India (IFCI) Industrial Development Bank of India (IDBI) Industrial Reconstruction Bank of India (IRBI) (ICICI) Life Insurance Corporation (LIC) General Insurance Corporation (GIC) (SIDBI)

In

addition to the above, there are also: Industrial Development Corporations State Financial Corporations Merchant Bankers Leasing and Financila Companies Mutual Funds Housing Finance Banks Stock Holding Corporation of India Discount and Finance House of India

The Organised sector of the Indian Capital Market is regulated by the Securities and Exchange Board of India. (SEBI). DIVISIONS OF CAPITAL MARKET: The Indian Capital Market is divided into : Gilt - edged Market and Industrial Security Market Gilt edged Market deals in Central, State & local government securities and are backed by the RBI. These are long term securities sold to the public, banks and financial Institutions. They carry low rates of interest compared to the bonds issued by companies, but they provide a variety of tax incentives and rebates. Industrial Security Market deals in the purchase and sale of new and old shares and debentures issued by the corporate sector. It is divided into (1) primary market and (2) secondary market

DEVELOPMENT BANKS:
Learning Objectives o Understand the meaning of development banks. o Analyse the operations and describe the trends of DFIs. o Make a critical evaluation of the role played by DFIs. o Recollect the findings of the expert committee on DFIs. o Carve the role of DFIs during the days ahead.

Assessment of Development Banks:

o o o o Promotion of SSI units Promotion of entrepreneurs Development of backward areas Industrial development

Weaknesses:
o o o o o o Low profitability Operating in competition-free environment Government control and political interference Regional imbalances still persist Could not remove sickness As nominee directors of lendee companies, their role is minimal

CRITICISMS OF INDIAN CAPITAL MARKET: 1. Inadequate Liquidity: According to a recent study, only 20 per cent of the scripts are traded everyday and that too of Group A, and another 20 per cent are traded 2 to 3 times a week and only 10 per cent once a fortnight. This proves that the Indian capital market suffers from lack of adequate liquidity. 2. Delayed deliver of scripts: It is a common knowledge that the delivery of scripts and settlement or payments are unusually delayed. Sometimes, the delivery of scripts takes 4 to 5 months and the payments are made after 2 to 3 months. There are bad deliveries as well. Insiders also deal in shares : Persons working in a company often deal in shares on the basis of the expected profitability or losses of the company which creates fluctuations in the price of the scripts and adversely affects the interests of the small investors. It has also been seen that big industrial houses also sometimes resort to transactions, in the shares of group companies. This sort of insider trading causes fluctuations in the Indian capital market and harms the small investors. Inadequacy of Market Instruments: The Indian capital market deals primarily in shares and debentures which are not at all adequate for its proper and smooth functioning. The newly introduced warrants, zero-coupon bonds, etc., have not yet gained popularity with the general investors. Defective Banking and Postal Services : The defective functioning of the banks and postal services have also added to the problems of the small investors. The refund and dividend warrants sent by the companies to the shareholder sub-ordinary posts are more often lost in the transit due to the dishonest postal and bank employees. Lack of Availability of Stockinvest : Stockinvest of small denominations are not easily available to small investors. Besides, the bank charges are also high and the use of stockinvest is full of procedural difficulties. Consequently, the small investors keep themselves away from this instrument which is mainly being used by big investors. Existence of Grey market: Sometimes transactions are unofficially conducted in the shares before they are listed. This is called the grey market. This sort of unofficial and unregulated market attracts gullible investors. Such investors are also attracted to invest in new shares by financial analysts whose analysis is neither fair nor objective. The result is that the small investor suffers. Lack of clarity in Prospectus: The SEBI has no doubt issued guidelines for the preparation of prospectuses issued by individual

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companies but it has been seen that most of he time the prospectuses issued by the companies do not supply full information to the prospective investors. Consequently they are duped straightaway. A large number of companies have disappeared from the scene after issuing the share certificates and the small investors are unable to find any trace of them. 9. Defective Stock-Broking System: The entire system of stock broking is full of defects. The brokers appoint their sub-brokers who in turn appoint their own sub-brokers who cheat the sellers and buyers of shares and debentures in the secondary market by manipulating the prices. Investors unprotected: In case of default by brokers and subbrokers the investors have no protection. The present provision regarding the protection given to an individual shareholder under the Consumer Protection Fund created at each Stock Exchange is limited to Rs.40,000 in case of a defaulting broker which is highly inadequate. Lack of Transparency: The buyers and sellers of shares are entirely at the mercy of brokers who quote the lowest traded rate of a share to the sellers and the highest to the purchasers. In this way they gain both ways. Moreover, there is no uniformity in the rate of brokerage. The brokers also do not maintain proper accounts. In short, the trading transactions in stock exchanges lack transparency. Defects of Stock Exchange: Further, the operations of the stock exchanges are also defective. They neither have the proper infrastructure, nor do they have adequate space for enabling the stock brokers to operate efficiently. They also do not have adequate telecommunication and computerization facilities. Consequently, they are still following the old trade practices. Fragmentation of the Secondary Market: The secondary capital market is fragmented into the ring-operated stock exchanges, the ringless OTCEI and the on-line screen-based and scriptless NSEI. This not only confuses the small investors but also throws them into the lap of the brokers and sub-brokers. Consequently, the small investors stand cheated and the liquidity in the capital market stands reduced.

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ROLE OF SEBI:
The establishment of the Securities and Exchange Board of India (SEBI) was a land mark government measure to monitor and regulate capital market activities and to promote healthy development of the market. The SEBI was constituted in 1988 by a resolution of Government of India and it was made a statutory body by the Securities and Exchange Board of India Act, 1992.

OBJECTIVES OF SEBI: According to the Act, the objectives of SEBI are to protect the interests of investors in securities and to promote the development of, and to regulate, the securities market for matters connected therewith or incidental therewith.

SEBI is a statutory body with a triple mandate: protection of interests of investors, proper regulation of the stock exchanges and healthy development of securities market.

CAPITAL MARKET REFORMS AND DEVELOPMENTS The number of Stock Exchanges has increased and the capital market has expanded substantially. However, the functioning of the stock exchanges were characterized by many shortcomings with long delays, lack of transparency in procedures and vulnerability to price rigging and insider trading. A number of measures have been taken to overcome these problems. The objectives of these measures, broadly, have been to: Provide for effective control of the stock exchange operations. Provide for effective control of the stock exchange operations. Increase the information flow and disclosures so as to enhance the transparency. Protect the interests of investors. Check insider trading. Improve the operational efficiency of the stock exchanges. Promote healthy development of the capital market.

NARASIMHAM COMMITTEE RECOMMENDATIONS:

i. ii. The ownership pattern of DFIs should be broad-based, like that of ICICI. The government should work out an action plan to be implemented in the next three years which would usher in a measure of autonomy of the DFIs in matters of internal administration. The appointment of chief executives of DFIs (as in the case of banks) should be men of proven professional competence and should be selected on the recommendations of a panel of eminent persons. The boards of DFIs should include representatives from the industrial sector. v. In the case of state-level financial institutions, the link with the State Governments should be broken and these institutions should be helped to work with improved efficiency, take up only that number of projects which they can efficiently follow up and recover their dues and approach the capital market for their funds. The DFIs should raise their funds from the capital market at marketrelated rates. They should also mobilise the savings of the household sector through some schemes which do not conflict with the commercial banks. As regards loan sanctions, each DFI should have the sole responsibility in loan sanctions. It should be guided by professional appraisal of the technical and economic aspects of the project evaluation of the promoters, competence and integrity. The DFIs should supervise their own loan implementation.

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viii.

The present system of consortium funding should be given up. The cross-representation in each others boards is no more necessary with the giving up of consortium funding. The role and functions of IDBI should be changed. The IDBI should retain only its apex refinancing role and its direct lending function should be transferred to a separate institution which could be incorporated as a company. In the matter of corporate take-overs, DFIs should lend support to existing managements with proven record beneficial to all concerned, except in these cases where the new management can do better. In all cases, the DFIs should exercise their individual profession nal judgements free of any pressures.

ix.

x.

Road ahead:
(i) (ii) (iii) (iv) (v) (vi) Promoting the growth of small, new and technical entrepreneurs in the country. Preventing concentration of economic power. Optimising the use of scarce resources. Promoting industrialisation of backward and neglected regions. Concessional funds having dried up, DFIs are forced to mobilise their own resources. Securitisation of assets has a potential to resolve the resource crisis through the faster turnover of assets. With the maturing of the Indian economy, service sectors like transportation, communications, medicare, recreation and tourism, consultancy and computer software services, insurance and investment banking would assure greater importance in the future. FDIs need to align themselves with these emerging areas. DFIs themselves need to restructure themselves. Two major institutions, viz., ICICI and IDBI have converted themselves into commercial banks. On May 3, 2002, ICICI merged into ICICI Bank, the name by which it is presently known. The ICICI is now a universal bank which is active in every area of finance. Similarly, the Industrial Development Bank of India Act has been repealed towards the end 2003 and consequently, the IDBI Bank has been merged into IDBI.

(vii)