Session II- Indian Financial system.

Objective of this session- Coverage:• Importance of Indian Financial system• Phases of evolution of Indian Financial system• Financial structures & Markets in India• Familiar Financial Instruments• Financial services offered by Financial Institutions• Connected Regulators• Financial Sector reforms in India• Corporate Governance

Importance of Financial System• An efficient financial system spurs economic growth• A sound financial system touching every aspect of economic

activities is a pre requisite of a vibrant & developed economy• Financial system is an economic driver and a catalyst for the

growth• Sans the financial system, there would be no development• Helps in lowering the cost of transactions, which has a

beneficial influence on money savers and also borrowers by getting finance at competitive interest.

• Comparison of financial system across countries reveal that the system is well developed in rich countries and not so in other countries.

Evolution

- Indigenous system existed in India for many centuries

- Kautilya Arthashastra in the 4th century BC refers to creditors and lending.

- It says that “ if any one became bankrupt, debts owed to the King had priority over other creditors”

- It also mentions about “ Interest on Commodities loaned”

- Thus it can be said that Finance activities were not entirely unknown in the medieval India. Cont…d

Cont…d• In the Modern History, the roots of commercial banking in India can

be traced to the early 18th century where Bank of Calcuta was established in June 1806 &renamed as Bank of Bengal in January 1809 mainly to fund Gen. Wellesley’s war.

• Bank of Madras was established in July 1843 by amalgamation of 4 banks viz. Madras bank, Carnatic bank, Bank of Madras & Asiatic bank.

• Bank of Madras introduced innovations, such as joint stock company with limited liability for share holders, acceptance of deposits from the general etc.

• Bank of Bombay was established in 1868.• These 3 presidency banks were amalgamated in January 1921 to

form Imperial bank of India.• Imperial bank of India was also performing the role of a regulator

till the formation of RBI in 1935. cont..d

Cont…d• RBI formed in 1935 with the enactment of RBI Act 1934• Comprehensive reform to RBI was brought out in 1949 with

the enactment of BR Act 1949.• SBI was formed in 1955 by renaming Imperial bank of India as

its regulatory functions were done by RBI.• In 1948 era of Developing banks started with the setting up of

Industrial Finance Corporation for financing large industrial houses.

• In 1951, State Financial corporation was set up to finance Small & Medium sector.

• Industrial Credit & Investment Corporation of India(ICICI) was set up in 1955 to support private sector. Cont….d

Cont…d• In 1956, Govt nationalised LIC by amalgamating 245 private

life insurance companies.• Refinance corporation of India(RCI) was set up in 1958 to

provide refinance to banks.• In 1964, UTI was set up to mobilize the savings from the

people.• IDBI was established as a subsidiary of RBI in 1964 to provide

term loans to big industries.• RCI merged with IDBI in 1964 and refinance functions were

accordingly taken over by IDBI.• For bringing out social control in the economy, 14 commercial

banks were nationalised in 1969. cont…..d

Cont…d• Industrial Reconstruction Corporation of India was set up in 1971 to

rehabilitate sick industries.• In 1972, General Insurance companies were nationalised.• In 1976 IDBI was delinked from RBI and made an independent

entity.• In 1980, 6 more commercial banks were nationalised.• IRDA act was passed to regulate Insurance sector.• Mutual funds started working from 1991.• NBFCs commenced their operation in 1991.• SEBI was set up in 1986 by taking over the functions of Controller of

Capital issues(CCI)• Since 1991, various reform measures have been initiated in the

financial sector.

Financial structures/Markets• The Indian Financial structure range from Pawnshops to

Moneylenders to Stock exchanges etc.• The Financial market is broadly bifurcated into Organised & Un

organised sectors.• The co-existence of two sectors is commonly referred to as “ Financial Dualism”• Organised Sector: Financial Institutions: - Commercial banks, Co operative banks Non banking FIs - NBFCs, Insurance Cos, Mutual funds, Debt Financials Financial Market: - Money Market & Capital Market cont….d

Cont….d• Development Institutions: - ECGC, DICGC, NHB, NABARD, SIDBI,IDFC, Exim bank, IIFCL• Public sector entities: - LIC, GIC, UTI, IFCI, SIDCs etc• Government establishments: - PF, Post offices, National Savings Corporation, etc.• Private secor: - Chit funds, Nidhi cos, Leasing and HP Cos, Merchant banking Divisions• Regulators; • Government, RBI, SEBI, IRDA, PFRDA, etc. • Unorganised sector: - Indigeneous Institutions, Money lenders, Traders, Commission agents,

Organised Sector & Un organised Sector

• The formal sector is characterized by the presence of an organised , institutional and regulated system which caters to the financial needs of the modern spheres of the econpmy.

• The informal sector is un-organised, non institutional, and non regulated system dealing with the traditional and rural spheres of the economy.

• The informal system lacks in some cases lacks ethics of business leading to very high rate of interest and oppressive way of recovery

• Thus the prime objective of the government is to cover the different economic activities under formal sector & hence propagating “ Financial Inclusion”

Financial Market• Bifurcated into Money Market & Capital Market.• Money Market is suitable for short term instruments such as

CDs, CPs, Call Money, etc. and helps in managing of short term liquidity in the system.

• Capital market is for long term securities like Equity & Debt.• The purpose is to: - Mobilize long term savings to fund long term investments - Encourage broader ownership of assets - Provide liquidity to the investors - Lower cost of transactions - Improve the efficiency of the market.

Financial Instruments• Cash-Apart from being a medium of exchange enables

exchange of goods and services.• Shares• Debt instruments• MF units• Bank Deposits• Post office schemes• ADR/GDR/IDR• Insurance policies• Derivative products• Loans/ Securities

Financial Services• Merchant banking• Parabanking,• Factoring/Forefaiting• Underwriting• Venture capital• Leasing/ HP • Credit rating• Loan Syndication• Trustee functions• Universal banking

Regulators

• RBI : - Head of Monetary system in the country - Regulates, Monitors & controls Financial system in

the country. - Bring about Monetary stability in the country.• SEBI:To maintain stable & efficient markets by creating & enforcing regulations in the market place. cont…d

RBI

• Established on 01.04.1935 based on RBI act 1934.• It regulates, monitors and controls the financial system in

India.• Bring about Financial stability in the country.• Not only addresses domestic economic situations but also

manages the external sector efficiently.

Functions of RBI

• Govt banker• Bankers bank• Control & Supervision of the economy• Exchange control regulation• Regulate & control money supply• Issue of currency notes• Promotional role• Moral suasion

RBI- Organisational structure

• Governor• 4 Dy. Governors• 1 central Govt nominee• 4 Directors( 1 each from their local Boards)• 10 Directors from various fields of economy.

Financial Sector Reforms• Pre Reforms position: - Administered interest rates - Industrial Licensing - Control Regime - Dominant public sector - Lack of competition - Uneconomic & inefficient production system - Inefficiency & Lethargy in different spheres of economy - High capital output ratio - Greater dependence on aid & support from foreign countries - Dependent on others & not self reliant - GDP growth rate averaged less than 4% - Unemployment all around - High inflation

Reasons for pursuing Economic Reforms

• Beginning of 1990s witnessed increase in world oil prices due to Gulf war.

• Above & coupled with sharp decrease in remittances from migrant workers from Gulf created a huge foreign exchange crisis in India.

• The crisis further aggravated on account of further outflow owing to fear of default by India.

• Increasing Deficit• Macro economic imbalances

Objectives of Economic Reforms

• Restore macro-economic stability• Reduce fiscal deficit• Increase balance of payment position• Provide environment sustainable for growth & stability of the

economy• Reorient the economy from the static, govt controlled

environment to market friendly environment.• Instill confidence among international community for treating

India as a safe investment destination

Reform Measures• Reform process commenced from 1991 & onwards.• Reform process enunciated through Liberalization, Privatization and

Globalization.• Abolition of bureaucratic control.• Liberalisation of domestic investment market for foreign

investments• Opening up of the economy for private sector participation• Economy opened up for foreign competition by reducing the

protective barriers to the domestic entities.• Deregulation of lending rates• Encouragement to foreign direct investments• Reforms in public sector• Reforms in banking through Narasimham committee

recomendation

Reform Measures

• Disinvestment of public sector undertakings• Reforms in tax structures• Moderation of Tax rates• Gradual convertibility of foreign currency• Setting up of DRTs to ensure recovery of bank loans(NPAs)• Opening up of banking for foreign banks• Abolition of CCI and setting up of SEBI• Replacement of FERA with FEMA• Establishment of stock exchanges

Effect of Reforms

• India is the most favored investment destination in the world• Build up of huge Forex reserves• Achieving continuous GDP of over 6%• Fastest growing economy in the world next to China• Strong Financial system, resilient to any shocks- clearly

established despite world wide economic recession• India is leading the revival of the economy in the world.• Considered as one of the leading nations of the world.• Aim to achieve double digit growth of GDP continuously, thus

aiming to attain the status of financial super power by 2020.

Corporate Governance

• Concept: - Nobel Laurette Milton Friedman has stated that “ Corporate

governance is the conduct of business in accordance with shareholders desire to make as much money as possible while conforming to the basic rules of the society,embodied in law and customs”

- Narayana Murthy “ It is about ethical conduct in business. It is beyond realms of law. It stems from the mindset of management and cannot be regulated by legislation”

- CG is a framework to facilitate shareholders and stake holders interest.

Corporate Governance• CG concept came into existence in India through Kumara Mangalam

Birla in 2000.• The first step was introduction of Clause 49 of Standard Listing

agreement.• The salient feature of the recommendations were: - 50% independent Directors on the Board. - Setting up of Audit committee - Board meetings to be held 4 times during a year - bring in Transparency and Disclosure in all the activities of the

company. - Stipulate qualification for Directors - Minimum attendance by Directors.

SESSION III- CORPORATE FINANCE• Corporate Finance is a segment of finance which deals with the decision

taken by the corporates to fund their requirements.• The primary objective of such decision is to maximize the corporate value.• The structure of corporate finance depends upon the period of funds

requirement.• It can be bifurcated into Long Term requirement & Short Term

requirement.• Long Term funds requirement could be met by: - Equity OR - Debt OR - Combination of both at a specified percentage.

Corporate Finance

• Sources of Long Term Finance:• Equity: - Equity Capital, including Preference capital - Retained Earnings• Debt: - Term Loans - Debentures.• Short Term Financial requirements met by: - Working capital - Money Market instruments like CP, CD, etc.

Corporate Finance• Differences between Equity & Debt Equity Debt Return by way of Dividend Interest Maturity Infinite Finite Control over company Yes No Dividend P&L appr P&L Dr Tax – Dividend is paid after Tax Interest: Tax is deductible Liquidation Last priority Better priority

Advantages of Equity Finance• No compulsion to pay dividends• No maturity and hence no need to redeem• Enhances the creditworthiness(networth) of the company• Enhances borrowing capacity & hence expansion

Disadvantages:• Issuance of shares dilutes the stake of the promoter & hence

the controlling the interest.• Cost of Equity is very high• Dividends are paid after tax & hence no advantage• Interest payments are Tax deductible expenses- Advantage

Advantages of Debt Financing

• Interest is a tax deductible expenses• Does not result in dilution of capital & controlling interest• Not entitled for the value created by the company.• Maturity of the instrument can be tailored to suit cash flows• Cost of debt is lower compared to equity• Fixed Maturity & Not perpetual• Provides protection against inflation• Regulatory prescriptions are manageable.

Disadvantages of Debt Finance

• Fixed repayment, irrespective of downtrend.• Loan default may result in bankruptcy• Increases the financial leverage• Reduces the ability for further borrowing unless

supplemented by further infusion of capital• If inflation is low, then cost of debt becomes costly