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UNIT-1

FinanciaI System
Financial System is one of the industries in an economy. t is a particularly important industry that
frequently has a far reaching impact on society and the economy. The product of the financial
industry is not tangible rather it is an intangible service. Financial industry as a whole, produce a
wide range of services but all these services are related directly or indirectly to assets & liabilities,
that is, claims on people, organization, institutions, companies and government. These are the form
in which people accumulate much of their wealth. n simple terms we are referring to paper assets:
shares, debentures, deposits, mortgages and other securities. This financial system performs
certain essential function for the economy, including maintenance of payment system (through
which purchasing power is transferred from one participant to another i.e. from buyer to seller),
collection and allocation of the savings of society, and creation of a variety of stores of wealth to suit
the preference of servers. Performance of these function pre-suppose the existence of financial
assets, financial institutions (intermediaries) and financial markets. A combination of these three
constitutes financial system.
To interpret the financial system and evaluate its performance, it requires an understanding of its
functions in an economy. Financial systems in fact have the following functions:-
(A) Provision of Iiquidity:- The major functions of the financial system is the provision of
money and monetary assets for the production of goods & services. These should not be
shortage of money for productive ventures. n financial language, the money and monetary
assets are referred to as liquidity. The term liquidity refers to cash or money and other
assets which can be converted into cash readily without loss. Hence, all activities in a
financial system are related to liquidity either provision of liquidity or trading in liquidity.
(B) MobiIization of Savings: Another important activity of the financial system is to mobilize
savings and channelize them into productive activities. The financial system should offer
appropriate incentives to attract savings and make them available for more productive
ventures. Their the financial system facilitates the transformation of savings into investment
& consumption. The financial intermediaries have to play o dominant role in this activity.
(C) Service Functions: An effective financial system offers the economic segments services in
form of providing opportunities to hold wealth in secured and convenient way so that they
pay a positive role of return. The availability of these services of the financial system
contributes importantly, if in an intangible way to the satisfaction of customer.

Constituents of Financial System

(A) FinanciaI Intermediaries or Institutions:
The term financial intermediary includes all kind of organizations which intermediate and
facilitate financial transactions of both individual and corporate customers. Thus it refers to
all kinds of financial institutions and investing institutions which facilitate financial
transactions in financial markets. They may be in the organized sector or in the unorganized
sector. They may also be classified into two:-

(i) Capital Market intermediaries


(ii) Money Market intermediaries.
apitaI Market Intermediaries: These intermediaries mainly provide long term funder to
individuals and corporate customers. They consist of term lending institution like financial
corporations and investing institutions like LC.
Money Market Intermediaries: Money market intermediaries supply only short term funds
to individuals and corporate customers. They consists commercial tanks, co-operative
banks, etc-
(B) FinanciaI Markets:
Generally speaking, there is no specific place or location to indicate a financial market.
Whenever a financial transaction takes place, it is deemed to have taken place in the
financial market. Hence financial are pervasive in nature since financial transactions are
themselves very pervasive throughout the economic system. For instance issue of Equity
shares, granting of loan by term lending institutions, deposit of money into a bank, purchase
of debenture and go on.
However, financial markets can be referred to as those centers and arrangements
which facilitate buying and selling of financial assets, claims and services. Sometimes, we
do find the existence of a specific place or location for a financial market as in the case of
stock exchange.
Iassification of FinanciaI Markets
(A) Organized Markets: n the organized markets, there are standardized rules and
regulations governing their financial dealings. There is also a high degree of
institutionalization and instrumentalization. There markets are subject to strict supervision
and canted by the RB or other regulatory bodies. These organized markets can be further
classified into. They are:
() apitaI Market
() Money Market.
() apitaI Market: The capital market is a market for financial assets which have a large or
indefinite maturity. Generally, it deals with long term securities which have a maturity period
of above one year capital market may be further divided into three namely :-
(i) ndustrial Securities Market
(ii) Govt. Securities Market
(iii) Long Term Loans Market.
(i) IndustriaI Securities Market: As the very name implies, it is a market for industrial
securities namely (a) Equity Share, (b) Preference Shares and (c) Debentures or bonds.
t is a market where industrial concerns raise their capital or debt by issuing appropriate
instruments. t can be further subdivided into two. They are :
(a) Primary market or new issue market.
(b) Secondary market or stock exchange.
(a) Primary Market: Primary market is a market for new issues or new financial claims.
Hence it is also called New ssue Market. The primary market deals with these securities
which are issued to the public you the first time. n the primary market, borrowers
exchange new financial securities for long term funds. Thus, primary market facilitates
capital formation.

There are three ways by which a company may raise capital in a primary market. They
are:
F Public issue
F Right ssue
F Private placement.
( b) Secondary Market: Secondary market is a market for sale of securities. n other words,
securities which have already passed through the new issue market are treated in this
market. Generally, such securities are quoted in the stock exchange and it provides a
continuous and regular market for buying and selling of securities. This market consists of
all stock exchanges recognized by the Govt. of ndia.
(ii) Government Securities Market: t is otherwise called Gilt-Edged securities market. t is a
market where govt. securities are traded. n ndia there are many kinds of Govt. Securities-
short term and long term. Long term securities are traded in this market while short term
securities are traded in the money market. Securities issued by the Central Govt., Stock
Governments, Semi-Government authorities like City Corporations, Post Trusts,
mprovement Trusts, State Electricity Boards, All ndia and State level financial institutions
and public sector enterprises are dealt in this market. Govt. securities are issued in
denominations of Rs. 100. nterest is payable half-yearly and they carry for exemptions
also.
The govt. securities are in many farmers. These are generally:
(a) Stock certificates or inscribed stock
(b) Promissory Notes
(c) Bearer Bonds which can be discounted.
Govt. securities are sold through the Public Dept Office of the RB while Treasury Bills
(short term securities) are sold though auctions.
(iii) Long Term Loan Market:
Development banks and commercial banks play significant role in this market by supplying
long term loans to corporate customers. Long term loans market may further be classified
into :
(a) Term loans market
(b) Mortgages market
(c) Financial Guarantees market
(a) Term Loan Market: n ndia, may industrial financing institutions have been created by the
Govt. both at the national and regional levels to supply long term and medium term loans
to corporate customers directly as well as indirectly. These development banks dominate
the industrial finance in ndia. nstitutions like DB, FC, CC and other state financial
corporation's come under this category. These institutions meet the growing and varied
long term financial requirements of industries by supplying long term loans.
(b) Mortgages Market: The mortgages market refers to those centers which supply mortgage
loan mainly to individual customers. A mortgage loan is loan against the security of
immovable property like real estate. The transfer of interest in a specific immovable
property to secure a loan is called mortgage. This mortgage may be equitable mortgage or
legal one. Again it may be a first charge or second charge. Equitable mortgage is created
by a mere deposit of little deeds to properties as security whereas in the case of legal
mortgage the little in the property is legally transferred to the lender by the borrower. Legal
mortgage is less risky.

The mortgage market may have primary market as well as secondary market. The
primary market consists or original extension of credit and secondary market has sales
and re-sales of existing mortgages at prevailing, prices. n ndia residential mortgages
are the most common ones. The Housing and Urban Development Corporation
(HUDCO) and the LC play a dominant role in financing residential projects. Besides the
Land Development Banks provide cheap mortgage loans for the development of lands,
purchase of equipment etc. These development banks raise finance through the sale of
debentures which are treated as trustee securities.
(c) FinanciaI Guarantees Market: A guarantee market is a center where finance is
provided against the guarantee of a repudiated person in the financial circle. Guarantee
is a contract to discharge the liability of a Third party in case of his default. Guarantee
acts as a security from the creditor's point of view. n case the borrower fails to repay the
loan, the liability falls on the shoulders of the guarantor. Hence the guarantor must be
known to bath the borrower and the lender and he must have the means to discharge his
liability.
Though there are many types of guarantees, the common forms are: (i) Performance
Guarantee and (ii) Financial Guarantee, performance guarantee cover the payment of
earnest money, Retention money, advance payments, non-completion of contracts etc.
On the other hand financial guarantees cover only financial contracts. n ndia, the
market for financial guarantees is well organized. The financial guarantees in ndia relate
to:
F Medium and long term loans raised abroad
F Deferred payments for imports and exports
F Loans advanced by banks and other financial institutions.
These guarantees are provided mainly by commercial banks, development banks,
government both central and states and other specialized guarantee institution like ECGC
(Export Credit Guarantee Corporation) and DCGC (Deposit nsurance and Credit
Guarantee Corporation) and
() Money Market:
Money market is a market for dealing with financial assets and securities which have a
maturity period of upto one year. n other words, it is a market for purely short term funders.
The money market does not refer to a particular place where short-term funds are dealt with.
t includes all individuals, institutions and intermediaries dealing with short term funds. The
transaction between borrowers, lenders and middleman take place through telephone,
telegraph, mail and agents,. No personal contact or presence of the two parties is essential
for negotiations in a money market. However, a geographical name may be given to a
money market operate from the Lombard Street and the New York money market operate
from Wall Street. But, they attract funds from all over the world to be lent to borrowers from
all over the globe. Similarly the Bombay money market is the centre for short-term loan-able
funds of not only Bombay but also for the whole of ndia.
According to Geottery Crowther, "The money market is the collective name given to the
various firms and institutions that deal in the various graders of near money."
Objectives of Money Market:
(i) To provide a parking place to employ short term surplus funds.
(ii) To provide room for overcoming short-term deficits.

(iii) To enable the Central Bank to influence and regular liquidity in the economy through
its intervention in this market.
(iv) To provide a reasonable access to users of short-term funds to meet their
requirements quickly adequately and at reasonable costs.
aracteristic/Features of a DeveIoped Money Market:
n order to fulfill the above objectives, the money market should be fully developed and
efficient. n every country of the world, some type of money market exists. Some of them are
highly developed while others are not well developed. Prof. S.N. Sen has described certain
essential features of a developed money market. They are as follow:
(i) HigIy Organized Banking System: The commercial banks are the nerve centre of the
whole money market. They are the principal suppliers of short term-funds. Their policies
regarding banks and advances have impact on the entire money market. The
commercial banks serve as vital link between the central bank and the various segments
of the money market.
(ii) Presence of a entraI Bank: The Central Bank Acts as the banker's bank. t keeps
their cash reserves and provides them financial accommodation in difficulties by
seconding their eligible securities. n other words it enables the commercial bank and
other institutions to convert their assets into cash in times of financial crisis. Through its
open market operations, the central bank absorbs surplus cash during off-seasons and
provides additional liquidity in the busy seasons. Thus the central bank is the leaders,
guide and controller of the money market.
(iii) AvaiIabiIity of Proper redit Instruments: t is necessary for the existence of a
developed money market continuous securities such as bill of exchange, treasury bills
etc. There should be a number of dealers in the money market to transact in these
securities.
(iv) Existence of sub-markets: The number of sub-markets determines the development of
a money market. The larger the number of sub markets, the broader and more
developed will be the structure of money market. The several submarkets together make
a coherent money market.
(v) AmpIe Resources: There must be availability of sufficient funds to finance transactions
in the sub-markets. These funds may come from within the country and also from foreign
countries. The London, New York and Paris money markets attract funds from all over
the world. The underdeveloped money markets are starved of funds.
(vi) Existence of Secondary Market: There should be an active secondary market in the
instruments.
(vii) Demand and SuppIy of funds: There should be a large demand and supply of short-
term funds. t presupposes the existence of a large domestic and foreign trade. Besides
it should have adequate amount of liquidity in the form of large amounts maturing within
a short period.
Importance of Money Market:
A developed money market plays an important role in the financial system of a country by
supplying short term funds adequately and quickly to trade and industry. The money market is
an integral part of country's economy. Therefore, a developed money market is highly
indispensible for the rapid development of the economy. A developed money market helps the
smooth functioning of the financial system in any economy in the following ways:
(i) DeveIopment of Trade and Industry: Money markets an important source of financing
trade and industry. The money market through discounting operations and commercial

papers, finances the short term working capital requirements of trade and industry and
facilitates the development of industry and trade both-national & international.
(ii) DeveIopment of apitaI Market: The short-term rates of interest and the conditions
that prevail in the money market influence the long term interest as well as resource
mobilization in capital market. Hence, the development of capital market depends upon
the existence of developed money market.
(iii) Smoot Functioning of ommerciaI Banks: The money market provides the
commercial banks with facilities for temporarily employing their surplus funds in easily
reliable assets. The banks can get back the funds quickly, in times of need, by resorting
to the money market.
(iv) Effective entraI Bank ontroI: A developed money market helps the effective
functioning of a Central Bank. t facilitators effective implementation of the monetary
policy of a Central Bank. The Central Bank though the money market, pumps new
money into the economy in slump and siphons it off in boom. The Central Bank, thus,
regulate the flow of money so as to promote economic growth with stability.
(v) FormuIation of SuitabIe Monetary PoIicy: Conditions prevailing in a money market
serve as a true indicator of the monetary state of an economy. Hence it serves as quid to
the Govt. in formulating and revising the monetary policy then and there depending upon
the monetary conditions prevailing in the market.
(vi) Non-infIationary source of finance to Government: A developed money market helps
the government to raise short-term funds through the treasury bills floated in the market.
n the absence of a developed money market, the Government would be forced to print
and issue more money or borrow from the Central Bank. Both ways would lead to an
increase in price and the consequent inflationary trend in the economy.
The money market may be further subdivided into four part. They are:
(a) Call money market (c) Treasury bills market
(b) Commercial bills market (d) Short term loan market
(a) aII Money Market: The call money market is a market for extremely short period loans say
one day to fourteen days. So it is highly liquid. The loans are repayable on demand at the
option of either the lender or the borrower. n ndia, call money markets are associated with
the presence of stock exchanges and hence, they are located in major industrial tours like,
Mumbai, Kolkata, Chennai, Delhi, Ahmadabad etc. The special feature of this market is that
the interest rate varies from day to day and even from hour to hour and centre to centre.
(b) ommerciaI BiIIs Market: t is a market for bills of exchange arising out of genuine trade
transactions. n the case of credit sale, the seller may draw a bill of exchange on the buyer.
n ndia the bill market is under developed. The RB has taken many steps to develop a
sound bill market. The RB has enlarged the list of participants in the bill market.
(c) Treasury BiIIs Market: t is a market for treasury bills which have short-term maturity. A
treasury bill is promissory note or a finance bill issued by the Government. t is highly liquid
because its repayment is guaranteed by the Government. t is an important instrument for
short term borrowing of the Govt. There are two types of treasury bills namely (i) ordinary or
regular and (ii) adhoc treasury bills popularly known as 'ad hoes'. Ordinary Treasury bill is
issued to the public banks and other financial institutions with a view to raising resources for
the Central Government to meet its short term financial needs. Adhoc treasury bills are
issued in favour of the RB only. They are not sold through tender or auction. They can be
purchased by the RB only. Adhoc are not marketable in ndia but holders of these bills can
sell them back to 364 days only.
(d) Sort-term Loan Market: t is market where short-term loans are given to corporate
customers for meeting their working capital requirements. Commercial banks play a

significant role in this market. Commercial banks provide short term loans in the form of
cash credit and overdraft. Overdraft facility is mainly given to business people whereas cash
credit is given to industrialists. Overdraft is purely a temporary accommodation and it is
given in the current account itself. But cash credit is for a period one year and it is
sanctioned in a separate account.



Money Market Vs apitaI Market
Money Market
(i) t is a market for short-term loan-able
funds for a period of not exceeding one year.
(ii) This market supplies funds for financially
current capital requirements of industries and
short period requirements of the Govt.
(iii ) The instruments that are dealt in a
money market are bills of exchange, treasury
bills, commercial papers, certificate of deposit
etc.
(iv ) Each single money market instrument is
of large amount minimum for one lakh. Each
CD or CP is for a minimum of Rs. 25 lakhs.
(v ) The Central Bank and commercial banks
are the major institutions in the money
market.
(vi ) Money market instruments generally do
not have secondary markets.
(vii ) Transactions mostly take place over-
the-phone and there is no formal place.
(viii ) Transactions have to be conducted
without the help of the brokers.
apitaI Market
(i) t is a market for long-term funds
exceeding a period of one year.
(ii) This market supplies funds for financing
the fixed capital requirements of trade and
commerce as well as the long-term
requirements of the govt.
(iii) This market deals in instruments like
shares debentures, Government bonds etc.
(iv) Each single capital instrument is of small
amount. Each share value is Rs. 10. Each
debenture value is Rs 100.
(v) Development banks and nsurance
companies play a dominant role in the
capital market.
(vi) Capital market instruments generally
have secondary markets.
(vii) Transactions take place at a formal
place viz, stock exchange.
(viii) Transactions have to be conducted only
through authorize dealers.

RBI
The RB as the Central Bank of the country, is the centre of the ndian financial and monetary
system. As the apex institution, it has been guiding, monitoring, relating, controlling and promoting
the destiny of the ES since its inception. t is quite young compared with such central banks as the
Bank of England, Rikrbank of Sweden, and the Federal Reserve Board of the U.S. However, it is
perhaps the oldest among the central bank in the developing countries. t started functioning from
April 1, 1935 on the terms of the Reserve Bank of ndia Act, 1934. t was a private shareholders/
institution till January 1949, after which it become a State-owned institution under the Reserve Bank
(Transfer to Public Ownership) of ndia Act 1948. This Act empowers the central government, in
consultation with the Governor of the Bank, to issue such directions to it as they might consider

necessary in the public interest. Further, the Governor and all the Deputy Governor of the bank are
appointed by the central government.
The bank is managed by a Central Board of Directors, four local Boards of Director and a
committee of the Central Board of Directors and a committee of the Central Board of Directors. The
functions of the local Boards are to advise the Central Board on matters referred to them; they are
also required to perform duties as are delegated to them. The final control of the bank vests in the
Central Board which comprises the Governor, four Deputy Governors, and fifteen Directors
nominated by the central government. The committee of the Central Board consists of the
Governor, the Deputy Governors, and other Director as may be presented at a given meeting. n
order to perform its various functions, the Bank has been divided and sub-divided into a large
number of departments. Apart from banking and issue departments there are at present 20
departments and three training establishments at the central office of the Bank.
Functions of RBI
The Preamble of the RB Act, 1934 states that "Whereas it is expedient to constitute a
Reserve Bank of ndia to regulate the issue of bank notes and the keeping of reserves with a view
to securing monetary stability in (ndia) and generally to operate the currency and credit system of
the country to its advantage."
The main functions of RB are as follows:-
(i) To maintain monetary stability so that the business and economic life can deliver welfare
gains of a properly functioning mixed economy.
(ii) To maintain financial stability and ensure sound financial institution so that monetary stability
can be safely pursued and economic units can conduct their business with confidence.
(iii) To maintain stable payments system so that financial transactions can be safely and
efficiently executed.
(iv) To promote the development of financial infrastructure of markets and systems, and to
enable it to operate efficiently i.e. to play a leading role in developing a sound financial
system so that it can discharge its regulatory functions efficiently.
(v) To ensure that credit allocation by the financial system broadly reflects the national
economic priorities and social concerns.
(vi) To regulate the overall volume of money and credit in the economy with a view to ensure a
reasonable degree of price stability.
RoIes of RBI
(1) Note Issuing Autority: The RB has, since its inception the sale register authority or
monopoly of issuing currency notes other than one rupee notes and coins, and coins of
smaller denominations. The issue of currency notes is one of its basic functions. Although
one rupee notes & coins, and coins smaller demonization's are issued by the Government of
ndia, they are put into circulation only through the RB. n order to discharge its currency
functions, the Bank has 15 full-fledged issue officer and two sub-officer, and 4127 currency
chests in which the stock of new and re-issuable notes and rupee coins are stored. Of
these, 17 chests are with the RB, 2877 with the SB and associate banks, 791 with
nationalized banks, 423 with treasuries, and 19 with private sector banks.
(2) Government Banker: The RB is the banker to the Central and state governments. t
provides to the governments all banking services such as acceptance of deposits, withdraw
of funds by cheques, making payments as well as receipts and collection of payments on
behalf of the government, transfer of funds and management of public debt. The Bank
receives government deposits free of interest and it is not entitled to any remuneration for
the conduct of the ordinary banking business of the Government.

As a banker to the government, the bank can make "ways and means advances"
(i.e. temporary advances and payments) to both the central & State Governments. The
maximum maturity period of these advances is three months. Apart from the ways and
means advances, the state governments have made heavy use of overdrafts from the RB.
At present, overdrafts upto and inclusive of the seventh day are charged at the Bank rate
and from the eight day onwards at 3 percent above the bank rate.
(3) Bankers' Bank: The RB, like all central banks, can be called a bankers' bank because it
has a very special relationship with commercial & co-operative banks and the major part of
its business is with these banks. The bank controls the volume of reserves of commercial
banks and there by determines the deposits/credit creating ability of the banks. The bank
holds a part or all of their reserve with the RB. t is, therefore, called "the bank of last resort"
or "the lender of last resort."
(4) Supervising Autority: The RB has vast powers to supervise and central commercial and
co-operative banks with a view to developing an adequate and sound banking system in the
country. t has, in this filed, the following powers: (a) to issue licences for the establishment
of new banks: (b) to issue licences for the setting up of bank branches, (c) to prescribe
minimum requirements regarding paid-up capital and reserves, transfer to reserve fund and
maintenance of cash reserve and other liquid assets; (d) to inspect the working of banks in
ndia as well as abroad. (e) to conduct ad hoc investigations, from time to time, into
complaints, irregularities and frauds in respect of banks: (f) to central methods of operations
of banks so that they do not fritter away funds in improper investments and injudicious
advances, (g) to control appointments, re-appointment, termination of appointment of the
Chairman and Chief executive officers of private sector banks, and (h) to approve or force
amalgamations.
(5) Excange entraI (E) Autority: One of the essential functions of the RB is to maintain
the stability of the external value of the rupee. t pursues this objective through its domestic
policies and the regulation of the foreign exchange market. As far as the external sector is
concerned the task of the RB has the following dimensions: (a) T to administer the "foreign
exchange control"; (b) to choose the exchange rate system and fix or manage the exchange
rate between the rupee and other currencies; (c) to manage exchange reserves; and (d) to
interact or negotiate with the monetary authorities of the sterling areas, Asian Clearing
Union and other countries, and with international financial institutions such as the ME,
World Bank and Asian Development Bank.
(6) Promoter of te FinanciaI System: Apart from performing the functions already
mentioned, the RB has been rendering 'developmental' or 'promotional' services which have
strengthened the country's banking and financial structure. This has helped in mobilizing
savings and directing credit flows to desired channels, thereby helping to achieve the
objective of economic development with social justice. t has helped in deepening and
widening the financial system. As a part of its promotional role, the Bank has been pre-
empting credit for certain sectors at concessional rates.
(i) Money Market: n the money market, the RB has continuously worked for the integration
of its unorganized and organized sectors by trying to bring indigenous bankers into the
mainstream of the banking business. n order to improve the quality of finance provided by
the money market, it introduced two Bill Market Schemes, one in 1952, and the other in
1970, with a view to increasing the strength and visibility of the banking system; it carried
out a programme of amalgamations and mergers of weal banks with the strong ones.
(ii) AgricuIture Sector: The RB has rendered service in directing and increasing the follow
of credit to the agriculture sector. t has been entrusted with the task of providing
agricultural credit in terms of the Reserve Bank of ndia Act, 1934. The importance with
which the RB takes these functions is reflected in the fact that since 1955, it has

appointed a separate deputy governor in charge of rural credit. As a part of its efforts to
increase the supply of agricultural credit, the bank has been working to strengthen co-
operative banking structure through the provision of finance, supervision, and inspection. t
established the Agricultural Refinance Corporation (now known as NABARD) in July 1963
for providing medium-term and long-term finance for agriculture. t also helped establishing
an Agricultural Faineance Corporation.
(iii) IndustriaI Finance: The role of the bank is diversifying the institutional structure for
providing industrial finance has been equally important. All the special development
institutions (SDs) at the Central and stock levels and many other financial institutions
mentioned earlier were either created by the Bank on its own or it advised and rendered
help in setting up these institutions. The UT, for example, was originally an associate
institution of the RB. Through these institutions, the RB has been providing short-term
and long-term funds to the agricultural and rural sectors, to small scale industries, to
medium and large industries, and to the export sector.
(iv) redit DeIivery: The bank has evolved and put into practice the consortium, co-operative
and participatory approach to lending among banks practice of inter-institutional
participation of expertise pealing and of geographical presence, it has helped to upgrade
credit delivery and service capacity of the financial system. By issuing appropriate
guidelines, in 1977, regarding the transfer of loans accounts by borrowers, it has evolved a
mutually acceptable system of lending, so that the banking business grow in a healthy
mummer and without cut-throat competition.
(v) FormuIating PrudentiaI Norms: To preserve and enhance the stability of the banking
and financial system is an important part of the "promotional" role of the RB. n fact,
financial stability has now assumed relatively greater importance as one of the tasks of the
RB. This is evident in its work to formulate prudential norms for banks and financial
institutions, its intervention in the foreign exchange market and its participation in the
operation of safety nets" i.e. the legal and organizational structure for overseeing the
safety and soundness of the banking & financial systems.

ReguIation of Money and redit
The regulation money and credit will be determined by the overall perception of the central
monetary authority on what the appropriate level of expansion of money and credit should be
depending on how the real factor in the economy are evolving.
The monetary and fiscal policies, although controlled by two different organizations, are the
ways that ndian economy is kept under control. Both policies have their strengths and weaknesses,
some situations favoring use of both policies, but most of the time, only one is necessary. The
monetary policy is the act of regulating the money supply by the Reserve Bank of ndia. One of the
main responsibilities of the RB is to regulate the money supply so as to keep production, prices
and employment stable. The RB has three tools to manipulate the money supply. They are the
reserve requirement, open market operations, and the discounter rate.
The functions of formulating and conducting monetary policy is of paramount importance for
any Central Bank. Monetary Policy regress to the use of techniques of monetary control at the
disposal of the Central Bank for achieving certain objectives.
Fiscal Policy refers to expenditure (used to provide goods and services), taxation (to finance
the various government expenses) and government borrowing. The main point of fiscal policy is to
keep the surplus or deficit swings in the economy to a minimum by reducing inflation and recession.

Monetary PoIicy
Monetary policy is basically concerned with the monetary system of the country. t deals with
monetary decisions and measures and such non-monetary decisions and measures as have
monetary effects.
Monetary policy is usually defined as the central bank's policy pertaining to the control of the
availability, cost and use of money and credit with the help of monetary measure in order to achieve
specific goals.
Monetary policy deals with the monetary system of a country. t is concerned with monetary
decisions and measure. Non-monetary decisions & measures having monetary effects are also
dealt with under the monetary policy. All those measures which affect the volume of money are
included under monetary policy. t controls, directs and guides the methods of cost and used of
money and credit. The central bank of the country is the traditional agent which formulates and
operates monetary policy.
Paul Einzig defined, "Monetary policy is the attitude of the political authority towards the
monetary system of the community under its control." According to Johnson, Monetary policy is
defined as "policy employing central bank's control of the supply of money as an instrument for
achieving the objectives of general economic policy."
There are two facts of monetary policy in a developing economy: (a) Positive, and (b)
Negative.
n its positive aspect, it sets out the promotional role of central banking in improving the
savings ratio and expanding credit for facilitating capital formation. n its negative approach it
implies a regulatory phase of restricting credit expansion, and its allocation according to the
absorbing capacity of the economy.
Objectives of Monetary PoIicy
There can be five major objectives of monetary policy:-
(1) Neutrality of Money.
(2) Price Stabilization.
(3) Exchange Stabilization.
(4) Full Employment.
(5) Economic Growth.
(1) NeutraIity of Money: This objective of monetary policy was first suggested by Wicksteed.
Later on, it was supported by Hayek and Robertson. According to these economists, the
monetary authority in a country should aim at complete neutrality of money vis-a-vis the
economy. The exponents of neutral money hold the view that monetary changes are the road
course of all economic fluctuations. The changes in money supply also cause imbalances
between demand and supply, production and consumption, in the economy. According to the
neutralists, the money changes are the real Villians of the peace. They believe that is somehow
the changes in money supply are criminated there will be perfect stability in the economic
system. There will be no cyclical fluctuations, no trade cycle, no inflation and no deflation in the
economy.
riticism of NeutraI Money PoIicy
(i) DifficuIties in impIementation: The concept of neutral money requires that the
supply of money be kept constant and adjustments be made in it on account of the
fundamental changes taking place in the economy. Now it is exceedingly difficult ot
keep the supply of money constant in actual price.

(ii) SeIf-contradictory: A policy of neutral money is rather self-contradictory in character.


On one side, the neutralists claim a passive role for money because this entire concept
is based on the philosophy of 'laissez-faire' or non intervention by the State in
economic affairs. On the other side, the monetary authority, according to them should
maintain a constant supply of money through frequent adjustments with the
fundamental changes in the economy. Now this role assigned to the monetary
authority conflict with the philosophy of laissez-faire.
(iii) NeutraI Money PoIicy ImpracticabIe: The policy of neutral money is unrealistic on
the ground that it cannot be put into actual practice. n other words, the supply of
money cannot be kept constant permanently at a particular level.
(iv) Wrong Basis: The vary basis of the policy of neutral money is wrong and unrealistic.
The policy has assigned a passive role to money. n actual practice, money plays a
very active role in the present days dynamic economy. As much, money can not be
neutral in its role.
(2) Price StabiIization: Some economists have suggested price stabilization as a viable objective
of monetary policy for an economy suffering from violent price fluctuations. Prof. Gustav
Cassels and Lord Keynes (during the early period of his career) suggested price stabilization
as a desirable objective of monetary policy.
Advantages of Price StabiIity:
(i) Elimination of Cyclical Fluctuations
(ii) Promotion of Economic Stability.
(iii) Facilitate Performance of Money Functions.
(iv) Prevention of Artificial Prosperity.
(v) Equitable Distribution of national income.
(vi) Promotion of Economic Welfare.
riticism of Price StabiIization PoIicy
(i) Vagueness of te concept: The concept of the price stabilization is rather ambiguous
in as much as it does not clearly state as to which price-level is to be stabilized in the
economy. t is rather difficult to choose a standard price-level for the purpose of
stabilization. The concept states no criteria for the selection of the standard price-level
for stabilization.
(ii) Prices to be stabiIized: The concept is also silent on the question as to which prices
are to be stabilized-wholesale price or retail prices, consumer goods prices or producer
goods price. Still another difficulty here is that it shall not be possible to establish stability
in the general price-level so long as there is relative stability in the prices.
(iii) PoIicy confers no Benefits: One of the draw backs of this policy is that it confers no
solid benefits on the economy. Price changes, it should be remembered, are the result,
not the cause of economic fluctuations in the economy. Price changes are the
symptoms, not the disease itself. Even, if the policy of price stabilization is adopted, it is
no guarantee for the stabilization of business activity in the economy.
(iv) Price stabiIization impedes Economic Progress: A policy of price stabilization will
hinder the economic progress of the country. With prices already stabilized, there shall
be no inventive left to the business community to increase production, because there
shall be no increase in profit margins.
(v) PoIicy of Price StabiIization is not practicabIe: Theoretically this policy may appear to
be viable but is not easily practicable. To ensure stability in the internal price level, it is
essential that there should also be stability in the supply of money and credit on the one
side and the supply of output on the one side, and the supply of output on the other.

New it is difficult, say impossible, to ensure perfect stability in these two quantities. The
policy is also not practicable on the ground that during a period of deflation expansion of
money supply very often fails to push up the prices back to their original level.
(3) Excange Rate StabiIity: Maintenance of stable exchange rates is an essential condition for
the creation of international confidence and promotion of smooth international trade on the
largest scale possible. nstability in exchange rather might lead to undesirable effects such as
weakening of the value of currency in the world market, speculation and even flight of capital
abroad.

The objectives of exchange stability of a monetary policy could easily achieve equilibrium in the
balance of payment of a country under the gold standard. Traditionally, countries forces with
balance of payments problems have used monetary policy are a means of eliminating their deficits.
A restrictive monetary policy tends to reduces country's balance of payments deficit in the
following ways:-
(i) t tends to reduce demand in the country, which in turn tends to reduce the demand for
imports as well as for domestic goods.
(ii) Reduction in domestic demands holds down the rate of inflation or reduces prices which
makes imported articles less attractive and makes the deficit country's exports, more
attractive to foreigners. Thus, import is curtailed and export expanded.
(iii) Under dear money policy, higher interest rates make it less attractive for foreign countries to
borrow from the deficit country and induce them to invest there.
RITIISM: Though a policy of stabilization of exchange rates was justified in the interest of
maintaining stable international economic relations, the exchange stability goal of monetary policy
has been vehemently criticized on the following grounds:
(i) Exchange stability can be achieved only at the cost of internal price stability. But
fluctuations in the domestic price level or changes in the purchasing power of money
cause severe disturbances in the economy of a country. This may call for internal price
stability which is of prime importance for the smooth functioning and progress of the
domestic economy.
(ii) Since inflationary or deflationary movements in some countries are passed on to some
other through fixed exchange rates, it puts the affected country at the mercy of the
countries. This may seriously affect the economy of the country whose prosperity does
not depend upon foreign trade.
Today, when gold standard is no longer in vogue and most of the countries of the world are
members of the nternational Monetary Fund (MF), the exchange stability objective of monetary
policy has lost much of its force. Modern welfare states realize that their prime duty is to maintain
conditions of internal stability. The MF has established a system of free multilateral trade and
members countries can continue to have adverse balance of payments to be achieved through
exchange stability is not new an objective of the monetary policy of modern countries.
(4) FuII EmpIoyment: Full employment is considered the foremost and ideal objective of monetary
policy. Full employment is achieved where saving is equal to the investment. There are as
many jobs as there are persons seeking them. Full employment is not an end in itself. t is a
pre-condition of social welfare. t relates employment of not only human resources, but full
utilization of all the resources with maximum efficiency and productivity. Thus, it is an ideal
objective of monetary policy for maximizing economic welfare. Employment will be provided to
all the members of the society and economic resources will be utilized most efficiently. Under
the condition of full employment, under employed and half-employed are also getting
alternative employments and they are utilizing their time fully well. t does not mean that certain

persons are over employed. Similarly it does not indicate that unemployable boys, girls, aged
and incapable persons are also employed. t means that the willing members and able persons
of the society are getting jobs.
(5) Economic Growt: Economic Growth relates to physical or real output. t means that growth
involves quantitative and qualitative production of goods, so as to satisfy the consumers. n
brief, economic growth implies substantial increase in per capita output or real national income.
t does not mean more money in economic growth. t is not but the real production that makes
a nation economically advanced. Economic growth ultimately aims to total welfare of masses. t
can be achieved through equitable distribution of income between different social classes are
individuals.
To achieve this objective the monetary policy should satisfy the following two criteria:-
(1) The monetary policy should be flexible in nature. This flexibility is necessary to ensure the
establishment of equilibrium between aggregate money demand on the one side and the
aggregate supply of goods and services on the other side. n case the aggregate money
demand exceeds the aggregate supply of goods, the monetary authority should then apply
a restrictive policy remove the disequilibrium in the economy this restrictive monetary policy
necessitates the contraction of currency and credit to check any inflationary rise in the price
level. f, on the contrary, the aggregate supply of goods exceeds the aggregate money
demand, then the monetary authority should pursue an expansionist monetary policy with a
view to remove the disequilibrium in the economy. This expansionist monetary policy
necessitates the expansion of currency and credit to check the fall in the price level. This a
flexible monetary policy is essential to ensure the internal equilibrium in the economy. The
flexibility in the monetary policy will ensure price stabilization, and that price stabilization
will, in its turn, promote the economic growth of the country.
(2) The monetary policy should not only be flexible in nature, but it should also be capable of
promoting capital formation in the economy. As is well-know, capital formation is one of the
essential perquisites of economic growth. But this capital formation is possible only under
conditions of price stabilization in the economy. A fluctuating price-level always discover
age capital formation in the country. Hence the monetary policy should be such as to
promote capital formation in the country by rooting out recurring price fluctuation. The
monetary policy should also promote the inflow of foreign capital which is one of the
essential perquisites of the economic growth of a country.
RoIe of Monetary PoIicy in a DeveIoping Economy
n modern times, any newly developing country may be concerned with the problem of how
to use the monetary policy successfully to stimulate economic growth. n an underdeveloped
country, the monetary policy has to play a vital role in developing the economy from a stage of
primary backwardness to a stage of self-sustained growth. Monetary policy which is one thing in an
advance economy, may be quite another in an underdeveloped economy.
Under the growth-oriented monetary policy, monetary management by the central bank
becomes a strategic of development in an underdeveloped country, on the following counts:-
(1) When the country aspires for rapid economic development, it adopts economic planning.
n the process, financial planning needs the support of credit planning and appropriate
monetary management.
(2) Underdeveloped countries are most susceptible to inflation- nflation in an underdeveloped
economy generally occurs when there is an abnormal increase in the effective demand
exerted mainly by huge government expenditures under the planning process. However
the maintenance of stability in the domestic price level and a fixed, realistic exchanged

rate are very essential preconditions for achieving a maximum rate of sustained economic
growth. This needs equilibrium of saving and investment. n an underdeveloped country,
however, since the rate of savings is very low, government is usually tempted to raise the
level of investment by means of credit expansion and deficit financing. Development
efforts of the nature are generally confronted by inflationary prices increases. To some
economist this (inflation) is an inevitable price to be paid for economic growth.
(3) The growth objective of monetary policy in underdeveloped countries implies the
promotional role of monetary authorities, Briefly the promotional role of the monetary
authorities in an underdeveloped country may be to improve the efficiency of the banking
system as a whole or extend sound credit where needed and to respond promptly to
changing conditions.
(4) t is an important task of the monetary authority to improve the conditions of unorganized
money and capital markets in poor countries in the interest of rapid economic development
and the successful working of monetary management.
(5) An important function of monetary policy in an underdeveloped economy is to have and
also to make use of a most suitable interest role structure.
(6) Public debt management responsibility also lies with the monetary authority of the country.
n a growing economy, thus it is very important and difficult task.
(7) Underdeveloped countries are characterized with 20-30 percent of non-monetized sector.
Hence, it is the prime duty of the monetary authority to extend the process of monetization
in there barters sections of the economy. This will tend to improve the working and
effectiveness of the monetary policy.
Limitations of Monetary PoIicy in DeveIoping ountries
Monetary policy in a developing country is an important instrument in the hands of the
central bank, which may be used to ensure economic growths. However, the success of monetary
policy is subject to following limiting factors:-
(i) UnderdeveIoped Money and apitaI Market: The central bank cannot effectively
implement the various credit central measures in the absence of well-organized money
and capital markets. Underdeveloped countries do not have well developed and fully
organized money and capital market.
(ii) No integrated rate of interest structure: The banking sector in underdeveloped
countries is unorganized from where a sizeable financial resource comes. There is
therefore, no integrated rate of interest and therefore the central bank fails to influence the
market rate of interest by changing the bank rate. n fact, the change in bank rate must be
reflected in the form of increased or decreased market rate of interest.
(iii) Lack of ooperation between te ommerciaI Banks: The monetary policy cannot be
effectively implemented in the absence of cooperation between the commercial banks and
the central bank because the central bank can implement its monetary policy through
commercial banks. n developing countries there is no such cooperation of commercial
banking institutions with the central bank and in some case the bank flout the central bank
directives.
(iv) Banking Habits of te PeopIe: n developing countries, people are not habitual to bank
their savings due to law level of income and savings and lock of banking facilities.
Consequently most of the transactions are entered into cash and not through credit
instruments. t is for this reason that the credit control measures of the central bank do not
have desired effect on the business activities.
(v) IIIiteracy and SociaI ObstacIes: Most of the developing countries suffer from mass
illiteracy, superstition, dogmatism and many other, social evils. People do not understand
the significance of banking institutions hence they do not deposit their money into or take

loans from the banks. The success of monetary policy depends upon the wide people,
adequate development of credit facilities, entrepreneurial ability etc.


Tecniques/Instruments of Monetary PoIicy

General (Quantitative) Methods Selective (Qualitative) Methods
(1) Bank Rate
(2) Open Market Operations
(3) Variations in the reserve requirement
(4) Repo Rate
(5) Liquidity Adjustment Facility
(1) Rationing of Credit
(2) Margin Requirement
(3) Variable interest rate

(4) Regulation of Consumer Credit
(5) Licensing

(A) GeneraI (Quantitative) Metods: There are following general quantitative instruments of
credit control:-
(1) Bank Rate: The Bank Rate, also known the Discount Rate, is the oldest instrument of
monetary policy. Bank rate is the rate at which the central bank discounts or more
accurately, re-discounts-eligible bills. n a broader sense, it refers to the minimum rate at
which the central bank provides financial accommodation to commercial banks in the
discharge of its function as the lender of the last resort. The bank rate policy seeks to affect
both the cost and availability of credit.
(2) Open Market Operations: Open Market Operations refers broadly to the purchase and sale
by the central bank of a variety of assets, such as foreign exchange, gold, government
securities and even company shares.
Under the open market operations, the central bank seeks to influence the economy either
by increasing the money supply or by decreasing the money supply.
(3) Variations in te Reserve Requirement: The Reserve Bank also uses the method of
variable reverse requirement to control credit in ndia. By changing the ratio, the Reserve
Bank seeks to influence the credit creation power of the commercial banks. These
requirements of are of two types.
(i) as Reserve Ratio: Cash Reserve Ratio refers to that portion of total deposits of a
commercial bank which it has to keep with the Reserve Bank in the form of cash
reserves. The Reserve Bank is empowered to vary this ratio between 3 percent to 15
percent of the total demand & time liabilities.
(ii) Statutory Iiquidity Ratio: Statutory liquidity Ratio refers to that portion of total deposits
of a commercial bank, which it has to keep with itself in the form of liquid assets. The
SLR at present is 25 percent for on tire net demand and time liabilities of the scheduled
commercial banks.
(4) Repo Rate: Repo Rate are classified into interbank repo and RB repo rate:-
(i) Inter Bank Repo: Such repos are new permitted only under regulated conditions. Repos
are miscued by bankers/bankers during the 1992 securities scam. They were banned
subsequently, with the lifting of the ban in 1995l repos were permitted for restricted,
eligible participants and instruments. nitially, repo deals were allowed in T-bills and five
dated securities on the NSE. Repo are allowed to develop a secondary market in PSU
bonds, Fs bonds, corporate bonds and private debt securities if they are heed in demit
form and the deals are done through recognized stock exchange(s). Non-bank

participants are allowed to participate only in the reverse repo i.e. they can only lend
money to other eligible participant. The non-bank entities holding SGL accounts with the
RB can enter into reverse repo transactions with banks PDs, in all Government
securities.
(ii) RBI Repos: The RB undertakes repo/reverse repo operations with banks and PDs as
part of its OMOs to absorb/inject liquidity, with the introduction of the LAF the RB has
been injecting liquidity into the system through repo on a daily basic. The repo auctions
are conducted on all working days except Saturdays and are restricted to bank and PDs.
This is an addition to the liquidity support given by the RB to the PDs through re-
finance/reverse repo facility at a fixed price. Auctions under LAF were earlier conducted
on a uniform price basis, i.e., there was a single repo rate for all successful bidders.
The RB conducts repo auctions to provide banks with an outlet for managing short-term
liquidity, even-out short-term liquidity fluctuations in the money market and optimize
returns on short term surplus liquid funds.
(5) Liquidity Adjustment FaciIity: An array or instrument to transfer short-term liquidity and
interest rate signals in a more flexible and bidirectional manner. A liquidity Adjustment
Facility (LAF) has been introduced since June 2000 to precisely modulate short-term
liquidity and signal short-term interest rates. The LAF, in essence, operator through repo
and reverse repo auctions, thereby setting a corridor for the short-term interest rate
consistent with policy objectives. The RB is able to modulate the large market borrowing
program by combining strategic debt management with active open market operations. The
bank rate has emerged as a reasonable signaling rate, while the LAF rate has emerged as
both a tool for liquidity management and signaling of interest rates in the overnight market.
The RB has also been able to use open market operations.
(B) SeIective (Quantities) Metods:
The quantitative contracts explained above effect indiscriminately all sector of the economy,
which depend upon bank credit, they central volume of credit but leave the directionary
credit completely free. Selective controls are designed to regulate the direction of credit.
These controls by distinguished between essential and non-essential user of bank credit,
divert resources to essential and priority sectors. These are explained below:
(1) Rationing of redit: Credit rationing implies controlling and regulating the purpose for
which bank credit can be used. t generally provides for three things:-
(i) an overall ceiling on loans and advances for every commercial bank.
(ii) fixing the ratio which the capital of commercial bank should have and
(iii) fixing ceilings for specific categories of loans and advances.
Credit rationing is also exercised by placing restrictions on demand of accommodation
and rediscounting facilities for each bank. The central bank may charge a penal rate on
interest from banks, which cross the prescribed limits in relation to their overall liquidity
position. This method curtails the freedom and initiative of the commercial bank.
(2) Margin Requirement: The difference between the value of security and the amount
borrowed against this security is known as margin. The central banks are generally
empowered to fix margin limits for various uses of credit which the commercial banks must
observe. Margin requirements, while directly affecting the lender also put a restraint upon
the borrower and thus keep-down the volume of credit. By presenting different margin
requirements for different uses, the central bank can direct credit to more urgent uses.
(3) VariabIe Interest Rates: Variable interests rates changed selectively for different user,
places or borrower can be considered or selective or against a general dear or cheap
money policy pursued through changes in the bank rate ceiling are also provided for rates
which commercial banks can change from the borrower for specific user.

(4) ReguIation of onsumer redit: This is often practiced when there is either abundance or
shortage of certain consumer articles, extending or limiting the time for repayment or by
lowering or raising the limit of down payment to meet the situation of depression recession
on the one hand and inflation on the other.
(5) Licensing: The RB ensures proper regional coverage through licensing. Though this
incidentally is served the cause of selectively in regional development.
FiscaI PoIicy
Fiscal Policy may be defined or that part of governmental economic policy which deals with
taxation, expenditure, borrowing and the management of public debt in an economy. t is an
instrument of modern public finance.
According to a Arthur Smithies, "Fiscal policy is a policy under which government uses its
expenditure and revenue programs to produce desirable effects and avoid undesirable effects on
the national income, production and employment."
Features of FiscaI PoIicy of India
(1) RationaIization of Product cIassification odes: A very welcome change brought about
for administrative convenience is the adoption of a rationalized standard product code
structure for indirect taxes. The change has resulted in reduced disputes and ligations about
product classification.
(2) ommon Accounting Year for Income Tax: Taxation policy has adopted standard
accounting year (April-March) for the purpose of ncome Tax. The change is intended to
reduce the malpractices and raise tax revenues.
(3) Long Term FiscaI PoIicy: Since 1986 budget, the government of ndia has introduced long
term fiscal policy to provide greater certainties in its budgetary policies and to improve the
over all environment of business.
(4) Impact on RuraI EmpIoyment: Generation of employment has been an important objective
of fiscal policy. The Govt. of ndia has introduced new employment schemes like Jawahar
Rozgar Yojna or strengthened the existing schemes like ntegrated Rural Development
Program or National Rural Employment Program.
(5) BIack Money: Unaccounted money has been a constant feature of ndia's economy fiscal of
black money. Schemes like Voluntary Disclosure, Bearer Bonds or ndira Vikas Patra have
had marginal impact on the incidence and growth of black money.
(6) ReIiance on Indirect Taxes: The tax policy is increasingly becoming regressive in nature by
large dependence on indirect taxes like excise duty or custom duty as compared to that on
direct taxes like incomes taxes, corporation tax, capital gains tax etc.
(7) Inadequate PubIic Sector ontribution: Contrary to repeated arresting by the
Government of ndia public sector continues to be drain on the meager resources of the
Government. Plan schemes of finance have expected sizable contribution from public sector
which has not materialized in most cases.
(8) Introduction of MODVAT: n 1986 the introduction of MODVAT has helped to reduce the
cumulative impact of indirect taxes on manufactured products. Under MODAVAT the
manufacturer while charging full rate of excise duty on his while charging full rate of excise
duty on his output, get credit for tax paid on inputs. This reduces the cascading effect of
excise duty.
(9) InfIationary PotentiaI: With large budget deficits, indirect taxes, shortages, black money
and rising money incomes, inflationary trend in economy has been remarkable. The fiscal
policy instead of being a cure of inflation has become the cause if inflation.

Objectives of FiscaI PoIicy


Fiscal Policy, in modern era, subscribes to the following major macro-economic goals:-
(1) FiscaI PoIicy for FuII EmpIoyment: Fiscal Policy is considered as an effective instrument
for reducing unemployment and securing full employment. Full employment occurs where
there is job available for everyone who is fit to work and wants a job at the prevailing wage
rates. Once full employment level is achieved, it has to be constantly maintained by
adopting appropriate fiscal measure from time to time.
(2) FiscaI PoIicy and Economic StabiIization: Economic stability is another prime aim of a
sound fiscal policy. This goal implies maintenance of full employment with relative price
stabilization. Price stability here means relative price stability. n flatiron should be curbed
and deflation should be avoided. n short, economic growth and stability are the twin
objectives jointly pursued by a developing country's fiscal policy. The forced stimulating
growth process should be given a boost at a time while inflationary processors are to be
curbed.
(3) FiscaI PoIicy and Economic Growt: Poor countries are entangled in the vicious circle of
poverty. t should be broken, thus rapid economic growth is the fundamental objective of
fiscal policy in a developing economy. Fiscal Policy as a means of encouraging growth
process has the following objectives:;
(i) To realize and mobilize potential resources into the productive channels.
(ii) To accelerate the rate of economic growth.
(iii) To induce and stimulate private sector investment.
(iv) To promote investment into socially durable channels.
(v) To alter the pattern of improve the general economic welfare and sustain equalitarian
goals like equity in distribution and eradication of poverty.
(4) FiscaI PoIicy and SociaI Justice: A welfare state should provide social justice by giving
equitable distribution of income and wealth. Fiscal Policy can serve as an effective means of
achieving this much desired goal of socialism in developed as well as developing countries.
Progressive tax system can be of much use in realizing this objective. Moreover, public
expenditure helps in redistributing income from the rich to the poor section of the society.
Fiscal policy insists that in a budget, growing allocation should be made for programs like
free medical care, free education, subsidized housing, subsidized essential commodities like
milk etc.
omponents/Instruments used in FiscaI PoIicy
The main components used in fiscal policy are as follows:
(1) Budgetary PoIicy: The old classical economists advocated a policy of balanced and small
budgets. However, this policy will not help to tide over depression and unemployment
according to Prof. J.M. Keynes. The need at such a time is to increase the follow of income
stream into the economy and could be made possible, according to Prof. J.M. Keynes, only
through deficit budgeting. Hence, it is essential that the government should incur large
deficits in the budget and then meet these deficits either by borrowing from the banks etc. or
through printing free currency notes. t will inject fresh purchasing power in the economy,
helping it to fight depression and employment effectively.
(2) Taxation PoIicy: n order to fight depression and unemployment, taxation policy of the
government, according to the Keynesians, should be so designed as to stimulate bath
consumption and investment simultaneously. The only way to do it successfully is to reduce
the general burden of taxation on the community. The commodity taxes should be cut down
to the minimum so as to stimulate consumption on the part of the public. Further, to promote
increased investment, it may also be essential to out down business and corporate taxes.

(3) PubIic Debt.: Public debt can also be employed by the government as an instrument to fight
depression and unemployment. The deficits in government's budgets shall have to be met
partly if not wholly through public borrowings. But while adopting the fiscal policy of public
debt, the government shall have to keep the following two considerations in mind. Firstly in
order to keep the burden of public debt law, the government should aim at a policy of law
interest rates during depressions. Secondly, the govt. should try as far as possible to borrow
from those sections of the community with whom the funds are lying idle. The idea is to
utilize those idle funds through borrowing for productive purposes.
(4) PubIic Expenditures: An increase in public expenditure can also be employed by the
government as an instrument to fight against depression and unemployment. ncrease in
public expenditure at such a time may take the following two forms:
(i) Pump Priming: Pump Priming refers to that public expenditure which helps imitate and
reins supreme consequent upon depression. The object is to increase private investment
through an injection of purchasing power in the form of increasing in public expenditure.
(ii) ompensatory Spending: Compensatory spending refers to the government
expenditure which is undertaken with a view to compensating the decline in private
investment. Usually private investment suddenly declines at the time of depression.
Under these circumstances there is no alternative before the government except to
resort to public investment.
Advantage of FiscaI PoIicy
(1) apitaI Formation: Fiscal Policy has played a very important role in raising the rate of
capital formation in country- in private as well as public sector. A major part of budgetary
resources has been invested in public sector enterprises which have resulted in increase in
gross domestic capital formation as percent of GDP from 10.2 percent in 1950-51 to 22.9 in
1997-98 and to 23.7 percent in 2001-02.
(2) Resource MobiIization: Fiscal Policy has helped to mobilize resources through taxes,
sowings, public debt, etc. for economic development of the country. Resource Mobilization
which was 70 per cent in 1965-66 has increased to 40 percent in 2001-02.
(3) Incentives to Private Sector: Private Sector has been encouraged under fiscal policy for
investment and production. Tax concessions can subsidies exemptions in taxes have been
give as incentives to private sector units set up in backward areas and export oriented units.
(4) Encourages Saving: Various incentives have been given to raise the rate of savings in
household and corporate sector. To encourage savings in house hold sector various
concessions and tax benefits have been given on fixed deposits, live insurance schemes,
Kisan Vikas Patras (KVPs), National Saving Certificates (NSCs), Provident Fund etc. saving
have also been encouraged in corporate sector by offering them tax concessions and tax
exemptions.
(5) Poverty aIIeviation and EmpIoyment generation: To fulfill one of its major objectives of
providing full employment, allocation of huge amount has been made in fiscal policy to
eradicate poverty and generate employment. For this a huge amount has been sprat on
different schemes like twenty point programme, ntegrated Rural Development Programme
(RDP), Jawahar Rozgar Yojna (JRY), Prime minister Rojgar Yojna (PMRY), Employment
Assurance Scheme (EAS), encouraging small scale and cottage industries etc.
(6) Reduction in InequaIity of Income & WeaIt: Fiscal Policy of the country has been making
constant endeavor to reduce inequality of income and wealth, Resources have been
mobilized from rich class to poor by way of progressive taxes, wealth tax, corporation tax
and capital gain tax, etc and this money has been utilized for the welfare of poor people.
(7) Export Promotion: Exports have been encouraged by way of providing subsidies,
concessions, tax exemptions, cash subsidies, etc. Exports have shown a rise from 4.5
percent in 1960-62 to 23.4 percent in 2001-02. mport duty on raw material and capital

goods used for productions of goods meant for export has also been reduced with a view to
encourage exports.

Foreign Excange Market
The foreign exchange (currency or forex or FX) market refer to the market for currencies.
Transactions in this market typically in value one party purchasing a quantity of one currency in
exchange for paying a quantity of another. The FX market is the largest and most liquid financial
market in the world, and includes trading between large banks, central banks currency speculators,
corporative government and other institutions.
According to Kindleberger, "Foreign exchange market is a place where foreign moneys are
bought and sold."
Foreign exchange market is an institutional arrangement for buying and selling of foreign
currencies. Exporters sell the foreign currencies. mporters buy them..
aracteristics of Foreign Excange Market
(1) EIectronic Market: Foreign exchange market does not have a physical place. t is a market
whereby trading in foreign currencies takes place through the electronically linked network
of banks, foreign exchange brokers and dealers whose function is to bring together buyers
and sellers of foreign exchange.
(2) GeograpicaI DispersaI: A redeeming feature of the foreign exchange market is that it is
not to be found one place. The market is vastly dispersed throughout the leading financial
centers of the world such as London, Newyork, Paris, Zurich Amsterdam, Tokyo, Hong
Kong, Toronto and other cities.
(3) Transfer of Purcasing Power: Foreign exchange market aims at permitting the transfer of
purchasing power denominated in one currency to another whereby one currency is treated
for another currency.
(4) Intermediary: Foreign exchange markets provide a convenient way of converting the
currencies earned into currencies wanted of their respective countries. For this purpose, the
market acts as an intermediary between buyers and sellers of foreign exchange.
(5) VoIume: A special feature of the foreign exchange market is that out of the total trading
transactions that take place in the foreign exchange market, around 95 percent takes the
forms of crore-border purchase and sale of assets, i.c., international capital flows. Only
around 5 percent relates to the export and import activities.
(6) Provision of redit: A foreign exchange market provides credit through specialized
instruments such as banker's acceptances and letters of credit. The credit, thus provided is
of much help to the traders and businessmen in the international market.
(7) Minimizing Risks: The foreign exchange market helps the importable and exporter in the
foreign trade to minimize their risks of trade. This is being done through the provision of
'Hedging', facilities. This enables traders to transact business in the international market with
a view to earning a normal business profit without exposure to an expected change in the
anticipated profit. This is because exchange rates suddenly change.
Functions of Foreign Excange Market
(1) Transfer Function: The basic function of any foreign exchange market is to facilitate the
conversion of one currency into another i.e., to accomplish transfers of purchasing power
between two countries. This transfer of purchasing power is affected through a variety of
credit instruments, such as telegraphic transfers, bank draft and foreign bills.
(2) redit Function: This function of the foreign exchange market is to provide credit, both
national and international to promote foreign trade; obviously, when foreign bills of exchange
foreign trade; obviously, when foreign bills of exchange are used in international payments,
a credit for about 3 months, till their maturity is required.

(3) Hedging Function: A third function of the foreign exchange market is to hedge foreign
exchange risks. n a free exchange, market when exchange rate, i.e., the price of one
currency in terms of another currency change there may be a gain or loss to the party
concerned. Under this condition, a person or a first undertakes a great exchange risk if there
are huge amounts of net claims or net liabilities which are to be mat in foreign money.
Exchange risk as such should be avoided or reduced. For this the exchange market
provides facilities for hedging anticipated or actual claims or liabilities through forward
contracts in exchange.


Structure of Foreign Excange Market






Banks and Money
Changers (Currencies nter-bank (Bank Central
bank note, cheques) accounts or deposits) Bank
(1) RetaiI Markets: The exchange of bank notes, bank drafts, currency, ordinary and traveler's
cheques between private customers, tourists & banks takes place in the retail market. The
RB has granted two types of money changer's licenses to certain established firms, hotels,
shops and other organizations to deal in currency notes, coins and traveler's cheques to a
limited extent.
(2) WoIesaIe Market: The wholesale market is primarily an inter-bank market in which major
banks trade in currencies held in different currency-dominated bank accounts, i.e., they
transfer market is far larger than the bank notes market. Only the head offices and regional
officer of the major commercial banks are the market makers in the wholesale market. Most
of the small banks and the local offices of even the major banks do not deal directly in the
inter-bank market. Most of the small banks do not deal directly in the interbank market. They
usually have a credit line with large banks with their head officer and they serve their
customers through the latter. Through correspondent relationship with banks in other
countries, major banks have ready access to foreign currencies.
(i) Inter Bank Market: (a) Direct Market: n the direct market, banks quote buying and
selling prices directly to each other and all participating and selling prices directly to each
other and all participating banks are market makers. t has been some times,
characterized as a "decentralized, continuous, opens-bid, double auction" market.
(b ) Indirect Market: n the indirect market, the bank put orders with brokers who put them on
"books", and try to match purchases and sales orders for different currencies. They
charge commission to both the buyers and sellers. This market is characterized as
"quasi-centralized", continuous, limit book, "single-auction" market.
(ii) entraI Banks: Normally the monetary authorities of a country are not indifferent to
changes in the external value of their currency, and even through exchange rates of the
major industrialized nations have been left to fluctuate freely since 1973, central bank
frequently intervene to buy and sell their currencies in a bid to influence the rate at which
their currency is traded. Under a fixed exchange rate system the authorities are obliged
Foreign Excange Market
RetaiI WoIesaIe

to purchase their currencies when there is excess supply and sell the currency when
there is excess demand.
Participants of Foreign Excange Market
(1) RetaiI Iients: These are made up of business international investors, multinational
corporations and the like who need foreign exchange for the purpose of operating their
businesses. Normally, they do not directly purchase or sell foreign currencies themselves;
rather they operate by placing buy sell order with commercial banks.
(2) ommerciaI Banks: The commercial banks carry our buy/sell orders from their retail clients
and buy/sell orders from their retail clients and buy/sell currencies of their assets and
liabilities in different currencies.
(3) Foreign Excange Brokers: Often banks do not trade directly with one, another, rather
they offer to buy and sell currencies via foreign exchange brokers. Operating through such
brokers is advantageous because they collect buy and sell quotations for most currencies
from many banks, so that the most favorable quotation is obtained quickly and at very low
cost.
(4) entraI Banks: Normally the monetary authorities of a country are not indifferent to
changes in the external value of their currency, and even though exchange rates of the
major industrialized nations have been left to fluctuate freely since 1973, central banks
frequently intervene to buy and sell their currencies in a bid to influence the rate at which
their currency is traded.
(5) Firms engaged in Foreign Excange transactions: Firms engaged in foreign exchange
transactions have a stable demand of foreign currency and supply. According to rule
imposed they do not have direct access to the foreign exchange market. They conducted
their business through commercial banks.
(6) Investment Funds: These companies, represented by various international investments,
mutual funds, insurance companies and trusts, realize the policy of diversified management
of portfolio of assets by placing their money in securities of the governments and
corporations of different countries.
(7) Private Persons: Private persons realize a wide range of transactions in the area of foreign
trade, tourism, pension, royal etc. this is also the biggest group involved into such
transactions.

Factors Affecting Foreign Excange Market
(1) Economic Factors: These include economic policy disseminated by government agencies
and central banks, economic conditions, generally revealed through economic reports, and
other economic indicators. Economic Policy comprises government fiscal policy (budget's
pending practices) and monetary policy.
Economic conditions incIude:
(i) Government Budget Deficits or SurpIuses: The market usually reacts negatively to
widening government budget deficits, and positively to narrowing budget deficits. The
impact is reflected in the value of a country currency.
(ii) BaIance of Trade LeveIs and Trends: The trades flow between countries illustrates the
demand for goods & services, which in turn indicates demand for a country's currency to
conduct trade. Surplus and deficits in trade of goods and services reflect the
competitiveness of a nation's economy. For example: trade deficits may have a negative
impact on a nation's currency.
(iii) InfIation LeveIs and Trends: Typically, a currency will lose value if there is a high level
of inflation in the country or if inflation levels are perceived to be rising. This is because
inflation erodes purchasing power, thus demand for that particular currency.

(iv) Economic Growt & HeaIt: Reports such as Gross Domestic Product (GDP),
employment levels, retail sales, capacity utilization and others detail the levels of a
country's economic growth and health. Generally the more healthy and robust a
country's economy, the better its currency will performs and the more demand for it there
will be.
(2) PoIiticaI onditions: nternal, regional and international political conditions and events can
have a profound effect on currency markets.
(3) Market PsycoIogy: Market psychology and trader perceptions influence the foreign
exchange market in a variety of ways:-
(i) FIigts to QuaIity: Unsettling international events can lead to a "flight to quality", with
investors seeking a "safe haven". These will be a greater demand thus a higher price, for
currencies perceived as stronger over their relatively weaker counterparts. The Swiss
Fran has been a traditional safe heaven during times of political or economic uncertainty.
(ii) Long-Term Trends: Currency market often moves in visible long term trends. Although
currencies do not have an annual growing season like physical commodities, business
cycles do make themselves felt. Cycle analysis looks at longer-term price trends that
may rise from economic or political trends.
(iii) "Buy te Rumar, SeII te Fact: This market tourism can apply to many currency
situations. t is the tendency for the price of a currency to reflect the impact of a
particular action before it occurs and, when the anticipated events come to pass, react in
exactly the opposite direction. This may also be referred to as a market being "oversold"
or "overbought". To buy the rumor or sell the fact can also be an example of the
cognitive bias known as anchor sing, when investors focus too much on the relevance of
outside events to currency prices.
(iv) TecnicaI Trading onsiderations: As in other markets, the accumulated price
movements in a currency pair such as EURUSD can form operated patterns that traders
may attempt to use. Many traders study price chart in order to identify such patterns.

Foreign Excange Transactions
(1) Spot transaction: A spot transaction is an outs right purchase and sale of foreign currency for
cash settlement not more than two business days after the date the transaction is recorded as
a spot dead.
(2) Forward Transaction: n this transaction, money does not actually change hands until some
agreed upon future date. A buyer and seller agree on an exchange rate for any date in the
future and the transaction occurs on that date, regardless of what the market sales.
(i) Futures: Foreign currency futures are forward transactions with standard contract sizes
and maturity dates-e.g. 5,00,000 British pounds for next November at an agreed rate.
These contracts are traded on a separate exchange setup for that purpose.
(ii) Swap: The most common type of forward transactions is the currency swop. n a swap,
two parties exchange currencies for a certain length of time and agree to reverse the
transaction at a later date.
(iii) Options: An option is similar to a forward transaction. t gives its owner the right to buy
or sell a specified amount of foreign currency at a specified certain date. An option that
gives the right to buy is known as 'call' while one that gives the right to sell is known as a
'put'.

FinanciaI Sector Reforms in India
The New Economic Policy of structural adjustments and stabilization programme was given
a big thrust in ndia in June 1991. The financial sector reforms have received special attention as a

part of this policy because of the perceived inter-dependent relationship between the real and
financial sectors of the modern economy. mmediately after the announcement of NEP, the
government had appointed a high level committee on financial system," to examine all aspects
relating to the structure, organization, functions and procedures of the financial system." The
committee submitted its main report in November 1991. Since then the authorities have introduced
a large number of changes or reforms in the ndian Financial sector in the light of the said report.
The need for financial reforms had arisen because the financial institutions and markets
were in a bad shape. The banking sector suffered from lack of competition, low capital base, low
productivity and high intermediation costs. The role of technology was minimal and the quality of
service did not receive adequate attention. Propose risk management system was not followed, and
prudential norms were weak. All there resulted in poor assets quality. Development financial
institutions operated in an over protected environment with most of the funding coming from
assured sources. There was little competition in insurance and mutual funds industries.
Objectives of FinanciaI Reforms introduced in 1991
(1) To develop a market-oriented, competitive, world integrated, diversified, autonomous,
transparent financial system.
(2) To increase the a locative efficiency of available savings and to promote accelerated growth
of the real sector.
(3) To increase or bring about the effectiveness, accountability, profitability, viability, vibrancy,
balanced growth, operational economy and flexibility, professionalism and de-politicization in
the financial sector.
(4) To increase the rate of return on real investment.
(5) To promote competition by creating level-playing fields and facilitating free entry and exit for
institutions and market players.
(6) To ensure that the rationalization of interest rates structure occurs, that interest rates are
flexible, market-determined or market related, and that the system offers to its users a
reasonable level of positive real interest rates. n other words, the goal has been to
dismantle the administered system of interest, rates.
(7) To reduce the levels of resource pre-emption and to improve the effectiveness of directed
credit programs.
(8) To build a financial infrastructure relating to supervision, audit, technology and legal matters.
(9) To modernize the instruments of monetary control so as to make them more suitable for the
conduct of monetary policy in a market economy.
Major Reforms After 1991 in FinanciaI System
(I) Systematica & PoIicy Reforms.
(1) Most of the interest rates in the economy deregulated, a beginning made to move towards
market rates on government securities.
(2) The perception of banks' resources through SLR in favour of the government was brought
down and the rate of return an SLR securities is maintained by and large at market rates.
(3) Capital Adequacy norms for banks, financial institutions, and virtually all market
intermediaries, introduced. The Basel Committee framework for capital adequacy adopted.
(4) A Board of Financial Supervision with an advisory council and an independent department
supervision established in RB.
(5) Recovery of Debts due to Banks and Financial nstitutions Act, 1993 passed to set up
special recovery tribunals to facilitate quicker recovery of loan arrears.
(6) The private sector was allowed to set up banks, mutual funds, money market mutual funds,
insurance companies etc. Public sector banks permitted diversified ownership by law subject
to 51 percent holding of government/RB, FC and RB converted into public limited
companies.

(7) Capital ssues (Control) Act, 1947 replaced and the office of controller of Capital ssues
abolished.
(8) Securities and Exchange Board of ndia (SEB) made a statutory body in February 1992 and
armed with necessary authority and power for regulation and reform of the capital market.
(9) The Reserve Bank of ndia (Amendment) Act, 1997 passed requiring all non-bank financial
companies (NBFCs) with net-owned funds of Rs 25 lacs and more to register with the RB.
(10) Over the Counter Exchange of ndia (OTCE) and the National Stock Exchange (NSE) with
nationwide stock tradition and electronic display, clearing and settlement facilities
established and made operational.
() Banking Reforms:
(1) nterest rates on deposits and advances of all co-operative banks including urban
cooperative bank deregulated. Similarly interest rates on commercial bank loans above Rs.
2 lacs, and on domestic term deposits above two years and Non-Resident (External) Rupee
Accounts [NRNR] deposits decontrolled.
(2) The State Bank of ndia and other nationalized banks enabled to access the capital market
for debt and equity.
(3) Prudential norms for income recognition, classification of assets and provisioning for bad
debts for commercial banks, including regional rural banks and financial institutions
introduced.
(4) Banks required making their balance sheets fully transparent and making full disclosures in
keeping with nternational Accounts Standards Committee.
(5) Banks gave greater freedom to open, shift and swap branches as also to open extension
counters.
(6) The budgetary support extended for recapitalization of weak public sector banks.
(7) Banks set free to fix their own foreign exchange open position limit subject to RB approval.
() Primary and Secondary Stock Market Reforms
(1) Primary ssue to be made compulsory through the Depositary Mode after a specified date.
(2) 100 percent Book Building in respect of issues of Rs 25 crore and above.
(3) Reduction in the number of mandatory collection centers in respect of issues above Rs. 10
crore to four metropolitan cities.
(4) The payment of any direct or indirect discounts or commissions to persons receiving firm
allotment prohibited.
(5) Housing finance companies considerate to be registered for issue purposes provided they
are eligible for refinance from the National Housing Bank.
(6) A ceiling of Rs. 10 crore imposed on stock market members doing business of financing
carry forwarded transactions.
(7) Stock lending scheme without attracting capital gains introduced. Under this scheme, short
sellers can borrow securities through an intermediary before making such sales.
(8) All stock exchanges required to institute the buy-in or auction process.
(9) The stock exchanges are being modernized, many of them have introduced electronic
trading system the Bombay Stock Exchange has started its on-line trading system, BOLT.
(10) Both long and short sales are required to be disclosed to the exchange at the end of each
day, and they are to be regulated through the imposition of margins.
(11) There are many other stock market reforms which have been introducing during the past
five to six years.
(V) Government Securities Market Reforms:
(1) A 364-day treasury bill (TB) replaced the 182-days TB in 1992-93, and it is being sold by
fortnightly auction since April 1992.
(2) Auction of 91 days TB commenced from January 1993.

(3) Maturity period for new issues of Central government securities shortened from 20 to 10
years and that for state government securities from 150 to 10 years.
(4) Funding of auction TBs into fixed coupon dated securities at the option of holders introduced
since April 14, 1493.
(5) Six new instruments were introduced:-
(i) Zero coupon bonds on 18-1-94
(ii) Top stock on 29-7-94.
(iii) Partly paid government stock on 15-11-94
(iv) An instrument combining the features of tap and partly paid stocks on 11.9.95.
(v) Floating rate bonds on 29.9.95
(vi) Capital ndexed Bonds in 1997.
(6) A scheme for auction of government securities from RB's own portfolio as a part of its open
market operations announced in March 1995.
(7) Reverse repo facility with RB in government dated securities extended to Discount and
Finance House of ndia (DFH) and Securities Trading Corporation of ndia (STC).

Please check to this matter for adjustment

(c) FinanciaI Assets & Instruments
FinanciaI Assets: n any financial transaction, there should be a creation or transfer of
financial assets hence the basic product of any financial system is the financial asset. A
financial asset is one which is used for production or consumption or for further creation of
assets. For instance, a buys equity share and there shares are financial assets since they
earn income in future. t is interesting to note that the objective of investment decides the
nature of the asset. For instance if a building is bought for residence purpose, it becomes a
physical asset. f the same is bought for hiring, it becomes a financial asset.
Iassification of FinanciaI Assets
Financial assets can be classified differently under different circumstances. One such
classification is:
(i) Marketable assets.
(ii) Non-marketable assets.
(i) MarketabIe assets: Marketable assets are those which can be easily transferred from one
person to another without much hindrance. Examples are sharers of listed companies,
Government securities, bonds of public sector undertaking etc.
(ii) Non-MarketabIe Assets: On the other hand, if the assets cannot be transferred easily, they
come under this category. Examples are bank deposits, provident funds, pension funds,
National Savings Certificates, nsurance Policies etc.
(iii) Yet another classification is as follows: (a) Money or cash asset (b) Debt asset (c) Stock
asset
(a) as Asset: n ndia, all coins and currency notes are issued by the RB and Ministry of
Finance, Government of ndia. Besides, commercial banks can also create money by means
of creating credit. When loans account is opened in the borrowers name and a deposit is
created. t is also a kind of money asset.
(b) Debt Asset: Debt asset is issued by a variety of organizations for the purpose of raising
their debt capital. Debt capital entails a fixed repayment schedule with regard to interest and
principal. There are different ways of raising debt capital. Examples are issue of debentures,
rising of term loans, working capital advance etc.

(c) Stock Assets: Stock is issued by business organizations for the purpose of raising their
fixed capital. There are two types of stock namely equity and preference. Equity
shareholders are the real owners of the business and they enjoy the fruits of ownership and
at the same time they bear the risk as well. Preference shareholders of debt asset) and at
the same time they retain some characteristics of equity.
FinanciaI Instruments: Financial instruments refer to those documents which represent
financial claims on assets. As discussed earlier, financial asset refers to a claim to the
repayment of a certain sum of money at the end of a specified period together with interest
or dividend. Examples are bill of exchange, Promissory Note, Treasury bill, Government
Bond, Deposit Receipt, Share Debenture etc. Financial instruments can also be called
financial securities. Financial securities can be classified into:-
(i) Primary or direct securities.
(ii) Secondary or indirect securities.
(i) Primary Securities: There are securities directly issued by the ultimate investors to the
ultimate severs. e.g. shares and debentures issued directly to the public.
(ii) Secondary Securities: These are securities issued by some intermediaries called financial
intermediaries to the ultimate savers, e.g. Unit Trust of ndia and mutual funds issue
securities in the form of units to the public and the money pooled is invested in companies.
Again these securities may be classified on the basic of duration as follows:
(a) Short-term securities
(b) Medium-term securities
(c) Long-term securities.
Short-term securities are those which mature within a period of one year. For example, Bill
of Exchange, Treasury Bill, etc. Medium-term securities are those which have a maturity
period ranging between one and five years like Debentures maturing within a period of 5
years. Long-term securities are those which have a maturity period of more than five years.
For example, Governments Bonds maturing after 10 year.

( D) Overview of FinanciaI Services
Financial services can be defined as the products as the products and services offered by
institutions like banks of various kinds for the facilitation of various financial transactions and other
related activities in the world of finance like loans, insurance, credit cards, investment opportunities
and money management as well as providing information on the stock market and other issues like
market trends.
NaturaI aracteristics of FinanciaI Services
Like any other service, financial services are characterized by the following:;
(1) IntangibiIity: The basic characteristics of financial services are that they are intangible in
nature. For financial services to be successfully created and marketed, the institutions
providing them must have a good image and the confidence of its clients.
(2) ustomer Orientation: The institution providing the financial services study the needs of
the customer's in detail. Based on the results of the study they come out with imitative
financial strategies that give due regard to costs liquidity and maturity considerations for
various financial products. This way, financial services are customer oriented.
(3) InseparabiIity: The function of producing and supplying financial services has to be carried
out simultaneously. This calls for a perfect understanding between the financial services
firms and their clients.

(4) PerisabiIity: Financial services have to be created and delivered to the target clients.
They cannot be stored. They have to be supplied according to the requirements of
customers. Hence, it is imperative that the providers of financial services ensure a match
between demand and supply.
(5) Dynamism: The financial services must be dynamic. They have to be constantly redefined
and refined on the basis of socio-economic changes occurring in the economy, such as
disposable income, standard of living, level of education etc.
(6) Derivatives and ataIysts: Financial services are derivatives of financial markets. They
form a part of the financial market and are, to an extent, catalysts in market operation.
(7) Act as Link: Financial services act as a link between investor and borrower. They provide,
various avenues to the investor for profitable investment and spreading out the risk. An
investor can exercise a high risk and high profit or low risk and low profit option, or can be
satisfied with a steady income pattern with reasonable risk.
(8) Distribution of Risks: Financial services make profitable deployment of funds and enable
the investor to distribute risk in multi-baskets, thereby, assuring a minimum rate of return.
Their market expertise enables them to advise investors in the selection of portfolio for an
assured return.





















Scope of FinanciaI Services


(1) Fund Raising: Financial services help to raise the required funds from a host of investors,
individuals, institutions and corporate. For this purpose, various instruments of finance are
used. The funds are demanded by corporate houses, individuals etc.
(2) Funds DepIoyment: An array of financial services is available in the financial markets which
help to players to ensure effective markets of the funds raised. Financial service assists in
the decision making regarding the financing mix.

(3) SpeciaIized Services: The financial services sector provides specialized services such as
credit rating venture capital financing, lease financing, factoring, mutual funds, merchant
banking, stock lending, depository, credit cards, housing finance, book-building, etc. besides
banking and insurance.
(4) ReguIation: There are agencies that are involved in the regulation of the financial services
activities. n ndia, agencies such as the Securities and Exchange Board of ndia (SEB),
Reserve Bank Of ndia (RB) and the Department of Banking and insurance of the
Government of ndia, through a plethora of legislations, regulate the functioning of the
financial services institutions.
(5) Economic Growt: Financial services contribute in good measure, to speeding up the
process of economic growth and development. This takes place through the mobilization of
the savings of a cross section of people, for the purpose of channeling them into productive
investment.
Types of FinanciaI Services
(1) Asset Based FinanciaI Services: When financial services or are supported by assets
where the funds are transferred into assets they are known as asset based financial
services.
(2) Fee Based FinanciaI Services: Fee based financial services do not create immediate
funds, they enable the creation of funds through their services for which they charge of fee.





Factoring
Forfeiting Credit Rating
Lease Financing Merchant Banking
Hire Purchase Securitization of Debt
Housing Finance
Mutual Funds

Importance of FinanciaI Services
(1) Financial Services form a major part of the GDP.
(2) Financial services are growing sector and so provide a lot of employment opportunities in a
developing country like ndia.
(3) Financial services help to increase the FD flow within the country, which help the country's
growth.
(4) Financial services help to mobilize the idle fund left with the public.
(5) Financial services provide cheap and long-term loans to various industries.
FinanciaI Services
Asset/Fund Based
FinanciaI Services
Fee-based
FinanciaI Services

(6) Financial services like insurance provide financial protection.





UNIT-2
Banking Industry in India
The modern banking system in ndia started with the establishment of General Bank of ndia
in 1786. n the mid-nineteenth century the East ndia Company established the Bank of Bengal in
1809, the Bank of Bombay in 1840 and the Bank of Bengal in 1843. There were initially
independent unit and were referred to as the Presidency banks. Subsequently, these three banks
were amalgamated and become known as the mperial Bank of ndia, After independence the
mperial Bank of ndia (which till then functioned as a private bank) was nationalized under the
State Bank of ndia Act of 1955 and became known as the State Bank of ndia. Nationalization was
a major theme during the period after independence due to the socialist philosophy adopted by the
first Prime Minister, Jawaharlal Nehru.
n 1969 his daughter ndira Gandhi, continued this process by nationalizing 14 major banks.
ndian banks are unique in many respects. Prior to 1991 all banks are unique in many respects.
Prior to 1991 all banks were state owned. n 1991 when the government opened banking tp private
banks. (e.g. CC banks and Bank of America), the public sector has dropped by 20%. However,
state owned banks still controls approximately 80% of the country's banking assets.
Structure of Banking System in India
At the apex is the Reserve Bank of ndia, the Central Bank of the country. t is a banker's bank
and lender of the last resort. Besides it acts as the fiscal agent of the government, manages the
currency and controls the credit in the national interest. The Reserve Bank of ndia is followed by
the State Bank of ndia which was created in July 1955 by nationalizing the mperial Bank of ndia.
Joint Stock Banks can be divided into two groups; the scheduled and non scheduled banks.
*Reserve Bank of India

() Schedules Banks () Non-Scheduled Banks

(A) Co-operative Banks (B) Commercial Banks

(1) Central (2) State (1) ndian (2) Foreign
Co-operative Co-operative Banks Banks
Banks Banks

(i) Public Sector (ii) Private Sector
Banks Banks

(a) SB and its (b) Other (c) Regional
associate Nationalized Rural Banks
Banks Banks



() SceduIed Banks: A scheduled bank is one which is registered in the second schedule of
the Reserve Bank of ndia. The following conditions must be fulfilled by a bank for
conclusion in the schedule.
Structure of Indian Banking System

(1) The banker concerned must be in business of banking in ndia.


(2) t is either a company defined in Section 3 of the ndian Companies Act, 1956, or
corporation or a company incorporated by or under any law in force many place outside
ndia or an institution notified by the Central Government in this behalf.
(3) t must have paid-up capital and reserves of an aggregate real or exchangeable value of not
than rupee five lacs.
(4) t must satisfy the Reserve Bank of ndia that its affairs are not conducted in a manner
detrimental to the interests of its depositors.
(A) o-operative Banks: Co-operative Banks came into existence with the enactment of the Co-
operative Credit Societies Act of 1904 which provided for the formation of Co-operative Credit
Societies.
Co-operative Banks fill in the gaps of banking needs of small and medium income groups not
adequately met through by the public and private sector banks. The co-operative banking
system supplements the efforts of the commercial banks in mobilizing saving and meeting the
credit needs of the local population.
Co-operative banks are again classified as:
(1) State o-operative Banks: The state co-operative Banks, also known as opex banks, from
the opex of the co-operative credit structure in each state. They obtain their funds mainly from
the general public by way of deposits, loans and advance from the Reserve Bank and their
own share capital and reserves anywhere between 50-90 per cent of the working capital of the
SCBs are contributed by the Reserve Bank.
(2) entraI o-operative Banks: The Central Co-operative Banks are federations of primary
credit societies in a specific area, normally a district and are usually located in district
headquarters of some prominent town of the district. These banks have a few private
individuals as shareholders who provide both finance and management. The Central Co-
operative Banks have three sources of fund via, their own share capital and reserves,
deposits from the public and loans from the State Co-operative Banks.
(B) ommerciaI Banks: Since a modern bank performs a variety of functions, it is difficult to give
an accurate definition of it. t is on account of this reason that different economists have
different definition of a bank.
Scheduled Commercial Banks are those included in the Second Schedule of the Reserve
Bank of ndia Act, 1934. n terms of ownership and function, commercial banks can be
classified into two categories, public sector banks and private sector banks.
Commercial banks can be further classified into ndian Banks and Foreign Banks.
(1) Indian Banks:
(i) PubIic Sector Banks: Public Sector banks are banks in which the government has a major
holding. These can be classified into three groups.
(a) State Bank of India: The State Bank of ndia was initially known as mperial Bank. The
mperial Bank was formed in 1921 by the amalgamation of three Presidency Banks-Banks of
Bengal, Bank of Bombay and Bank of Madras.
The mperial Bank was nationalized under the State Bank of ndia Act, 1955, which was
passed on May 8, 1955. The State Bank of ndia came into existence of July 1, 1955. This
marked the beginning of the first phase of nationalization of banks. The main objectives of
nationalization were extending banking facilities on a large scale, particularly in the rural and
semi-urban areas. The other objectives for which the Bank was established were:
F To promote agricultural finances and to remedy the defects in the system of agricultural
finance.
F To help the RB in its credit policies.
F To help the government to pursue the broad economic policies.

The State Bank of ndia has seven subsidiaries:-


(a) State Bank of Bikaner and Jaipur
(b) State Bank of Hyderabad
(c) State Bank of Mysore
(d) State Bank of Patiala
(e) State Bank of Travancore
(f) State Bank of ndore.
The State Bank of ndia hold the dominant market position among all ndian banks. t is the
world's largest commercial bank in terms of branch network with a staggering 13,000 branches and
51 foreign branches.
(b) NationaIized Banks: The nationalization of banks in ndia took place in 1969 by Mrs.
ndira Gandhi the Prime Minister then 14 banks were nationalized. These banks were
mostly owned by businessmen and even managed by them. Before the steps of
nationalization of ndian Banks, only State Bank of ndia (SB) was nationalized. t took
place in July 1955 under the SB Act of 1955. Nationalization of seven State Banks of
ndia took place on 19
th
July, 1960.
The second phase of nationalization of ndian banks took place in the year 1980.
Seven more banks were nationalized with deposits over 200 crore. Till this year,
approximately 80% of the banking segments in ndia were under Government
ownership.
(c) RegionaI RuraI Banks: Regional Rural Banks (RRBs) are oriented towards meeting the
needs of the weaker sections of the rural population consisting of small and marginal
farmers, agricultural laborers, artisans and small entrepreneurs. The regional rural banks
were setup after nationalization of ndia in 1969 when the emphasis shifted to providing
more credit to weaker sections. They are expected to make credit available to rural
householders besides instilling thrift.
(ii) Private Sector Banks: After the nationalization of 14 large banks in 1969, no banks
were allowed to be set up in the private sector. n the pre-reforms period, there were
only 24 banks in the private sector. Today there are 31 private sector banks in the
banking sector, 23 old private sector banks and 8 new private banks. These banks
exported profits in the very first year of their existence. The public sector banks are
facing a stiff competition from the new private sector banks. The guidelines for entry
of new banks in the private sector were revised in January 2001. The guidelines
prescribed an increase in initial minimum paid-up capital from Rs 100 crore to Rs
200 crore. Moreover the initial minimum paid up capital shall be increased to Rs 300
crore in subsequent three years after commencement of business. The guidelines
also enable a Non-Banking Finance Company (NBFC) to convert into a commercial
bank, if it satisfies the prescribed criteria of:
(a) Minimum net worth of Rs. 200 crore.
(b) A credit rating of net loss than AAA (or its equivalent) in the previous year.
(c) Capital adequacy of not less than 12 percent, and
(d) Net NPAs not more than 5 per cent.
[] Non-SceduIed Banks: Banks, which are not included in the Second Schedule of the
RB are known as non-scheduled banks. Non-scheduled banks are not entitled to all these facilities
that the scheduled banks avail of from the Reserve Bank of ndia. Since the enactment of the
Banking Regulation Act in 1949, non-schedules banks have also come under the ambit of the RB
control. t has become obligatory on the part of these banks to carry a portion of these deposits with
the RB or in vault with the bank itself, and prepare their annual accounts and balance sheets in
accordance with the requirements stipulated in section 29 of the Banking Companies Act.

Functions of ommerciaI Banks


The Commercial Banks perform a variety of functions which can be divided in the following
three categories:-
(1) Basic Function
(2) Agency Function
(3) General Utility Function
(1) Basic Functions: The basic functions of bank are those functions without performing
which an institution cannot be called a banking institution at all. That is why these
functions are also called primary or acid test function of a bank. These basic/primary/acid
test functions of banks are:-
(A) Accepting Deposits
(B) Advancing of Loans and
(C) Credit Creation
(A) Accepting Deposits: The first and the most important function of banks is to accept
deposits from those people who can save and spare for the safe custody with the bankers. t
serves two purposes for the customers. On one hand their money is safe with the bank
without any fear of theft and on the other hand they also earn interest as per the kind of
saving they have made. For this purpose the banks have different kinds if deposit accounts
to attract the people which are as under:
(i) Saving Deposit Account
(ii) Fixed Deposit Account
(iii) Current Deposit Account
(iv) Recurring Deposit Account
(v) Home Loan Account
(B) Advancing of Loans: Advancing of loans is the second acid test function of the commercial
banks. After keeping certain cash reserves, the banks lend their deposits to the needy
borrowers. t is one of the primary functions without which an institution cannot be called a
bank. The bank lends a certain percentage of the cash lying in the deposits in a higher rate
of interest than it pays on such deposits. The longer the period for which the loan is required
the higher is the rate of interest. This is how a bank earns profits and carries on its banking
business. Some of the important ways of advancing loans are as under:-
(i) Call Money Advances
(ii) Cash Credits
(iii) Overdrafts
(iv) Discounting Bills of exchange
(v) Term Loans
(C) redit reation: Credit creation is one of the basic functions of a commercial bank. A bank
differs from the other financial institutions because it can create credit. Like other financial
institutions. The commercial banks also aim at earning profits. For this purpose they accept
deposits and advance loans by keeping a small cash in reserve for day-to-day transactions.
n the layman language when a bank advances a loan, the bank creates credit or deposit.
Every bank loan creates an equivalent deposit in the bank. Therefore the credit creation
means multiple expansions of bank deposits. The word creation refers to the ability of the
bank to expand deposit as a multiple of its reserves.
The credit creation refers to the unique power of the banks to multiply loans and
advances, the hence deposits, with a little cash in hand, the banks can create auditioned
purchasing power to a considerable extent. t is because of this multiple credit creation

power that the commercial banks have been named the 'factories of creating credit/ or
manufacturers of money.
[2] Agency Functions: 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 helped 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.
(ii) oIIecting ustomers Funds: The bank collects the funds of its customers from other banks
and credits them to their accounts.
(iii) Purcase and saIe of sares 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.
(iv) oIIecting Dividends: The bank collects dividends as well as interest on the shares and
debentures of its customers of its customers and credits them to their accounts.
(v) Payment of Prima: The bank pays Premia to the insurance companies on behalf of its
customers. t may also pay certain bills of the customers as per their directions.
(vi) Acts as Trustee: The banks preserve the 'Wills' of the customers and executes them after
their death.
(vii) Income Tax onsuItant: The bank may also give advice to its customers on income-tax
matters. t may even prepare the income-tax returns of its customers on payment of its fee.
[3] GeneraI UtiIity Function: n addition to basic functions and agency functions the commercial
banks also provide general utility services for their customers which are needed in the various
walks of life and the commercial banks provided a helping hand in solving the general
problems of the customers, like safety from loss or theft and so many other facilities, some of
them are as under :-
(i) Locker Facility
(ii) Traveler's Cheque Facility
(iii ) Gift Cheqe facility
(d) Letter of Credit
(e) Underwriting Contract
(f) Foreign Exchange Facilities
(g) Merchant Banking Services
(h) Acting as Referll.

Banking Sector Reforms (1992-2005)
Despite stiff from bank unions and political parties in the country, the government of ndia
accepted all the major recommendations of Narasimhan Committee (1991) and started
implementing them.
(1) Statutory Liquidity Ratio (SLR): Statutory Liquidity ratio on incremental net Demand and
Time Liabilities (DTL) has been reduced from 38.5 percent to 25 percent and SLR on
outstanding net domestic demand and time liabilities were reduced gradually from 38.5

percent to 25 percent in October, 1997; this was the minimum stipulated under section 24 of
Banking Regulation Act, 1949.
(2) as Reserve Ratio (RR): The ncremental Cash Reserve Ratio (CRR) of 10 percent
was abolished but RB could not reduce CRR immediately. When conditions eased and
money growth started slowing down since 1995-96, RB reduced CRR gradually from 15 per
cent to 5-5 percent in December 2001
(3) PrudentiaI Norms: Prudential norms have been started by RB as part of the reformative
process. The purpose of prudential system of recognition of income, classification of assets
and provisioning of bad debts is to ensure that the books of the commercial banks reflect
their financial position more accurately and in accordance with internationally accepted
accounting practices. There help in more effective supervision of banks.
(4) apitaI Adequacy Norms: Capital adequacy norms were fixed at 8 percent by RB in April
1992 and banks had to comply with them over a three years period. By end March 1996, all
public sector banks had attained capital to risk weight age assets ratio of 8 percent. The full
norm of 8 percent was also attained by foreign banks in ndia and by some ndian banks.
(5) Access to apitaI Market: The Government of ndia has amended the Banking Companies
(Acquisition and transfer of under takings) Act to enable the nationalized banks to access
the market for capital funds through public issues, subject to the provision that the holding of
the Central Government would not fall below 51 percent of the paid-up capital.
(6) Freedom of Operations: Scheduled commercial banks have now been given freedom to
open new branches and upgrade extension counters, after obtaining capital adequacy
norms and prudential accounting standards.
(7) LocaI Area Banks: n the 1996-97 budget, the Government of ndia announced the setting
up of new private Local Area Banks (LABs) with jurisdiction over three contiguous districts.
These banks would help to mobilize rural savings and to channelize them into investment in
local areas. The RB has issued guidelines for setting up such banks in 1996 and gave its
approval.
(8) Supervision of ommerciaI Banks: Supervision of commercial banks is being tightened
by RB, especially after the securities scam of 1992. The RB has set up a Board of
Financial Supervision with an Advisory Council under the chairmanship of the Governor to
strengthen the supervisory and surveillance system of banks and financial institutions. RB
has also established in December 1993 a new department known as Department of
Supervision as an independent unit for supervision of commercial banks and to as list the
Board of Financial Supervision.
(9) Recovery of Debts: The Government of ndia passed "Recovery of Debts due to Banks and
Financial nstitutions Act, 1993" in order to facilitate and speed up the recovery of debts due
to banks and financial institutions. Six Special Recovery Tribunals have been set up at
Calcutta, New Delhi, Jaipur, Ahmadabad, Bangalore and Chennai to facilitate quicker
recoveries of loan arrears with months and an Appellate Tribunal has also been set up in
Mumbai.

Management of apitaI Funds
The capital funds constitutes one of the sources of funds for a commercial banks. t
represents owned resources, and includes the share capital subscribed by its shareholders as well
as the reserves built up by the bank by plugging back a part of its business earnings. Further, we
considered the following three important aspects of the management of capital funds in a
commercial bank.
(1) What are the real functions of bank capital?

(2) What is an adequate capital funds?


(3) Why is adequate capital fund necessary?
(1) Functions of apitaI Funds in ommerciaI Banks
(i) Bank apitaI Acts as LOSS absorber: Like other business, a commercial bank needs
capital to commence its operations, and to continue its existence as a running business.
Commercial and industrial companies require capital initially to finance their operation and
secondly to provide a bail-out for creditors or to cover possible losses. From the standpoint
of a bank, the reserve is generally true. The primary role of a bank capital is to absorb
possible losses so that depositors may be fully protected at all times. The true nature of the
protection function of the capital fund is that it is the ultimate of financial protection from the
risk of insolvency. n the short run, a major portion of the banks losses may be offset by its
current earnings, not by its capital funds. Even in the long run, the capital fund may not fulfill
the protective role because, if a bank had poor earnings, loose internal control and a large
quantity of risk assets-symptoms of bank liquidation-the bank management (and perhaps
the Central Bank also) would step in long before the capital funds were severely impaired.
(ii) Bank apitaI SuppIies Working TooIs or Banks: The secondary function of the capital
funds is to provide the funds for the acquisition of such fixed assets as buildings, equipment,
furniture etc. The provision of permanent asset is a continuous function of the bank capital
fund, mainly because depositors cannot be expected to supply the funds for such assets,
say a new branch building. Under conditions of expansion. therefore, the capital base must,
of necessity, be strengthened in line with the expansion in the operations of the bank.
(iii) Bank apitaI act as source of Loan Funds: Another important function of bank capital is
the assurance that the bank will be able to fulfill the credit needs of the community and
assume the risks inherent in its safety. n other words, there are certain types of investments
for which borrowed funds may not be helpful; reliance is placed only on capital funds.
(2) Meaning of Adequate apitaI Fund: To define the adequacy of bank capital funds is not
an easy job. As a matter of fact, the capital fund of a banking system may not be judged as
adequate or inadequate on any a priori ground. "The more capital, the better" is not the
answer to the question. t is a question of "how much capital" & for "what purposes". The
depositors may favor the maximum amount of capital fund so that the bank may be able to
absorb all the lesser which may occur, they would thus be fully protected.
(3) Necessity of Adequate apitaI Fund: The need for adequate capital funds arises because
of the following reasons:-
(i) n a country like ndia, where other factors of public confidence, viz, deposit
insurance, tanking inspection, sound management policies and the social status of
bank management, have not been fully appreciated by the public, an adequate
capital fund is needed to bring about solidarity scope, operation and the ultimate
strength of the banks.
(ii) A bank must have an adequate capital fund to cover the normal hazards inherent in
its operations.
(iii) Adequate capital is necessary to secure the permission of the RB to open a new
branch. According to section 23 of the Banking Companies Act, 1949, the RB must
be satisfied, among other things, that the capital structure is adequate. t may without
all the facilities from the bank which has an insufficient capital structure.
apitaI Adequacy Norms
The committee on Banking Regulations and Supervisory Practices (Barel Committee) had
released the guidelines on capital measures and capital standards in July 1988 which were been

accepted by Central Banks in various countries including RB. n ndia it has been implemented by
RB w.e.f. 1.4.92.
The fundamental objective behind the norms is to strengthen the soundness and stability of
the banking system. t is a measure of a bank's capital. t is expressed as a percentage of a bank's
risk weighted credit exposures.

Tier one capital + Tier two capital
CAR =
Risk weighted assets.
This ratio is used to protect depositors and promote the stability and efficiency of financial
systems around the world.
A new capital framework was introduced for ndian scheduled commercial banks, based on
the Basel Committee recommendations presenting two tiers of capital for the banks:-
(1) Tier or core capital, considered the most permanent and readily available supported
against unexpected losses, includes paid-up capital, statutory reserves, share premium and
capital reserve; and
(2) Tier capital consisting of undisclosed reserves, fully paid-up cumulative perpetual
preference shares, revaluation reserves, general previsions and loss reserves, etc.
(3) t was also prescribed that Tier i capital should not be more than 100 percent of Tier
capital.
Minimum requirements of capital fund in ndia:
(1) Existing Banks 09%
(2) New Private Sector Banks 10%
(3) Banks undertaking nsurance Business 10%
(4) Local Areas Banks 15%
Tier capital should at no point of time be less than 50% of the total capital. This implies that
Tier cannot be more than 50% of the total capital.
BaseI Norms:-
BaseI I: The Basel Committee on Banking Supervision had published the first Basel Capital
Accord (popularly called as Basel framework) in July, 1988 prescribing minimum capital adequacy
requirements in banks for maintaining the soundness and stability of the nternational Banking
System and to diminish existing source of competitive inequality among international banks.
BaseI II Norms: Basel is the second of the Basel Accords, which are recommendations on
banking laws and regulations issued by the Basel Committee on Banking Supervision.
Three Pillars of Basel i Norms:
Basel user a "three pillars" concept
(i) Minimum capital requirements (addressing risk)
(ii) supervisory review
(iii) Market discipline to promote greater stability in the financial system.
BaseI III Norms: Basel is the third of the Basel Accords, which are recommendations on
banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose
of Basel , is to create an international standard that banking regulators can use when creating

regulations about how much capital banks need to put aside to guard against the types of financial
and operational risks banks face.
Te overaII goaIs of BaseI III norms are:
(i) To refine the definition of bank capital
(ii) Quantify further classes of risk.
(iii) To further improve the sensitivity of the risk measures.

Liquidity Management
Liquidity is essential in all banks to compensate for expected and unexpected balance sheet
fluctuations and to provide funds for growth. The recent liquidity crisis faced by banks and financial
institution has brought to the fore, the need to review their existing Liquidity Management policies,
Practices and Procedures.
Liquidity and ProfitabiIity
The basic problem facing a bank manager is to have a satisfactory tradeoff between liquidity
and profitability the two principal but conflicting goals of a bank. Liquidity and profitability are,
therefore, contrary to each other. Cash has perfect liquidity but lack yield. At the other end are
some loans and investments which yield a high rate of interest, but are hardly liquid at all. The
conflict between liquidity and income is not as sharp as it appears. n order to ensure long-run
earnings, the commercial bank must retain public confidence in order to continue to service and
provide of the liquidity needs of the bank.
A number of approaches ways and means of resolving the conflicts have been developed
from time-to-time. These approaches subsequently came to be known as theories of liquidity
management.
Teories of Liquidity Management
The traditional theorists believe that a golden mean between liquidity and profitability can be
struck by a judicious allocation of funds between different kinds of assets. However, a new theory
has recently emerged, according to which a prudent management of liabilities yields a solution of
the problem of liquidity management. A brief discussion is as follows:-
(1) Self-liquidating Paper Theory/Commercial Loan Theory
(2) Shift ability Theory
(3) Anticipated ncome Theory
(4) Liabilities Management Theory
[1] SeIf-Iiquidating Paper Teory: This is considered to be the traditional or conservative
theory. According to this theory earning assets of a bank should primarily consists of such assets
which are self-liquidity in the short-term viz. short-term government or semi-government securities,
short-term productive advancer etc. Such assets are fairly liquid and meet one of the very basic
cannons of lending by a commercial banks. Short-term securities help the banks in maintaining their
liquidity through continuous loan repayments. They can also be pledged with Central Bank if an
emergency arises. Short-term productive loans help the bank in preserving their liquidity through
continuous repayment of these loans out of the sale proceeds of the goods covered by such loans.
Moreover short-term loans have less of risk as compared short-term loans have less of risk as
compared to long-term loans because of better estimate of the likely future events.

[2] SiftabiIity Teory: According to Shiftability Theory the problem of liquidity is not so much
a problem of the maturity of bank but one of shifting the assets to others for cash without material
loss. The bank need not rely upon maturities if it has maintained a substantial amount of such
assets as can be shifted on to others to meet an unexpected heavy run on it. Liquidity is this
equivalent to shiftability.
According to the shiftability theorists, an asset, to be perfectly shift able, must fulfill the
attributes of immediate transferability to others, without appreciable capital loss for the purpose of
meeting a temporary liquidity crisis caused by a sudden demand on the part of customers. This
would, however, not be possible in times of a general liquidity crisis engulfing the entire banking
community. n such circumstances, a bank should in order to maintain its liquidity, possess such
assets as can be shifted on to the Central Bank the lender of the last resort, the ultimate source of
cash, Therefore in judging the shift ability of any assets, due regard must be paid to the shift ability
of assets on to the Central Bank. Generally, Central Banks give cash on demand against treasury
bills and certain bills of exchange which fulfill the eligibility conditions.
The commercial loan theory and the shift ability theory, both have failed to distinguish clearly
between the liquidity of an individual banks and that of the banking system as a whole. An
improvement in the liquidity of an individual bank by the traditional method or by the process of
shifting assets is possible at the expense of the liquidity of other banks.
[3] Anticipated Income Teory: This is considered to be the modern theory. This has particularly
gained prominence since 1930 when commercial banks in SA started granting long term loans to
trade, and industry. According to this theory the liquidity of loans is not simply guaranteed by the
period of the loan but the anticipated income the loan is intended to produce to the borrower in
future.
A term loan is one which is granted for a period of more than one year but not exceeding
five years. Such loan is usually accompanied by agreements between the bank and the borrower,
containing restrictive covenants with respect to the financial activities of the latter. Banks grant
these loans against the hypothecation of stocks, machinery, the potential earnings of the borrower,
which a bank takes into account while considering the loan request and deciding about the amount
of the lean to be granted. f a banker is satisfied that the borrowing concern has the potentiality to
earn a reasonably high income in the foreseeable future, it will grant the loans even though they are
not of a self-liquidating nature or if the assets, against which the loans are given, are not, shift able.
This is what the anticipated ncome Theory holds.
n other words, according to this theory the mere fact that the loan is for short period cannot
ensure its liquidity. As a matter of fact all loans, short-terms, are liquid provided the borrower has
the capacity to pay, i.e., he earns enough to meet the loan commitments.
[4] LiabiIities Management Teory: During the 1960's a new theory of bank liquidity emerged,
which may be labeled as the Liabilities Management Theory. According to this theory, it is
unnecessary to observe traditional standards in regard to self-liquidating loans and liquidity
reserves, for reserve money can be borrowed or "bought" in the money market whenever a bank
experiences a reserve deficiency.
According to the liabilities management view, an individual bank may acquire riversides
include a number of items, some of which are listed below.
(i) s assurance of time certificates of deposit?
(ii) Borrowing from other commercial banks.
(iii) Borrowing from the Central Bank.
(iv) Raising Capital Funds by issuing shares and by means of retained earnings.


Asset-LiabiIity Management
Management of assets and liabilities or Asset-Liability Management (ALM) can be termed as a risk
management technique designed to earn an adequate return while maintaining a comfortable
surplus of assets beyond liabilities. t takes into consideration interest rate, earning power and
degree of willingness to take on debt and hence is also known as Surplus Management.
But in the last decade the meaning of ALM has changed. t is new used in many different
ways under different contexts. ALM, which was actually pioneered by financial institutions and
banks are new widely being used in industries too.
n banking, asset and liability management is the practice of managing risks that arise due
to mismatched between the assets and liabilities (debts and assets) of the bank.
Banks face several risks such as the liquidity risk; Liability Management (ALM) is a 'strategic
management tool to manage interest rate risk and liquidity risk faced by banks, other financial
services' companies and corporations.
Need of Asset-LiabiIity Management
Asset-Liability Management (ALM) is the art and science of analyzing, interpreting and managing
the composition of a financial institution's balance sheet. ALM focuses on up to four challenges:-
1) Understanding the risks that a bank is exposed to due to the composition of its assets and
liabilities.
2) Forecast the future composition of the bank's balance sheet and its risk exposure.
3) Determine and attribute interest-related profits to individual assets or liabilities business
units or activities through Funds Transfer Pricing.
4) Forecast capital requirements and manage the balance sheet in a way to maximize
shareholder value.
While not all ALM departments will deal with all four of these activities, they are all closely
related and require the same type of information and skills making them the natural scope of
responsibilities for on ALM group.
Procedure of Asset-LiabiIity Management
A step-by-step approach of ALM examination in case of a bank has been outlined as follows:-
Step 1: The bank/financial statements and internal management reports should be reviewed to
assess the asset/liability mix.
Step 2: t is to be determined that whether bank management adequately assesses and plans its
liquidity needs and whether the bank has short-term sources of funds.
Step-3: The banks future development and expansion plans, with focus on funding and liquidity
management as pacts have to be looked into.
Step 4: Examining the bank's internal audit report in regards to quality and effectiveness in term of
liquidity management.
Step 5: Reviewing the bank's plan of satisfying unanticipated liquidity needs.
Step 6: Preparing an Asset/Liability Management nternal Control Questionnaire/
Tecniques for Assessing Asset-LiabiIity Risk
These are two techniques for assessing asset liability risk. They are as follows:

1) nterest Rate Risk Management


2) Liquidity Risk Management.
1] Interest Rate Risk Management: The purposes of measuring ALM interest-rate risk are to
establish the amount of economic capital to be held against such risks and to show managers how
the risks can be reduced. Risks can be reduced by buying or selling interest rate sensitive
instruments, such as bonds and swaps or by restructuring the products that the bank offer, e.g.
promoting floating-rates mortgages over fixed-rate mortgages or encouraging more fixed deposits
Banks use three alternative approaches to measure ALM interest-rate risk, as listed below:-
(i) Gap Analysis
(ii) Duration Model
(iii) Rate-shift scenarios.
(i) Gap AnaIysis: Gap analysis is a tool used by credit unions to analyze the match between
Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL). The Gap is the difference
between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time
bucket. The positive Gap indicates that it has more RSAs than RSLs whereas the negative
Gap indicates that it has more RSLs. The Gap reports indicate whether the institution is in a
position to benefit from rising interest rates by having a positive Gap (RSA>RSL) or whether it
is in a position to benefit from declining in interest rates by a negative Gap (RSL>RSA). The
Gap can, therefore, be used as a measure of interest rate sensitivity.
(ii) Duration ModeI: Duration is an important measure of the interest rate sensitivity of assets
and liabilities as it takes into account the time of arrival of cash flows and the maturity of
assets and liabilities Duration basically refers to the average life if the asset or the liability.


The above equation describes the percentage fall in price of the bond for a given increase in
the required interest rates or yields. The larger the value of the duration, the more sensitive is
the price of that asset or liability to changes in interest rates. As per the above equation, the
bank will be immunized from interest rate risk if the duration gap between assets and the
liabilities is zero. The duration model has one important benefit. t uses the market value of
assets and liabilities.
(iii) Rate Sift Scenarios: Rate-shift scenarios attempt to capture the non-linear behavior of
customers. A common scenario test is to shift all rates up by 1%. After shifting the rates, the
cash flows are changed according to the behavior expected in the new environment, e.g.
mortgage prepayments may increase some of the checking and savings accounts may be
withdrawn and the prime rate may increase after a delay. The NPV of this new set of cash
flows is then calculated using the new rates. The analysis is used to show the changes in
earnings and value expected under different rate scenarios.
The rate-shift scenarios are useful in giving a measure of the changes in value and income
caused by implicit options, but they can miss losses caused by complex changes in interest
rates such as a shift up at one time followed by a fall.
[2] Liquidity Risk Management: Liquidity risk management is of paramount importance because
a liquidity shortfall at a single institution can have system-wide repercussions. Financial
market developments in the decade have increased the complexity of liquidity risk and its
management. Following are the methods used in liquidity risk management:-
(i) Liquidity Tracking: Measuring and managing liquidity needs are vital for effective operation of
the company. By assuring the Company's ability to meet its liabilities as they become due,
DPp = D(dR/1 + R)

liquidity management can reduce the probability of an adverse situation. The importance of
liquidity transcends individual institutions, as liquidity shortfall in one institution can have
repercussions on the entire system.
(ii) Time Buckets: The Maturity Profile could be used for measuring the future cash-flows of a
financial institute in different time buckets. The time buckets shall be distributed as under:-
(a) 1 day of 30/31 days (one month)
(b) Over one month and upto two months.
(c) Over two months and upto three months.
(d) Over three months and upto six months.
(e) Over six months and upto one year.
(f) Over one year and upto three years.
(g) Over three years and upto five years.
(h) Over five years and upto seven years.
(i) Over seven years and upto ten years.
(j) Over ten years.
Within each time bucket there could be mismatches depending on cash inflows and
outflows. While the mismatches upto one year would be relevant since these provide early
warning signals of impending liquidity problems, the main focus should be on the short-term
mismatches, viz, 1-90 days.
(iii) RR/SLR Requirement: Every financial institute is required to maintain a Cash Reserve
Ratio (CRR) on its customer deposits. n addition, every financial institute is required to
maintain a Statutory Liquidity Reserve (SLR) OF 5% (including CRR) on all its liabilities. There
is no restriction on where these SLR will be maintained. The financial institutions holding
deposits are given freedom to place the mandatory securities in any time buckets as suitable
for them. These SLRs shall be kept with banks and financial institutions for different
maturities.
Non Performing Assets (NPAs)
An asset is classified as non-performing asset (NPAs) is dues in the forms of principal and
interest are not paid by the borrower for a period of 180 days. However with effect from March
2004, default status would be given to a borrower if dues are not paid for 90 days. f any advance or
credit facilities granted by bank to a borrow become non-performing then the bank will have to treat
all the advances/credit facilities granted to that borrower as non-performing without having any
regard to the fact that there may still exist certain advances/credit facilities having performing
status.
So an asset is classified as NPA if dues in the form of principal and interest are not paid by
the borrower for a period of 180 days. However with effect from Mar 31, 2004 it is 90 days.
With effect from year ending Mar. 31, 2004, a NPA shall be a loan or advance where:-
1) nterest/installment of principal remains overdue for a period of more than 90 days.
2) Account remains 'out of order' for a period of more than 90 days.
3) The bills remain overdue for a period of more than 40 days in the case of bills purchased
and discounted.
So an assets becomes non performing when it cases to generate income for the bank on
actual realization basis.
RBI PrudentiaI Norms
RB has introduced prudential norms to regulate NPA which involves assets classification,
recognition of income and provisioning norm.

1) Iassification or Identification of Assets


For the purpose of recognition on income and for making the provisions for estimated future
losses in terms of NPA a bank has to classified its assets mainly in two categories:-
(A) Performing Assets/Standard Assets: These are loans and advances which do not
have any problem and less risk. At these loans and advances banks get the interest
installment amount at the time when it due. These assets are also known as standard
assets.
(B) Non-Performing Assets: Non-Performing Assets are those assets on which interest
and installment of principal amount are overdue for a specified period of time that is now
90 days. These assets can be further classified into following three categories:
(i) Substandard Assets: With effect from the year ending Mar 2004, a sub-standard
assets is one which has remained NPA for a period less than or equal to 12
months earlier it was 18 months.
(ii) DoubtfuI Assets: A doubtful asset is one which has remained NPA for a period of
more than 12 months, earlier it was 18 months.
(iii) Lass Assets: A loss assets is one where loss has been identified by the banks or
internal or external auditions or the RB inspection but the amount has not been
written off fully. n other words such an asset is considered uncontrollable.
2) Recognition of Income: As per the prudential norms suggested by the RB a bank cannot
book interest on an NPA on accrual basis. n other words, such interest can be booked only
when it has been actually received.
On performing assets interest can be booked on the accrual basis or when it is due
other received or not yet.
3) Provisions: A bank has to make the provisions in respect of various assets for the
set up of estimated losses due to various NPAs:-
(%)
(a) For Standard Assets 0.25
(b) For Substandard Assets 10.00
(c) For Doubtful Assets :-
For unsecured portion 100.00
For secured portion:-
(i) Up to one year 20.00
(ii) One to three year 30.00
(iii) More than three years:
Upto Mar. 31, 2004 50.00
After Mar. 31, 2004 :-
For the year ended Mar. 31, 2005 60.00
-,,- -,,- 2006 75.00
-,,- -,,- 2007 100.00
(d) Loss Assets 100.00
When advance are guaranteed by Export Credit Guarantee Corporation (ECGC) or by
Deposit nsurance and Credit Guarantee Corporation (DCGC) to make the provision the amount
guaranteed is to be deducted from the amount of NPA. f the bank also holds security in respect of
such advances, such security must be deducted, first then the guarantee provided by
ECGC/DCGC.

Factor for Rise in NPAs:


The banking sector has been facing the serious problems of the rising NPAs. But the problem
of NPAs is more in public sector banks when compared to private sector banks and foreign banks.
The NPAs in banks are growing due to external as well as internal factors.
[A] ExternaI Factors:
(1) Ineffective Recovery TribunaI: The Government has set number of recovery tribunals, which
works for recovery of loans and advances. Due to their negligence and ineffectiveness in their
work the bank suffers the consequences of non-recover, thereby reducing their profitability
and liquidity.
(2) WiIIfuI defauIts: There are borrowers who are able to pay back loans but are internationally
withdrawing it. These groups of people should be identified and proper measure should be
taken in order to get back the money extended to them as advances and loans.
(3) NaturaI aIamities: This is the major factor, which is creating alarming rise in NPAs of the
banks. Mainly formers depend on rainfall for cropping. Due to regulations of rain fall the
farmers are not to achieve the production level thus they are not repaying the loans.
(4) IndustriaI Sickness: mproper project handling, ineffective management, lack of adequate
resource, lack of advance technology, day to day changing government policies give birth to
industrial sickness. Hence the banks that finance those industries ultimately end up with a low
recovery of their loans reducing their profit and liquidity.
(5) Lack of Demand: Entrepreneurs in ndia could not foresee their product demand and starts
production which ultimately piles up their product thus, making them unable to pay back the
money they borrow to operate these activities.
(6) ange on Government PoIicies: With every new government banking sector gets new
policies for its operation. Thus it has to cope with the changing principles and policies for the
regulation of the rising of NPAs. The fallout of handloom sector is continuing as most of the
weavers Co-operative societies have become defund largely due to withdrawal of state
patronage. The rehabilitation plan workout by the Central Government to revive the handloom
sector has not yet been implemented. So the over dues due to the handloom sectors are
becoming NPAs.
B] InternaI Factors:
(1) Defective Lending Process: There are three cardinal principles of bank lending that have
been followed by the commercial bank since long.
(i) Principle of Safety.
(ii) Principle of liquidity.
(iii ) Principle of profitability.
The banker should, therefore take utmost case in ensuring that the enterprise or business for
which a loan is sought is a sound one and the borrower is capable of carrying it out successfully. He
should be a person of integrity and good character.
(2) In appropriate TecnoIogy: Due to in appropriate technology and management information
system, market driven decision on real time basis cannot be taken. Proper MS and financial
accounting system is not implemented in the banks, which leads to poor credit collection,
thus NPA. All the branches should be popularized.

(3) Improper SWOT AnaIysis: The improper SWOT analysis is another reason for rise in
NPAs, while providing unsecured advances the banks depend more on the honesty,
integrity and financial soundness and creditworthiness of the borrower.
(4) Poor redit AppraisaI System: Poor credit appraisal is another factor for the rise in NPAs.
Due to poor credit appraisal the bank gives advances to those who are not able to repay it
back. They should use good credit appraisal to decrease the NPAs.
(5) ManageriaI Deficiencies: The banker should always select the borrower very carefully and
should take tangible assets as security to safeguard its interests.
(6) Absence of ReguIar IndustriaI Visit: The irregularities in spot visit also increase the NPAs.
Absence of regularly visit of bank officials to the customer point decreases the collection of
interest and principals on the loan. The NPAs due to willful defaulters can be collected by
regular visits.
(7) Re-Ioaning Process: Non-remittance of recoveries to higher financing agencies and re-
loaning of the same have already the smooth operation of the credit cycle. Due to re-loaning
to the defaulters and CCBs and PACs, the NPAs of OSC B is increasing day by day.
ProbIems/Impact of NPAs
NPAs have their effect on both banks and depositor.
(1) Impact on te Bank: NPAs impact the profitability of the Bank in the following ways:
(i) NPAs do not generate any income forth Banks whereas the resources locked into
these unproductive asset have a cost.
(ii) Bank has to make provisions for NPAs out of its profits.
(iii) 100% risk weight has to be reckoned for Capital Adequacy thus blocking capital.
(iv) Other administrative and legal costs have to be incurred for maintaining these
assets.
(v) High level of NPAs in the balance sheet lead to low customer confidence and
consequently higher cost of deposits.
(vi) NPA may spill over the banking system and contract the money stock, which may
lead to economic contraction.
(2) Impaction Depositor: NPAs impact the profitability of the deposit in the following ways:-
(i) Owners do not receive a market return on their capital in the worst case, if the banks
fails, owners lose their assets. n modern times this may affect a broad pool of
shareholders.
(ii) Depositors do not receive a market return on swing. n the worst case is the bank
fails, depositors lose their assets or uninsured balance.
(iii) Banks redistribute losses to other borrowers by charging higher interest rates, lower
deposit rates and higher lending rates repress saving and financial market, which
hamper economic growth.
(iv) Non-performing loans epitomize bad investment. They misallocate credit from good
projects, which do not receive funding, to failed projects. Bad investment ends up in
misallocation of capital and by extension, labour and natural resources.
Management/strategy of NPA
(A) Preventive Management:

(1) redit Assessment and Risk Management Mecanism: A lasting solution to the
problem of NPAs can be achieved only with proper credit assessment and risk
management mechanism. The documentation of credit policy and credit audit
immediately after the sanction is necessary to upgrade the quality of credit appraisal in
banks. t is necessary that the banking system is equipped with prudential norms to
minimize if not completely avoid the problem of credit risk.
(2) OrganizationaI Restructuring: With regard to internal factors leading to NPAs the ones
for containing the same rest with the bank themselves. These will necessities
organizational restructuring improvement in the managerial efficiency, skills up gradation
for proper assessment of credit worthiness and a change in the attitude of the banks
towards legal action, which is traditionally viewed as a measure of the last resort.
(3) Reduce dependence on Interest: The ndian Banks are largely depending upon
lending and investments. The banks in developed countries do not depend upon this
income where as 86 per cent of income of ndian Bank is accounted from interest and
the rest of the income is fee based. The banks can earn sufficient net margin by
investing in safer securities though not at high rate of interest. t facilitates for limiting of
high level of NPAs gradually. t is possible that average yield on loans and advances net
default provisions and services costs do not exceed the average yield on safety
securities because of the absence of risk and service cost.
(4) PotentiaI and BorderIine NPAs under eck: The potential and borderline accounts
require quick diagnosis and remedial measures so that they do not step into NPAs
categories. The auditors of the banking companies must monitor all outstanding
accounts in respect of accounts enjoying credit limits beyond cut-off points, so that new
substandard assets can be kept under check.
B] urative Management: The curative measurers are designed to maximize recoveries so
that banks funds locked up in NPAs are released for recycling. The Central Government and RB
have taken steps for arresting incidence of fresh NPs and creating legal and regulatory environment
to facilitate the recovery of existing NPAs of banks, they are:
(1) Debt Recovery TribunaI (DRT): n order to expedite speedy disposal of high value claims
of banks Debt Recovery Tribunals were set up. The Central Govt. has amended 'the recovery of
debts due to banks and financial institutions Act' in January 2000 for enhancing the effectiveness of
DRTs. The provisions for placement of more than one recovery officer, power to attach dependents
properly before judgment, penal provision for disobedience of Tribunals order and appointment of
receiver with powers of realization management, protection and preservation of property are
expected to provide necessary teeth to the DRTs and speedup the recovery of NPAs in times to
come.
(2) Lok AdaIats: The Lok Adalats institutions help banks to settle disputes involving accounts in
doubtful and loss categories. These are proved to be an effective institution for settlement of dues
in respect of smaller loans. The Lok Adalats and Debt Recovery Tribunals have been empowered
to organize Lok Adalats to decide for NPAs Rs 10 lacs and above.

(3) Asset Reconstruction ompany (AR): The Narosimham Committee on financial system
(1991) has recommended for setting up of Asset Reconstruction Funds (
ARF). The following concerns were expressed by the Committee.
(i) t was felt that centralized all ndia fund will severely handicap in its recovery efforts by lack
of widespread geographical reach which individual bank posses, and
(ii) given the large fiscal deficits, there will be a problem of financing the ARF.
Subsequently, the Narsimham committee on banking sector reforms has recommended for
transfer of sticky assets of banks to the RAC. This enables a one-time clearing of balance
sheet of banks by sticky loans.
(4 ) orporate Debt Restructuring: The corporate debt restructuring is one of the methods
suggested for the reduction of NPAs. ts objective is to ensure a timely and transparent mechanism
for restructure of corporate debts of viable corporate entitles.











UNIT-3
Securitization
Securitization means the conversion of existing or future cash inflows of any person into
tradable security, which then may be sold in the market. The cash inflow from financial assets such
as mortgage loan, automobile loan, trade receivables, credit card receivables, fare collections
become the security against which borrowings are raised. n fact, even individuals can take the help
of securitization instruments for better economic efficiency.
According to Oxford Dictionary, "Securitization means to convert an asset (specially a loan)
into marketable securities for the purpose of rising cashed or funds." Thus, the process of
securitization involves 'pooling of assets and selling these to investors through a specialized
intermediary created for this purpose.
For exampIe: An individual having regular inflows by way of rent from property can raise a loan by
offering his rent receivables as security, i.e., the rent receipts will first be used to pay the loan and
then for other purposes. Since the lender is assured of regular cash inflows, there is an enhanced
element of credit worthiness and therefore, he may offer the loan at a lower rate of interest. The
importance of securitization lies in the fact that it helps convert illiquid assets or future receivable
into current cash inflows and that too at a low cost. The company may sell the receivables in the
market and raise loans.
ExampIes of Securitization:
(1) City Bank carved out car loan portfolios to CC Bank.
(2) The Housing and Urban Dev. Corporation Ltd. (HUDCO) which financer infrastructure
finance, wanted to securitize its future receivables.
Nature/Features of Securitization
(1) MarketabiIity: The very purpose of securitization is to ensure marketability to financial
claims. Hence the instrument is structured in such a way as to be marketable. This is one of
the most important features of a securitized only to ensure this feature.
(2) MercantabIe QuaIity: To be market-acceptable, a securitized product should be of
saleable quality. This concept in case of physical goods, is something which is acceptable to
merchants in normal trade. When applied to financial products, it would mean that the
financial commitments embodied in the instruments are secured to the investments
satisfaction.
(3) Wide Distribution: The basic purpose of secularization is to distribute the product. The
extent of distribution which the originator would like to achieve is based on a comparative
analysis of the costs and the benefits that can be achieved. Wider distribution leads to a
cost benefit, in that the issuer is able to market the product with lower return and hence,
lower financial cost to him.
(4) Homogeneity: To serve as a marketable instrument, the instrument should be packed into
homogenous last. Homogeneity, like the above features is a function of retail marketing.

Mist securitized instruments are broken into lots affordable to the marginal investor and
hence, the minimum denomination becomes relative to the needs of the smallest investor.
(5) Integration and Differentiation: Securitization is the process of integration and
differentiation where the entity that securitizes its assets first pools them together into a
common hatched (assuming it is not one asset but several assets, as is normally the case).
This is the process of integration. Then, the poal itself is broken into instruments of fixed
denomination. This is the process of differentiation.
(6) De-construction: Securitization is the process of de-construction of an entity wherein, if one
envisages an entity's assets as being composed of claims to various cash flows, the process
of securitization would split apart these cash flows into different buckets, classify them and
sell those classified parts to different investors according to their needs, Thus, securitization
breaks the entity into various subsets.
Need for Securitization
(1) HeIping SmaII Investor: Financial claims often involve sizeable sums of money, clearly
outside the reach of the small investor. The initial response to this was the development of
financial intermediation, whereby an intermediary, such as a bank, would poal together the
resources of the small investors and uses the same for a larger investment need of the user.
(2) FaciIitating Liquidity: Small investors are typically not in the business of investments and
hence, liquidity of investments is most critical for them. Underlying financial transactions
need investments over a fixed time ranging from a few months to may be a number of years.
This problem could not even be sorted out by financial intermediation, since if the
intermediary provided a fixed investment option to the seekers and itself sought funds with
an option for liquidity, it would get caught in a serious problem of mismatch. Hence the
answer is a marketable instrument.
(3) UtiIity of Instruments: Generally, instruments are easily understood than financial
transactions. An instrument is homogenous, usually made in a standard form and generally
containing standard issues obligations. Besides, an important part of investor information is
the quality and price of the instrument and both are for easier known in case of the
instruments than in case of underlying financial transactions.
Parties InvoIved in Securitization
(1) Originator: The Originator also interchangeably referred to as the Seller- is the entity whose
receivable portfolio forms the basis for Asset Backed Security (ABS) issuance.
(2) SpeciaI Purpose VeicIe (SPN): Special Purpose Vehicle (SPV), which as the issue of the
ABS ensures adequate distancing of the instrument from the originator.
(3) Investors: The investors may be the form of individuals or institutional investors like FRs,
mutual funds etc. They buy a participating interest in the total poal of receivables and
receive their payment in the form of interest and principal as per agreed pattern.
(4) Oter Parties:-
(i) ObIigor: The obligor is the originator's debtor (borrower of original loan).
(ii) Servicer: The Servicer, who bears all administrate responsibilities relating to the
securitization transaction.

(iii) Trustee: The trustee or the investor representative, who act, in a fiduciary capacity
safeguarding the interests of investors in the ABS.
(iv) redit Rating Agency: The Credit Rating Agency, which provides an objective
estimate of the credit risk in the securitization transaction by assigning a well-defined
credit rating.
(v) ReguIators: The regulators, whose principal concern relate to capital adequacy,
liquidity, and credit quality of the ABS, and balance sheet treatment of the
transaction.
(vi) Service Providers: Service provides such as Credit Enhancers and Liquidity
Providers.
(vii) SpeciaIist Functionaries: Specialist functionaries such, as legal and tax consuls,
accounting firms, poal auditors etc.
Securities Issued by SpeciaI Purpose Entity
Standard categories securities are:-
(1) Mortgage-Backed Securities (MBS), which are backed by mortgages;
(2) Asset-Backed Securities (ABS), which are mostly backed consumer debt;
(3) Collateralized Debt Obligations (CDO), which are mostly backed by corporate bonds or
other corporate debt.
Each segment of the market offers unique opportunities and risks, affecting the nature of the
underlying assets and market conventions that have evolved over time.
() Mortgage Backed Securities (MBS)
The securitization of assets historically began with, and in sheer volume remains dominated
by residential mortgages. The receivables are generally secured by way of mortgage over the
property being financed, thereby enhancing the compact for investors. This is because
mortgaged property does not normally suffer erosion in its value like other physical assets
through depreciation. Rather, it is more likely that real estate appreciates in value over time
further,
(1) The receivables are medium to long-term, thus catering to the needs of different categories
of investors,
(2) The receivables consist of a large number of individual homogenous loans that have been
underwritten using standardized procedures. t is hence suitable for securitization.
(3) n the US where it originated, these mortgages were also secured by guarantees from the
Government.
(4) The receivables also satisfy investor preference for diversification of risk, as the
geographical spread and diversify of receivables profile is very large.



- - - - - - - - - - - - - - - - - - - - ----
Excess Debt-Services-MBS
Collective Servicing
Agreement
ssuance of MBS

ssuance Proceeds

Purchase Price Purchase Receivables

Housing Finance
Loans
--------
Mortgage

(Mortgage-Backed Securitization)

[] Asset-Backed Securities:-
An asset-backed security is a security whose value and income payments are derived from
all collateralized (or "backed") by a specific pool of underlying assets. The poal of assets is typically
a group of small and illiquid assets that are unable to be sold individually. Poaling the assets into
financial instruments allows them to be sold to general investors; a process called securitization,
and allows the risk of investing in the underlying assets to be diversified because each security will
represent a fraction of the total value of the diverse poal of underlying assets. The poals of
underlying assets can include common payments from credit cards, auto loans, and mortgage
loans, to esoteric cash flows from aircraft lease, royalty payments and movie revenues.
(1) Housing/Home Equity Loans: Home Equity Loans allow a homeowner to borrow money by
pledging the house as collateral. Borrowers who want to borrow a relatively large amount of
money or who do not have good credit often find the home equity loan to be attractive.
Home equity is basically a second loan against the mortgage of a house. The
possibility of such a loan arises when the value of a house is more than the outstanding
value of a mortgage-quite likely situation after the first mortgage has been partly amortized.
The second lender takes a second mortgage over the house, normally secondary in priority
over the rights of the first lender, and provides funding. Normally, the home equity loan does
not find its application in the same house application of the money borrowed is normally not
controlled.
A home equity loan could either be a close-end loan, meaning the loan is paid off
over a stated period, or it may be a line of credit, i.e., one where the borrower pays regular
interest but continues to enjoy the line of credit as an overdraft against the value of the
house.





Servicer
Housing
Finance
Fund-ssuer
Founder
Holders
of MBS
Housing Finance
nstitution Originator
Consumers

Types of Home Equity Loans:


(i) Iosed End Home Equity Loan: n the borrower receives a lump sum amount at the time
to the closing and cannot borrow further. The maximum amount of money that can be
borrowed is determined by variables including credit history, income and the appraised
value of the collateral, among others. t is common to be able to borrow up to 100% of the
appraised value of the homeless any liens, although there are lenders that will go above
100% when doing over-equity loans.
Closed-end home equity loans generally have fixed rates and can be amortized for periods
usually upto 15 years, some home equity loans offer reduced amortization whereby at the
end of the term, a balloon payment is due. These larger lump-sum payments can be
avoided by paying above the minimum payment or refinancing the loan.
(ii) Open End Home Equity Loan: This is a revolving credit loan, also referred to as a Home
Equity Line of Credit (HELOC), where the borrower can choose when and how often to
borrow against the equity in the property, with the lender setting an initial limit to the credit
line based on criteria similar to those used for closed end loans. Like the closed end loan, it
may be possible to borrow upto 100% of the value of a homeless any lines. These lines of
credit are available up to 30 years, usually at a variable interest rate.
The minimum monthly payment can be as low as only the interest that is due.
Advantages of Housing/Home Equity Loans
Home equity loans are attractive to borrowers for a few main reasons:-
(i) They typically have a lower interest rate (or APR)
(ii) They are easier to quality for if one has bad credit.
(iii) Payments on a home equity loan may be tax deductable.
(iv) Borrowers can get relatively large loans with this type of loan.
(2) Auto Loans Securitization Market: Securitization of automobile loans began in 1985, and
from 1985 to 1987, it was the largest sector of the ABS market. By 2005, auto-loan
securitization had reached almost $220 billion. The securitization of auto loans is actually
the securitization of retail installment sales contracts that are backed by autos and light
trucks. The maximum maturity of the loan is 60 months and the loans pay principal and
interest on a monthly basis. These loans are packaged and sold are loan-backed securities
called Certificates of Automobile Receivables, or "CARS". They are usually pass through
securities, with both the principal and interest passed on directly to the certificate holders.
However, the pay0through structure has also been used (e.g. by GMAC) CAPs usually
involve a higher servicing fee than mortgage-backed securities because an auto loan
requires more monitoring. Moreover the value of the collateral (the car) tends to depreciate
somewhat unpredictably through time, compared to the value of a home. Nevertheless auto
loans are readily securitizable because they have predictable default rates, as well as
reasonably stable prepayment rates.
Ever since the emergence of the ABS market, auto loans have formed an important
segment. The interesting features of auto loan markets are high asset quality and case in
liquidation of delinquent receivables. n the securitized auto-loan market prepayment speed
is usually indicated by the "absolute prepayment rates". This rate represents the percentage
of the original loans that are expected to prepay every month. The emergence of an
alternative in form of asset-backed commercial paper has reduced the significance of auto
loan securitization but the activity in this segment is still important.

The payment structure of auto loans normally ranges between three to six years
which is ideal for direct pass through as well as collateralized bonds.
Types of Auto Loans:
(i) Prime ABS: Prime auto ABS are collateralized by loans made to borrowers with strong
credit histories.
(ii) Non-Prime ABS: Non-prime auto ABS consist of loans made to lesser credit quality
consumers which may have higher cumulative losses.
(iii) Sub-Prime ABS: Sub-prime borrowers will typically have lower incomes, tainted
credited histories, or both.
() oIIateraIized Debt ObIigations: Collateralized Debt Obligations are securitized interests in
poals of generally non mortgage assets. Assets (called collateral) usually comprise loans or
debt instruments. A CDO may be called a Collateralized Loan Obligation (CLO) or
Collateralized Bond Obligation (CBO) if it holds only loans or bonds, respectively. nvestors
bear the credit risks of the collateral. Multiple trenches of securities are issued by the CDO,
offering investors various maturity and credit risk characteristics. Tender are categorized as
senior, mezzanine, and subordinated/equity, according to their degree of credit risk. f there
are defaults or the CDO's collateral otherwise under performs, scheduled payments to senior
trenches take precedence over those of mezzanine trenches and scheduled payments to
mezzanine trenches take precedence over those to subordinated/equity trenches. Senior and
mezzanine trenches are typically rated, with the former receiving ratings of A to AAA and the
latter receiving rating of B to BBB. The ratings reflect both the credit quality of underlying
collateral as well as how much protection a given trends is afforded by trenches that are
subordinate to it.
Instruments of Securitization
(1) Pass troug ertificates: A pass through certificate is an instrument which signifies
transfer of interest in the receivable in favour of the holder of the pass through Certificate.
The investors in a pass through transaction acquire the receivables subject to all their
fluctuations, prepayment etc. The material risks and rewards in the asset portfolio, such as
the risk of interest rate variations, risk of prepayments, etc, are transferred to the investors.
Features of Pass troug ertificate:
(i) nvestors get a proportional interest in a poal of receivables.
(ii) Collections months after months are divided proportionally.
(iii) All investors receive proportional payments-no slower or faster repayment, through in
some cases, some investors may be senior over others.
(iv) No investment of cash collected by the SPN.
(2) Pay troug ertificates: n case of Pay through Certificates, the SPV invested of
transferring undivided interest on the receivables issues debt securities such as bonds,
repayable on fixed dates, but such debt securities intern would be backed by the mortgages
transferred by the originator to the SPV. The SPV may make temporary reinvestment of
cash flows to the extent required for bridging the gap between the dates of payments on the
mortgages along with the income out of reinvestment to retire the bonds. Such bonds were
called mortgage backed bonds.
Mecanism of Securitization
The crucial link in the securitization chain is the creation of a special purpose Vehicle (SPV),
which intermediates between the primary market for the underlying asset and the secondary market
for the asset backed security. The steps involved in the securitization process are the following:-

(1) The originator or lending institution identifies the assets out of its portfolio for securitization.
The identification of the assets has to be done in a manner so that an optimum mix of
homogeneous assets having almost same maturity forms the portfolio.
(2) The aforementioned poal of identified assets is then "passed through" to another institution,
called a special purpose Vehicle (SPV) usually by way of trust. Such trust, which is usually
an investment banker, issues the securities to investors. So once the assets are
transference they are no longer held in the originator's portfolio.
(3) After acquisition of the assets, the SPV splits the pool into individual shares or securities
and reimburses itself by selling these to investors. These securities are known as pay of
pass through certificates. These securities are normally without resource to the originator
Thus, investor can hold only 'SPV' liable for principal repayment and interest recovery.
(4) n order to make the issues attractive, the SPV enters into credit enhancement procedures
either by obtaining an insurance policy to cover the credit losses or by arranging a credit
enhancement procedures either by obtaining an insurance policy to cover the credit losses
or by arranging a credit facility from a third party lender to cover the delayed payments. To
increase marketability of the securitized assets in the form of securities, these may be rated
by some reputed credit rotting agencies as CRSL, CARE and CRA etc. Credit rating
increases the trading potential of the certificate, thus, its liquidity is enhanced. The investor's
confidence is heightened owing to the third party objectivity of the rating agencies. The pass
through certificates before maturity is trade able in a secondary market to ensure liquidity
forth investors. Once the end investor gets hold of these investors. Once the end investor
gets hold of these instruments excreted out of securitization, he is to hold it for a specific
maturity period which is well defined with all other related terms and conditions. On maturity,
the end investors get redemption amount from the issuer along with interest due on the
amount.



Credit Enhancement, Liquidity
nterest and Support, Forex and nterest Rate
Principal Hedging, etc.



Sales of Asset ssues of Securities
Servicing of
Securities

Consideration for Subscription of
Assets Purchased Securities

Credit Rating
of Securities




Obligor(s)
Ancillary Service
Providers
Special Purpose
Vehicle
(SPV)
Originator
nvestor
Rating Agency
Structure

Securitization in India
Securitization is a relatively new conception ndia but is gaining ground quite rapidly. CRSL
rated the first securitization program in ndia in 1991 when Citibank securitized a poal from its auto
loan portfolio and placed the paper with GC Mutual Fund. Since then, securitization of assets has
begun to emerge as a clear option of fund raising by corporates and a few transactions of well rated
companies have taken place in the country.
CRSL has rated about 50 transactions till date with volume aggregating to well over Rs.
4,500 crore. Other rating agencies in ndia, viz., CRA, DCR, and CARE, have also been actively
involved in the process.
As per an estimate out of the total asset securitization attempted between 1992 and 1998, as
much as 35% relates to hire purchase receivable of truck and auto loan segment. The car loan
segment of the auto loan market has been more successful than the commercial vehicle loan
segment mainly because of factor such as perceived credit risk, higher volumes and homogeneous
nature of receivables.
So far, "Securitization in ndia was meant to imply any of the following distinct activities:
(1) Structured Obligations against receivables (whether loans or debentures/bends)
(2) Outright sale of financial/trade receivables without issue of securities.
(3) Securitization transactions involving assignment of receivables to any SPV and issue of
securities backed by these receivables.


DeveIopment FinanciaI Institution
Specialized and hybrid financial institutions that are engaged in the provision of financial and other
assistance for the purpose of undertaking long-term development activities in certain identified
sectors of the economy such as small scale sector, exports promotion, industrial development,
agricultural development etc are known as 'development banks'.
Development banks are financial agencies that provide medium and long-term financial
assistance and act as catalytic agents in promoting balanced development of the country. They are
engaged in promotion and development of industry, agriculture and other key sectors. They also
provide development services that can aid in the accelerated growth of an economy.
Objectives of DeveIopment Banks
(1) To serve as an agent of development in various sectors, viz., industry, agriculture, and
informational trade.
(2) To accelerate the growth of the economy.
(3) To allocate resources to high priority areas.
(4) To foster rapid industrialization, particularly in the private sector, so as t5o provide
employment opportunities as well as higher production.
(5) To develop entrepreneurial skills.
(6) To promote the development of rural areas.
(7) To finance housing, small scale industries, infrastructure and social utilities.
n addition, they are assigned a special role in:
(1) Planning, promoting and developing industries to fill the gaps in industrial sector.
(2) Coordinating the working of institutions engaged in financing, promoting or developing
industries, agriculture or trade.
(3) Rendering promotional services such as discovering project ideas, undertaking feasibility
studies and providing technical, financial and managerial assistance for the implementation
of projects.


DeveIopment FinanciaI Institutions (DFI) in India
The need for development financial institutions war felt very strongly immediately after ndia
attained independence. The country needed a strong capital goods sector to support and
accelerate the pace of industrialization. The existing industries required long-term funds for their
reconstruction, modernization expansion and diversification programs while the new industries
required enormous investment for setting up gigantic projects in the capital goods sector. However,
there were gaps in the banking system and capital markets which needed to be filled to meet this
enormous requirement of funds.




All ndia Specialized Financial nvestment Reference
Development Bank nstitutions nstitutions nstitutions

DB (1964) EXM Bank UT (1964) NABARD
CC (1955) CC Venture UC (1956) (1982)
SDB (1990) (Formerly TDC) (1988) GC & Subsi- NHB (1980)
B (1997) TFC (1989) daries (1972)
FC (1948) DFC (1997)






SFCs (18) SDCs(28)




ECGC (1957) DCGC(1962)
OrganizationaI Structuring of FinanciaI Institutions]

IndustriaI DeveIopment Bank of India (IDBI)
The ndustrial Development Bank of ndia was established under the ndustrial Development Bank
of ndia Act, 1964, as a wholly owned subsidiary of the Reserve Bank of ndia. The ownership of
DB has since been transferred to Control Government from February 16, 1976. The main objective
establishing DB has since been transferred to Control Government from February 16, 1976. The
main objective establishing DB was to set up an apex institution to co-ordinate the activities of
other financial institutions and to act as a reservoir on which the other financial assistance to
industrial units also to bridge the gap between supply and demand of medium and long term
finance.
Management of IDBI
The management of DB is vested with the Board of Director consisting of 22 members
nominated by the Central Government. Representation is also given to the RB, other financial
All ndia Financial nstitutions
All Financial
nstitutions
State Level nstitutions
Other nstitutions

institutions and employees in the Board of Directors. The Board constitutes different Committees in
order to assist in its operations.
Objectives of IDBI
(1) To co-ordinate, supplement and integrate the activities of other existing financial institutions
including commercial banks.
(2) To provide term-finance to industry.
(3) To provide direct financial assistance to industrial concerns.
Functions of IDBI
(1) To co-ordinate the activities of other institutions providing term finance to industry and to act
as an apex institution.
(2) To provide refinance to financial institutions granting medium and long-term loans to
industry.
(3) To provide refinance to scheduled banks or co-operative banks.
(4) To provide refinance for export credits granted by banks and financial institutions.
(5) To provide technical and administrative assistance for promotion, management or growth of
industry.
(6) To undertake market surveys and techno-economic studies for the development of industry.
(7) To grant direct loans and advances to industrial concerns.
(8) To render financial assistance to industrial concerns.
IndustriaI redit and Investment orporation of India
The World Bank was helping the setting up of development banks in underdeveloped
countries. CC was one of such banks which were set up in ndia in January, 1995 the ownership
of the corporation was entirely in private hands but certain safeguards were contemplated against
the acquisition of control by vested interests.
CC provides funds of various kinds. The primary purpose for which funds are made
available by the corporation is the purchase of capital assets such as land, building and machinery.
Management of III
A Board of Directors consisting of both ndian and Foreign Directors manages the CC. The
Board of Directors is assisted by a number of committees in day to day operations of the
corporation.
Objectives and Functions of III
The corporation has been established for the purpose of assisting industries in the private
sector by undertaking the following functions:-
(1) Assisting in the creation, expression and modernization of such enterprises.
(2) Encouraging and promoting the participation of private capital, bath internal and external.
(3) Encouraging and promoting private ownership.
(4) Expansion of investment market.
(5) Provide finance in the form of long or medium-term loans.
(6) Underwriting issues of shares and debentures.
(7) Making funds available for re-investment.
(8) Furnishing managerial technical and administrative, services to ndian ndustry.
(9) To advance loans in foreign currency towards the cost of imported capital equipment.

FinanciaI Resources of III


The CC was constituted with an authorized capital of Rs. 100 crores. ts paid-up capital was
subscribed by ndian and foreign private institutions, LC, scheduled commercial banks, joint stock
companies and individuals. The corporation is permitted to augment its resources through the issue
of debentures and by resorting to borrowings from the Government of ndia, World Bank, U.K.
Government and Agency for nternational Development.
IndustriaI Finance orporation of India (IFI)
The ndustrial Finance Corporation of ndia was established in 1948 under the FC Act, 1948.
The main objectives of the corporation have been to provide medium and long-term credit to
industrial concerns in ndia.
The financial assistance of the corporation is available to limited companies or co-operative
societies registered in ndia and engaged or proposing to engage in manufacture, preservation or
processing of good. (b) the mining industry (c) the shipping business; (d) the hotel industry; and (e)
the generation or distribution of electricity or any other form of power.
Management of IFI
The management of the FC is vested in Board of Directors which includes one full-time
chairman appointed by the Central Government in consultation with the board. The Board consists
of 12 Directors, of which two are nominated by the Central Government four by DB, two by
Scheduled Commercial Banks, two by Cooperative Banks and the remaining two are elected by
other shareholder- institutions. The head office of the FC is in New Delhi. t has its regional and
branch offices in other parts of the country.
Functions of IFI
The functions of FC can be broadly classified into:-
1) FinanciaI Assistance: The FC is authorized to render financial assistance in one or more
of the following forms:-
(i) Granting loans or advances to or subscribing to debentures of industrial concerns repayable
within 25 years.
(ii) Underwriting the issue of industrial securities i.e. shares, banks or debentures to be
disposed off within 7 years.
(iii) Subscribing directly to the shares and debentures of public limited companies.
(iv) Guaranteeing of differed payments for the purchase of capital goods from abroad or within
ndia.
(v) Acting as an agent of the Central Government or the World Bank in respect of loans
sanctioned to the industrial concerns.
Financial Assistance is available from FC for the following purposes"-
(i) For the setting up of new industrial undertakings.
(ii) For expansion or diversification of the existing concerns.
(iii) For the modernization and renovation of the existing concerns.
(iv) For meeting existing liabilities or working capital requirement of industrial concerns in
exceptional cases.
2) PromotionaI Activities: The Corporation discovers the opportunities for promoting new
enterprises. t helps in developing small and medium scale entrepreneurs by providing them
guidance through its specialized agencies in identification of projects. Preparing project

profiles, implementation of the projects, etc, it acts an instrument of accelerating the


industrial growth and reducing regional industrial and income disparities.
FinanciaI Resources of IFI
The Financial resources of the Corporation comprises: ownership capital, borrowings from Central
Government and the market by issue of bonds as mentioned below:
(1) The corporation had an original authorized capital of Rs. 100 crores which was later
increased to Rs. 259 crores.
(2) The Corporation is authorized to issue and sell bonds and debentures for raising its working
capital.
(3) The Corporation is also authorized to borrow from the Central Government, Reserve Bank of
ndia and ndustrial Development Bank of ndia and to accept deposits from the public, State
Governments and local authorities for a period of less than 5 years.
(4) The Corporation is also empowered to raise money from foreign financial institutions in the
respective foreign currency.
NABARD
n the light of the recommendations of the Committee to Review Arrangements for ndustrial
Credit for Agriculture and Rural Development, the Government of ndia setup the National Bank for
Agriculture and Rural Development (NABARD) on July 12, 1982, to act as an agency for promoting
integrated rural development and to provide all sorts of production and investment credit for
agriculture and rural development.
Objective of NABARD
(1) To give undivided attention and purposeful direction to integrated rural development.
(2) To act as a centre piece for the entire rural credit system at the national level.
(3) To act as a provide of supplement funding to rural credit institutions.
(4) To arrange for investment credit to small industries, village and cottage industries,
handicrafts and other rural crafts, artisans and farmers.
(5) To improve the credit distribution system by institution building, rehabitation of credit
institutions and training of bank personnel.
(6) To provide refinance facilities to SLDBs, SCBs, RRBs and commercial banks for
development purposes in rural areas.
(7) To coordinate the working of different agencies engaged in development work in rural areas
at the regional levels and to have liaison with Government of ndia, RB, State Governments
and other policy making institutions at the national level.
(8) To inspect monitor and evaluate projects getting refinance from the NABARD.
Management of NABARD
The NABARD is managed by a Board of Directors, consisting of Chairman, Managing
Director, 2 Directors from amongst experts in rural economics, rural development etc., 3 directors
from out of the in the working of cooperative banks, 3 director from out of the directors of the RB,
3 directors from amongst the officials of the Government of ndia and 2 directors from among the
officials of State Governments. They are appointed by the Central Government.
The NABARD stated with a capital of Rs. 100 crores which has an equal proportion held by
the Government of ndia and the Reserve Bank. The NABARD has replaced the Agricultural
Refinance Development Corporation (ARDC) by taking over the entire assets and liabilities of the
latter. The bank is also authorized to accept deposits for over a year from the Central, State arid
local governments, scheduled commercial banks, etc.

Functions of NABARD
The functions of NABARD have been divided into three categories:-
(1) Credit Distribution
(2) Development
(3) Regulatory
(1) redit Distribution: The NABARD provides refinance of various types to the following
institutions:-
(i) Sort Term redit: t provides short term credit to State Cooperative Banks (SCBs),
Regional Rural Banks (RRBs), and other financial institutions approved by the RB for the
following purposes:-
(a) Seasonal agricultural operations.
(b) Marketing of agricultural produce.
(c) Other activities related to rural/agriculture sector.
(d) Real commercial trade activities.
(e) Production and marketing of the following activities handicrafts, small industries, village
and cottage industries, artisans, silk industry etc.
(ii) Medium Term redit: The NABARD provides medium term credit to SCBs, KDBs, RRBs
and other approved institutions for a period ranging from 18 months to 7 years. The
medium term loans are given for investment schemes, relating to agriculture and rural
sector.
(iii) Long-Term redit: The NABARD provides long term credit to State Land Development
Banks, RRBs, Commercial Banks, SCBs and to any approved financial institution.
(iv) Refinancing of Industries in RuraI Areas: The NABARD provides refinancing facilities to
all small, village and cottage industries in rural areas.
(2) DeveIopment Functions: The NABARD performs the following development functions:-
(i) Coordinate the rural credit institutions.
(ii) Develops specialization to solve problems relating to agriculture and villages.
(iii) Helps the government, RB and other institutions in their rural development, RB and
other institutions in their rural development efforts.
(iv) Acts as an agent of the Government and RB for monitoring work in agricultural related
areas.
(v) Provides facilities for research and training to the staff of RRBs, SCBs, LDBs, etc, and
promotes research in agricultural and rural development activities out of its R&D Fund.
(vi) Spreads information regarding rural banking and development.
(vii) Provides direct credit incases approved by the Central Government connected with
agricultural and rural development.
(3) ReguIatory Functions:
(i) t inspects the working of RRBs and cooperative banks of all types except the primary
cooperative banks,
(ii) t also inspects apex cooperative marketing federations, state handloom weaving
societies etc. which are financed on voluntary basis.
(iii) All applications for opening of a branch by the RRB or a cooperative bank, other than a
primary cooperative society, are required to be submitted to the RB or a cooperative
banks, other than a primary cooperative society, are required to be submitted to the
RB through the NABARD.
(iv) t is empowered to obtain any information or statement from the RRBs and cooperative
banks.

RegionaI RuraI Banks (RRBs)


The idea of establishing Regional Rural Banks was moved in the Twenty Point Economic
Programme of July 1975 to cater to the credit needs of rural people. The Government of ndia
appointed the Narasimham Committee in July 1975 to set up the new institution in order to:-
(1) Provide employment to the rural educated youth,
(2) Bring down the cost of rural banks by recruiting their staff on the same scale of pay and
allowances as for the employees of State Government/local bodies.
t was on the recommendation that the first five RRBs were set up on 2 October 1975 under
an ordinance promulgated on 26 September 1975 which was replaced by the Regional Rural Bank
Act of 1976.
Management of RRBs
The RRB is governed by a Board of Directors who exercises all the powers and discharges all
the functions of RRB. t consists of a chairman appointed by the Central Government for five years,
three directors nominated by the Central Government, two directors nominated by the concerned
State Government and three director nominated by the sponsor bank. Usually the Chairman of the
RRB belongs to the sponsor banks; through he is nominated by the Central Government.
The authorized capital of an RRB at present is Rs. 5 crores. The issued share capital is Rs.
1 crore now and is subscribed by the Central Government, the sponsor bank and the concerned
State Government in the ratio of 50:35:15. The Government of ndia raised the issued share capital
of 27 RRBs from Rs 50 lakh to Rs. 75 lakh and of 47 RRBs from Rs. 75 lakh to Rs. 1 crore during
1994-95. This has raised the number of RRBs having issued capital of Rs 1 crore to 62 and those
having issued capital of Rs 75 lakh to 122.
Functions of RRBs
(1) To grant loans and advances to the weaker sections of the rural population, especially to the
small and marginal farmers, agricultural laborers, artisans and small entrepreneurs who are
engaged in agricultural, trade, commerce, industry and other productive activities.
(2) To grant loans and advances to co-operative societies including marketing societies,
agricultural processing societies, cooperative farming societies, primary agricultural credit
societies of farmers service societies for agricultural purposes.
(3) To take the banking services to the doorsteps of the rural masses.
(4) To mobilize rural savings by accepting deposits and channelize them for productive
activities in the rural areas.
(5) To create a supplementary channel for flow of credit from the urban money market to the
rural areas through refinances.
(6) To generate employmentary channel for flow of credit from the urban money market to the
rural areas through refinances.
(7) To bring down the cost of supplying credit in rural areas.
State LeveI Institutions
Several Financial nstitutions have been set up at the State level, which supplement the
financial assistance provided by the all ndia institutions. They act as a catalyst for promotion of
investment and industrial development in the respective states. They broadly consist of 'State
financial corporations' and "state industrial development corporations'.
(1) State FinanciaI orporation (SFs): SFCs are the State-level financial institutions which
play a crucial rule in the development of small and medium enterprises in the concerned
Stages. They provide financial assistance in the form of term loans, direct subscription to
equity/debentures quarantines, discounting of bills of exchange and seed/special capital,

etc. SFCs have been set up with the objective of catalyzing higher investment, generating
greater employment and widening the ownership base of industries. They have also started
providing assistance to newer types of business activities like floriculture, tissues culture,
poultry farming commercial complexes and series related to engineering, marketing etc.
Objectives of SFs
SFCs were established to provide financial assistance to medium and small-scale industrial
concerns which are outside the scope of the FC. The scope of the SFCs activities includes public
limited companies and also private limited companies, partnership firms and proprietary concerns.
Functions of SFs
The main functions of the SFCs is to provide loans to small and medium scale industries
engaged in the manufacture, preservation or processing of goods, mining, hotel industry,
generation or distribution of power, transportation, fishing, assembling, repairing or package articles
with the aid of power, etc. State Financial Corporation is authorized to grant financial assistance in
the following forms:-
(i) Granting of loans or advances to industrial concerns repayable within a period not
exceeding twenty years.
(ii) Subscribing to the debentures of industrial concerns repayable within a period not
exceeding twenty years.
(iii) Guaranteeing loans raised by industrial concerns repayable within a period not exceeding
twenty years.
(iv) Underwriting the issue of stock, shares, banks or debentures by the industrial concerns
subject to their being disposed off within seven years.
(v) Guaranteeing differed payments due from any industrial concerns in connection with
purchase of capital goods in ndia.
(vi) Acting as an agent of the Central Government or State Government.
[2] State IndustriaI DeveIopment orporation (SIDs)
SDCs have been established under the Companies Act, 1956, as wholly-owned undertakings
of State Governments. They have been set up with the aim of promoting industrial development in
the respective States and providing financial assistance to small entrepreneurs. They are also
involved in setting in setting up of medium and large industrial projects in the joint sector/assisted
sector in collaboration with private entrepreneurs or wholly-owned subsidiaries. They are
undertaking a variety of promotional activities such as preparation of feasibility reports, conducting
industrial potential surveys, entrepreneurship training and development programmes, as well as
developing industrial areas/estates.
Functions of SIDs
(i) Grant of Financial assistance.
(ii) Provision of industrial sheds or plots.
(iii) Promotion and management of industrial concerns.
(iv) Promotional activities such as identification of project idea, selection and training of
entrepreneur, provision of technical assistance during project implementation.
(v) Providing risk capital to entrepreneur by way of equity participation and seed capital
assistance.


Non Banking FinanciaI ompanies (NBFs)


The financial institutions which provide the various banking facilities but are not termed as
banks because they do not hold the banking license are known as the Non-Banking Financial
nstitutions. t is a company registered under the Companies Act, 1956. Non-banking finance
companies consist mainly of finance, housing finance, investment, loan, equipment leasing or
mutual benefit financial companies but do not include insurance or stock exchanges or stock-
broking companies.
t may be noted that a company carrying on any of the following activities as its principal
business is not an NBFC:-
(1) Agricultural Operations
(2) ndustrial Activity.
(3) Purchase or sale of any goods (other than securities) or providing of any services.
(4) Purchase, construction or sale of immovable property so however, that no portion of the
income of the institution is derived from the financing of purchase constitution or sale of
immovable property by other persons.
(5) The Company will be treated an NBFC, if its financial assets are more than fifty percent of its
total assets (needed-off by intangible assets) and its income from financial assets is more
than fifty percent of the gross income. Both these tests are required to be satisfied as the
determinant factor for principal business of a company.
(6) A company cannot commence on carry on business as an NBFC unless it is registered with
RB.
Functions of NBF
Following are the functions of NBFC:
(1) Brokers of LoanabIe Funds: They act as broker of loan able funds and in this capacity
they intermediate between the ultimate saver and the investor. They sell indirect securities
to the savers and purchase primary securities from investors. Thus, they change debt into
credit, By doing so, they take risks ion themselves and reduce the risk of the ultimate
lenders.
(2) MobiIization of Savings: The NBC mobilize savings for the benefit of the economy. By
providing financial services like easy liquidity, safety of the principal amount and ready
divisibility of savings into direct securities of different values they are able to mobilize more
funds and attract larger share of public savings.
(3) anneIization of Funds into Investment: The NBFCs, by mobilizing public savings
channelize them into productive investments; each intermediary follows its own investment
policy.
(4) StabiIize te apitaI Market: The NBFC trade in the capital market in a variety of assets
and liabilities and thus equilibrate and demand for and supply of assets. Since they function
within a legal framework and rules they protect the interests of the savers and bring stability
to the capital market.
(5) Provide Liquidity: Since the main function of the NBFCs is to convert a financial asset into
cash easily, quickly and without loss in the capital values they provide liquidity. They are
able to do so, because:-
(i) They advance short-term loans and finance them by issuing claims against themselves
for long periods, and
(ii) They diversify loans among different types of borrowers.
Types of Services Provided by NBFS
(1) Hire Purcase Services: Hire purchase is the legal term for a conditional sale contract with
an intention to finance consumers towards vehicles, white goods etc. f a buyer cannot

afford to pay the price as a lump sum but can afford to pay a percentage as a deposit, the
contract allows the buyer to hire the goods for a monthly rent. f the buyer defaults in paying
the installments, the owner can repossess the goods. H.P. is a different form of credit
system among other unsecured consumer credit system and benefits.
(2) Leasing Services: A lease or tenancy is a contract that transfers the right to possess
specific property. Leasing service includes the leasing of assets to other companies either
on operating lease or finance lease. An NBFC may obtain license to commence leasing
services subject to, they shall not hold, deal or trade in real estate business and shall not fix
the period of lease for less than 3 years in the case of any finance lease agreement except
in case of computers and other T accessories.
First Century Leasing Company Ltd., Sundram Finance Ltd. is some of the Leasing
companies in ndia.
(3) Housing Finance Services: Housing Finance Services means financial services related to
development and construction of residential and commercial properties. An housing finance
company approved by the National Housing Bank may undertake the services/activities
such as providing long-term finance for the purpose of constructing, purchasing or
renovating any property.
CC Home Finance Ltd, LC Housing Finance Co. Ltd., HDFC are some of the housing
finance companies in ndia.
(4) Asset Management ompany: Asset management company is managing and investing
the poaled fund of retail investors in securities in line with the stated investment objectives
and provides more diversification, liquidity and professional management service to the
individual investors.
Mutual fund comes under this category. Most of the financial institutions having their
subsidiaries as Asset Management Company like SB, BOB, UT and many others.
(5) Venture apitaI ompanies: Ventures capital finance is a unique form of financing activity
that is undertaken on the belief of high-risk-high-return Venture capitalist invest in those
risky projects or companies (ventures) that have success potential and could promise
sufficient return to justify such gamble.
CC ventures and Gujarat venture are one of the first venture capital organizations
in ndia and SDB, DB and others also promoting venture capital finance activities.
Strategy/ReguIations/PoIicy of NBFs
NBFC have been rendering many useful services, several adverse, unhealthy features of
their working also have been observed. The protection of savers from malpractices has been one of
the appropriate regulatory/statutory framework to observe the operations of NBFCs.
NBFC have been rendering many useful services, several adverse, unhealthy features of their
working also have been observed. The protection of savers from malpractices has been one of the
important issues. The authorities have evolved an appropriate regulatory/statutory framework to be
serve the operation of NBFCs.
At present all NBFCs except HFCs are regulated by the RB. With the enactment of RB
(Amendment) Act, 1997, they have been brought under the jurisdiction of RB. All of them with net-
owned funds of Rs 25 lakh and above have to register with the RB now.
The major regulatory provisions currently in force are as given below:-
(1) The minimum net owned funds of Rs 25 lakh and RB registration are the entry points norms
now.

(2) NBFC have to maintain 10 and 15 percent of their deposits in liquid assets effective from
January 1 and April 1, 1998, respectively.
(3) They have to create reserve fund and transfer not less than 20 percent of their net deposits
to it every year.
(4) The RB can now direct them on issues of disclosures, prudential norms, credit, investment,
etc.
(5) Nomination Facility is now made available to depositors of these companies.
(6) Unincorporated bodies engaged in financial activity can not accept deposits from the public
from April 1, 1997.
(7) They have to achieve a minimum capital adequacy norm of eight percent by March 31,
1996.
(8) They have to obtain a minimum credit rating from any one of the three credit rating
agencies.
(9) A ceiling of 15 percent interest rate on deposits has been prescribed for NBFCs or niches,
effective from July 8, 1996.
urrent Status of NBF in India
NBFCs have improved their operations and strategies. ndustry experts opine that they are
much more mature today than they were during the last decade. Timely intervention of RB helped
to reduce the negative effect of credit crunch on banks and NBFCs. n fact, aggressive strategies
helped LC Housing Finance to grab new customers (including customers of the other banks) and
increase its market share in national mortgage market. Surprisingly it was able to maintain its profit
ability in 2009 (around 37%). HDFC, the largest NBFC in ndia, however experienced a slowdown in
customer growth due to stiff competition, especially from LC Housing Finance and tight monetary
conditions.
Other NBFCs that were stable during this period of credit crunch are nfrastructure
Development (PFC) and Rural Electrification Corporation (REC). Growth prospects are strong for
these companies given the acute shortage of power in the country and expected increase in
demand for infrastructure projects.
The segment which was hit hardest was Vehicle Financing. Companies financing new Vehicle
purchases experienced a drastic reduction in new customer's numbers. Fortunately, since vehicle
finance is asset based business, their asset quality did not suffer as against other consumer
financing businesses, Contrary to this, Shriram Transport Finance, the only NBFC which deals in
second-hand vehicle financing was able to maintain its growth primarily due to its business model
which does not entirely depends on health of the auto industry.
Meaning and Definition of Insurance
nsurance may be described as a social device to reduce or eliminate risk of loss to life and
property. nsurance is a collective bearing of risk. nsurance spreads, the risks and losses of few
people among a large number of people as people prefer small fixed liability instead of big uncertain
and changing liability. nsurance is a scheme of economic cooperation by which members of the
community share the unavoidable risks.
nsurance can be defined as a legal contract between two parties whereby one party called
insurer undertaken to pay a fixed amount of money on the happening of a particular event, which
may be certain or uncertain. The other party called insured pays in exchange a fixed sum known as
premium.

aracteristics of Insurance:
(1) Risk Saring: nsurance is considered as a device to share the financial loss which might
affect the individual or his/her family members. The unforeseen event may be death of a
breadwinner of a family in case of life insurance, dangers associated with the sea in case of
general insurance, theft or damage to vehicle in case of motor insurance. The loss arising
from these damages can be compensated if they are insured by paying the required
premium
(2) Risk Assessment: Evaluation of risk is the important factor that decides on the amount of
premium to be calculated. When the threat perception is more, a higher premium will be
charged. There are different ways of evaluating the risk and the probability of loss is
evaluated at the time of insurance.
(3) Payment at te time of ontingency: The insurance compensates the insured by paying
compensation in the event of loss; i.e., payment is made at the time of contingency. For
payment to be made there is a prerequisite of contingency to happen.
(4) Quantum of ompensation: The value of compensation depends on the extent of loss
suffered by the insured from a particular risk provided the maximum capped value is not
surpassed. n case of life insurance, the claim is settled for which it was inspired provided
that at the happening of the event the policy is valid and in force. n case of property and
general insurance, the dependents will be required to prove the happening and the extent of
damage caused.
(5) Large te Number, Better te are: The number if insured persons shall be large enough
to spread the loss immediately, smoothly and economically. When the number if insured is
smaller, it would translate into a higher premium and hence it becomes unaffordable and
unpopular.
(6) Insurance by oice and not by ance: The productivity of a community is increased by
means of insurance because it eliminates worry and increases the initiatives. The
uncertainty is changed to certainty because the insurance gives the assurance to
compensate the loss monetarily in the event of loss. For example, in the absence of
property insurance, the choice left to the property owner is limited and he could not get full
protection to the whole property. Similarly in case of life insurance, in the absence of life
coverage, the time taken to accumulate a considerable saving takes a longer time where as
death may happen at any time and in the event of loss of brad winner of the family, the other
members have to fend for themselves.
(7) Insurance, a arity: Charity is practiced without giving consideration whereas insurance is
a business and without premium it is not possible to run the business. t offers security and
safety to the individual and society in return of premium and thereby compensates the loss
suffered. t is a well laid out business or profession, wherein the loss is adequately
compensated in a timely manner.

Types/ategories of Insurance

Life nsurance General nsurances

There are mainly two types of insurance in ndia, i.e., life insurance and general insurance.
(1) Life Insurance: n a life insurance policy the amount of policy is paid either on the death
ever is earlier. LC has a monopoly of life insurance. Life private and foreign insurances. n
1956, life insurance was nationalized and LC was set-up by taking over the business of
about 245 large and medium companies doing business of life insurance.
Benefits of Life nsurance:

(i) Safeguards the insured family against an untimely death and provides for a secured
income.
(ii) s a means of compulsory savings.
(iii) s a source of income during old age.
(iv) Helps in meeting certain periodic financial needs, either for a Childs education or
marriage.
(v) mproves the life style of the insurance and his family.
(vi) Takes care of disabilities and uncertain future adversities of life.
(vii) Brings in tax-benefits under section 88 of the ncome Tax Act, 20 percent of the
contributions made towards life insurance premiums quality for deductions from total tax
payable.

Life Insurance Products
(i) Term Insurance: Term insurance provides for life insurance protection for the selected
term (period of years) only. n case the person (whose life is insured) dies during the
term, the benefits are payable under the policy and in case of his survival till the end of
the selected term the policy normally expires without any benefit becoming payable.
(ii) WoIe Life Insurance: As the name suggests, the whole life insurance policies are
intended to provide Life nsurance protection over one's lifetime. The essence of whole
life insurance is that it provides for payment of the assured amount upon the insured's
death regardless of when it occurs.
(iii) Endowment Assurance: These are the most commonly sold policies. These policies
assure that the benefits under the policy will be paid on the death of the life insured
during the selected term or on his survival to the end of the term. Hence the assured
benefits are payable either on the date of maturity or on death of the life insured, if
earlier.
(iv) Annuities: An annuity is a serious of periodic payments. An annuity contract is an
insurance policy, under which the annuity provides (insurer) agrees to pay the purchases
of annuity (annuitant) a series of regular periodical payments for a fixed period or during
someone's life time.
[2] GeneraI Insurance: n case of general insurance the loss is indemnified. There may or
may not be a loss in general insurance. The money received from people is in the custody of
insurance companies as trustees. The funds at the disposal of these companies are judiciously
used by keeping in view safety, and liquidity. Though return on these funds is important but safety
factor cannot be ignored. These funds cannot be speculative activities.
nsurance funds play an important role in the economic development of only country. This role
is all the more signifcant in ndia because of resource crunch. The development activities need
more and more finances and insurance companies can help in this area. These companies can
finance industrial ventures and thus add to the strength and stability to the national economy.

GeneraI Insurance Products
(i) Fire Insurance: Fire insurance provides protection against damage to property caused
by accidents due to fire, lightning or expansion, whereby the explosion is caused by
boilers not being used for industrial purpose.
(ii) AutomobiIe Insurance: Automobile insurance also known as auto insurance, car
insurance and motor insurance, is probably the most common form of insurance and
may cover both legal liability claims against the driver and loss of or damage to the
vehicle itself.

(iii) HeaIt Insurance: Health nsurance, or Health cover, is defined in the Registration of
ndian nsurance Companies Regulations, 2000, as the effecting of contracts which
provide sickness benefits or medical, surgical, hospital expenses benefits whether in
patient or out patient, on an indemnity, reimbursements, service, prepaid, hospital or
other plans basis, including assured benefits and long-term case.
(iv) Marine Insurance: Marine nsurance basically covers three rick areas, namely, hull,
cargo and collectively known as "perils of the Sea". These perils include theft, fire,
collision, etc.
(v) Business and commerciaI Insurance: This caters to the need of business insurance
requirement provides wide coverage to property at work, e.g. offers protection against
loss/damage to the building and its contents. t also covers liabilities of employers,
buyers and users.
(vi) PoIiticaI Risk Insurance: Political risk insurance can be taken out by businesses with
operations in countries in which there is a risk that revolution or other political conditions
will result in a loss.
(vii) ProfessionaI Indemnity Insurance: Professional ndemnity nsurance is normally a
mandatory requirement for professional practitioners such as Architects, Lawyers,
Doctors and Accountants to provide insurance cover against potential negligence claims.
(viii) Property/asuaIty Insurance: Provides Protection for properties like home, car and
household possessions. t may also protect from liability as a result of their use.
(ix) redit Insurance: Credit insurance pays some or all of a loan back when certain things
happen to the borrowers such as unemployment, disability or death.
(x) TraveI Insurance: Travel insurance is an insurance cover taken by those who travel
abroad, which covers certain losses such as medical expenses, lost of personal
belongings travel delay, personal liabilities, etc.
(xi) Locked Funds Insurance: Locked Funds nsurance is a little known hybrid insurance
policy jointly issued by governments and banks. t is used to protect public funds from
tamper by unauthorized parties.
(xii) MisceIIaneous: As per the insurance act, all types of general insurance other than fire
and marine insurance are covered under miscellaneous insurance. Some of the
examples of general insurance are theft insurance, personal accident insurance, money
insurance, engineering insurance etc.

Recent Status/Trends in Insurance Sector in India
With the de-regulation in ndia nsurance ndustry, the monopoly of public sector companies in life
insurance and general insurance has come to a end. This has augmented the innovative practices
invited by the private players Growth in the interactive technology such as internet has further
created a wave of excitement in the insurance market. ndian economy and nsurance sector is
committed to a double digit growth. n the year 2007 first online nsurance portal,
www.insurancemal, in, set up by an ndian nsurance Broker, Bonsai nsurance Broking Pvt. Ltd.
The Government of ndia liberalized the insurance sector in March 2000 with the passage of
the nsurance Regulatory and Development Authority (RDA) bill, lifting all entry restrictions for
private players are allowing foreign players to enter the market with some limits on direct foreign
ownership.
Minimum capital requirement for direct life and Non life nsurance Company is NR 1000
million and that for re-insurance company is NR 2000 million. n the 2004-05 budgets, the
government proposed for increasing the foreign equity stake to 49%, this is yet to be effected.
Under the current guidelines, there is a 26 percent equity cap for foreign partners in direct
insurance and Reinsurance Company.

OnIine Insurance in India:-


nternet access in ndia has doubted every year over the last five years and forecasts predict this
growth to quadruple every year over the next three years. According to e-marketer report on ndia
online, in 2007 about 33.2 million people in ndia accessed internet and that's about 2.9% of ndian
population. This figure is going to be 71.6 million people, which will be about 6% of population by
2011. Considering limited access of human insurance agents in rural areas, there will more demand
of purchasing insurance online from these areas followed by semi-urban areas. The insurance
portals that are active in online distribution are www.icicilombard.com, www.bjajalliancemails in
have been developed for providing comparison of different types of insurance policies, their
premiums and their purchase online. The policy details are stored digitally and all transactions are
made over secure channels. E-insurance offers a new gateway of incomes and provides additional
market preparation, which is a need of an hour for ndian nsurance Segment.


MutuaI Fund
Mutual Fund is an organization, which collects the small savings from general public with the
aim of investing it in the securities. The profit resulting from the investment is distributed among the
contributors, called unit holders. Mutual funds are based on the principle of 'Trusteeship', which
means working on the behalf of someone else fir the benefit of interested party and providing a
protection to such party.
The concept of mutual funds gained momentum because of the increasing complexities of
capital market. t is difficult for an individual investor to create and manage his portfolio of
investment due to the lack of knowledge and experience about the stock market. Mutual funds
provide this benefit of diversification to unit holders as a result of which risk on investment gets
minimized.
Mutual Funds Provide the following benefits:-
F Expert Knowledge
F Diversification
F Low cost of investment
F Risk sharing
F Small size of investment
HistoricaI Facts about Indian MutuaI Fund Industry
1963-Te Beginning: The ndian Mutual Fund industry is dominated by UT, which has a total
corpus of Rs. 700 billion collected from more than 20 million investors.
1990-Entry of MutuaI Funds by PubIic Sector Banks: n 1990, the government allowed
public sector banks and institutions to set up mutual funds, this sector now accounts for the second
largest category of mutual funds floated by national banks. Can bank Asset Management floated by
Canara Bank and SB Funds Management company floated by State Bank of ndia are the largest.
The aggregate corpus of funds managed by this category of AMCs is more than Rs. 150 billion.
1993-Announcement of SEBI ReguIation and entry of Private MutuaI Funds
n 1993 SEB announced the rules and regulations for mutual funds sponsored by Private
sector entities were allowed in ndia. This category of M.F. is the third largest category of
mutual funds in ndia. The largest of these is Prudential CC AMC and Birla Sun Life AMC.

Organization and ReguIation of MutuaI Fund


Mutual Funds are established on the principle of trusteeship, and the following pattern is
practiced in ndia:-
F Mutual fund trust is to be established by a sponsoring company.
F The sponsoring company should be registered under Companies Act.
F Mutual Fund trust to establish Asset Management Company (AMC).
F AMC and mutual fund trust should get registered with SEB
F One Custodian to be appointed by the mutual fund trust.
onstituents of MutuaI Fund Organization
1) Sponsor: Sponsor is an organization, which set up the mutual fund organization. The
formulation of mutual funds is done according the rules laid down by SEB. Following organization
are eligible to become sponsor:-
F Bank
F Financial nstitution
F Private & Public Ltd. Companies.
A sponsor must have a track record of profitability of at least 5 years with positive net worth. And
the sponsor must contribute minimum 40% of the capital of AMC.
2) Trust: This is established by the sponsor, and it functions as Mutual Fund, mutual fund
organization is in the form of a trust. n ndia almost all the mutual funds are in the form of a
trust. This trust has the task of launching mutual fund schemes, through which savings of
investors are allocated and pooled with the objective of making investment in the stock
market/money market.
3) Asset Management ompany: t is a team of professionals and exports with the
knowledge of the investment activities. An AMC is responsible for investment of the funds
collected by the mutual fund trust. Every Mutual Fund has its own AMC. At least 213 of the
directors must be independent directors in the BODs. Some Currently Operating AMCs are:
Ownersip
Alliance Capital Asset management () Private Limited - Private Foreign
Birla Sum Life Asset Management Co. Ltd.- - Private ndian
State Bank of ndia Funds Management Ltd. - Banks
DB nvestment Management Company Ltd.- - nstitution
4) ustodian: Custodian is an organization, which keeps the securities in safe custody on behalf
of the mutual fund organization. Following functions are performed by a custodian:-
F Safe keeping of securities.
F Collection of dividends and benefits on behalf of the mutual fund.
F Maintain the account of holding the securities.
(All the constituents should be registered with SEB and must functions as per the guidelines
laid by it.)



Types of MutuaI Funds





F Open Ended Funds F Growth Funds F Tax Saving Scheme
F Close Ended Funds F ncome Funds F ndustry-Specific-
F nterval Funds F Balanced Funds Scheme
F Money Market Funds F ndex Fund
F Load Funds
F No-Land Funds

(A) Iassification of MF based on Structure
1) Open Ended Funds: An open-ended fund is one that is available for subscription
through out of the year. These do not have a fixed maturity. nvestors can conveniently
buy and sell units at Net Asset Value (NAV) related prices. The key feature of open
ended schemes is liquidity.
2) Iosed Ended Funds: A closed-ended funds has a stipulated maturity period, which
generally ranges from 3-15 years. The funds are open for subscription only during a
specified period. nvestors can invest in the scheme only when it is launched. The
scheme remains open for a period not exceeding 45 days.
3) IntervaI Funds: nterval funds combine the features of open-ended and close-ended
schemes. They are open for sale or redemption during predetermined intervals at NAN-
related prices.
(B) Iassification of MF Based on Investment Objective
1) Growt Funds: The aim of growth funds is to provide capital appreciation over medium
to long-term. Such Schemes normally invest a majority of their corpus in equities. t has
been proven that returns from stocks have outperformed most other kind of investments
held over the long-term. Growth schemes are ideal for over the long-term. Growth
schemes are ideal for investors having a long-term outlook, seeking growth over a
period of time.
2) Income Funds: The aim of income funds is to provide regular and steady income to
investors. Such scheme generally invests in fixed incomes securities. Such as bonds,
corporate debentures and government securities.
3) BaIanced Funds: The aim of balanced funds is to provide growth and regular income.
Such schemes periodically distribute a part of their earning and invest both in equities
and fixed income securities in the proportion indicated in their offer documents.
4) Money Market Funds: The aim of money market funds is to provide easy liquidity,
preservation of capital and moderate income. These schemes generally invest in safer
short-term instruments-treasury bills, certificates of deposits, commercial paper etc.
Returns on these schemes may fluctuate, depending on the interest rates prevailing in
the market. These are ideal for corporate and individual investors as a means to park
their surplus funds for short period.
5) Load Funds: A load fund is one that charges a commission for entry or exit. That is,
each time one buys or sells units in the fund, a commission needs to be paid. Typically,
entry and exit loads range from 1-2%. t could be worth paying the load, if the funds have
a good performance history.
6) Non-Load Funds: A No-Load Funds is one that does not charge commission for entry
or exit. That is no commission is payable on purchase or sale of units in the funds.
Based on
Structurer
Based in nvest-
ment Objective
Other
Schemes

(C ) Oter Scemes:
1) Tax-Saving Scemes: These Schemes offer tax rebates to investors under specific
provisions of the ndian ncome Tax Laws. nvestment made in Equity Linked Saving
Schemes (ELSS) and Pension Scheme is allowed as deduction U/s 88 of the ncome
Tax ACT 1961. The Act also provides opportunities to investors to save capital gains u/s
54EA and 54EB by investing in mutual funds.
2) Industry Specific Scemes: ndustry Specific Schemes invest only in the industries
specified in the offer document. The investment of these funds is limited to specific
industries like nfoTech, FMCG and Pharmaceuticals etc.
3) Index Funds: ndex funds attempt to replicate the performance of a particular index,
Such as the BSE, Sensex or the Nifty 50.


























UNIT- 4
Leasing
Conceptually, a lease may be defined as a contractual arrangement/transaction in the asset
for use to another/transfer the right to use the equipment to another/transfer the right to use the
equipment to the user (lessee) over a certain/for an agreed period of time for consideration in form
of/in return for periodic payment (rentals) with or without a further payment (premium). At the end of
the period of contract (lease period), the asset/equipment reverts back to the lesser unless there is
a provision for the renewal of the contract. Leasing essentially involves the divorce of ownership
from the economic use of asset equipment.
t is a device of financing the cast of an asset. t is a contract in which a specific equipment
required by the lessee is purchased by the lesser (financier) from a manufacturer/vender selected
by the lessee. The lessee has possession and use of the asset on payment of the specified rentals
over a predetermined period of time. The lesser (financier) is the nominal owner of the asset as the
possession and the economic use of the equipment vests in the lessee.
EvoIution of Leasing Industry
Leasing activity was initiated in ndia in 1973. The first leasing company of ndia, named First
Leasing Company of ndia Ltd. was set up in that year by Farouk rani with industrialist A.C. Muthia.
For several years this company remained the only company in the century until 20
th
Century
Finance Corporation was set up around 1980.
By 1981, the trickle started and Shetty nvestment and Finance, Jaybharat Credit and
nvestment, Motor and General Finance and Sunderam Finance etc., joined the leasing game. The
last three names, already involved with hire purchase of commercial vehicles, were looking for a tax
break and leasing seemed to be the ideal choice.
The industry entered the third stage in the growth phase in late 1982, when numerous
financial institutions and commercial banks either started leasing or announced plans to do so.
CC, promenaded among financial institutions, entered the industry in 1983 giving a boost to the
concept of leasing. Thereafter, the trickle soon developed into flood and leasing became the new
gold mine. This was also the time when the profit performance of the two dozen companies. First
leasing and 20
th
Century had been made public, which contained all. The fascination for more many
companies to join the industry.
As per RB's records by 31
st
March, 1986, there were 339 equipment leasing companies in
ndia whose assets leased totaled Rs. 2395.5 million. One can notice the surge in number from
merely 2 in 1980 to 339 in 6 years.
Another significant phase in the development of ndians leasing was the Dahotre
Committee's recommendations based on which the RB formed guideline on commercial bank
funding to leasing companies. The growth of leasing in ndia has distinctively been assisted by
funding from banks and financial institutions. The post-liberalization era has been witnessing the
slow but sure increase in foreign investment into ndian leasing. Starting with GE Capital's entry, an
increasing number of foreign-owned financial firms and banks are currently engaged or interested in
leasing in ndia.

EssentiaI EIements of Lease Financing
(1) Parties to te ontract: There are essentially two parties to a contract of lease financing,
namely, the owner and the user, called the lesser and the lessee respectively.
(2) Asset: The asset, property or equipment to be leased is the subject matter of a contract of
lease financing. The asset may be an automobile, plant and machinery, equipment, land
and building, factory, a running business, aircraft and so on. The asset must, however be of
the lessee's choice suitable for his business needs.

(3) Ownersip Separated from User: The essence of a lease financing contract is that
during the lease-tenure, ownership of the assets vests with the lesser and its use is allowed
to the lessee. On the expiry of the lease tenure, the assets revert to the lesser.
(4) Terms of Lease: The term of the lease is the period for which the agreement of lease
remains in operation. Every lease should have a definite period otherwise it will be legally
inoperative. The lease period may sometimes stretch over the entire economic life of the
asset (i.e. financial lease) or a period shorter than the useful life of the asset (i.e. operating
lease). The lease may be perpetual, that is, with an option at the end of lease period to
renew the lease for the further special period.
(5) Lease RentaI: The consideration which the lessee pays to the lesser for the lease
transaction is the lease rental. The lease rentals are so structured as to compensate the
lesser for the investment made in the asset, the interest on the investment, repairs and so
forth-borne by the lesser and servicing charges over the lease period.
(6) Modes of Terminating Lease: The lease is terminated at the end of the lease period and
various courses are possibly namely,
(i) The lease is renewed on a perpetual basis or for a definite period, or
(ii) The asset reverts to the lesser, or
(iii) The asset reverts to the lesser and the lesser sells or leases it to a third party, or
(iv) The asset reverts to the lesser


Parties InvoIved in Leasing
Following are the two parties involved in leasing:-
(1) Lessee: The user or renter of the leased asset or property is called lessee. n case of
capital leases, the lessee is also the 'debtor' to the lesser. When real estate is leased, the
lessee is called a tenant.
Types of Lessee
(i) orporate ustomers wit very Hig redit Ratings: These essentially look at
leasing to leverage against assets which are otherwise not bankable, or for pure junk
financing.
(ii) PubIic Sector Undertakings: This market has witnessed a very high rate of growth in
the past. With budgetary grants to the PSUs coming to a virtual halt, there is an
increasing number of both centrally as well as state-owned entitles which have resorted
to lease financing. Their requirements are usually massive.
(iii) Mid-Market ompanies: The mid-market companies, i.e., companies with reasonably
good creditworthiness but with lower public profile have resorted to lease financing
basically as an alternative to bank/institutional financing which to them-consuming and
tedious.
(iv) onsumers: Retail funding for consumer durables was frowned-upon at one point of
time, but recent had experience with corporate financing has focused attention towards
consumer durables which incidentally, is the all time favorite of financiers world-over.
(v) ar ustomers: Car leasing world-over is a very big market, and the same is true for
ndia. So long, most car leases were plain-vanilla financial leases but one now finds few
instances of value-added car lease services also being offered.
(vi) ommerciaI VeicIes: Commercial vehicles customers have always relied upon
funding by hire purchase companies. The customer profile ranges from large fleet
owners to individual truckers.
(vii) Government Department and Autorities: One of the latest entrants in leasing
markets is the Government itself. The Department of Telecommunications of the Central
Government took the lead by floating tenders for lease finance worth about Rs 1000

crore. n its reforms' programme, ndia has limits to the extent to which it can resort to
deficit financing, and leasing is easily going to appeal to the Government, if not for cost
reasons, at least for the fact that it will not feature in national accounts as a commercial
financing.
[2] Lesser: Owner or the title holder of the leased asset or property, the lesser is also the lender
and secured party in case of capital leases and operating leases. n case of leveraged leases,
however, a third party (the lender) and not the lesser hold the title.
Types of Lesser:
(i) SpeciaIized Leasing ompanies: There are about 400 odd large companies which
have an organizational four on leasing and hence, are know as leasing companies. Till
recently, most of them were diversified financial houses, offering several fund-based and
non-fund based financial services. However recent SEB rules on bifurcation of fund
based and non-fund based activities have resulted into having off of merchant banking
divisions of these entities. Most of these companies also offer hire-purchase activities,
and some of them might have consumer finance division as well. These companies are
known as NBFCs.
(ii) Banks and Bank Subsidiaries: Till 1991, there were some ten bank subsidiaries active
in leasing, and over-active in stock-investing. The latter variety was ravaged in the
aftermath of the 1992 securities scam. n Feb., 1994, the RB allowed banks to directly
enter leasing. So long, only bank subsidiaries were a allowed to engage in leasing
operations, which was regarded by the RB as a non-banking activity. However, the
1994 notification saw an essential thread of similarity between financial leasing and
traditional lending.
(iii) SpeciaIized FinanciaI Institutions: There is a wide variety of financial institutions at the
Central as well as the state level in ndia. Apart from the apex financial institutions, viz.,
the DB, the FC, and the CC, there are several financing agencies devoted to
specific causes, such as sick-industries, tourism, agriculture, small industries, housing,
shipping, railways, roads, power, etc. n most states too, there are multiple financing
agencies for generic or focused cause.
(iv) One Off Lesser: Some of the companies engaged in some other business which give
them huge taxable profits, how resorted to one-off leasing on a causal basis to defer
their taxes. These people are interested only in leasing of high depreciation items,
preferably those entitled to 100% depreciation. The major items eligible for 100%
depreciation are gas cylinders, certain energy-saving devices, pollution control devices,
etc.
(v) Manufacturer-Lesser: This part of the lesser-industry is in highly under-grown form in
ndia, for simple reasons. Vendor leasing is a products of competition in the product
market. As competition forces the manufacturer to add value to his sales, he finds the
best way to sell the product is to sell it without the buyer having to pay for it instantly.
Product markets so far for most durables were oligopolistic and good products used to
sell seven otherwise at a premium, with the economy decisively moving towards market
orientation competition has become inevitable and competition brings in its wake sales-
aid tools. Hence, the potential for vendor leasing is truly great.

Iassification or Types of Lease
(1) Finance Lease: n a finance lease the lesser transfers to the lessee, substantially all the
risks and rewards incidental to the ownership of the assets whether or not the little is
eventually trans-furred. t involves payment of rental over an obligatory non-cancellable
lease period, sufficient in total to amortize the capital outlay of the lesser and leave some
profit. n such lease the lesser is only financier and is usually not interested in the assets. t

is for this reason that such leases are also called as "full payment leases" as they enable a
lesser to recover his investment in the lease and derive a profit. Types of assets included,
under such lease, are ships, aircrafts, railways wagons, lands, buildings, heaving
machinery, diesel generating sets and so on.
(2) Operating Lease: An operating lease in one which is not a finance lease. n an operating
lease, the lesser does not transfer all the risks and rewards incidental to the ownership of
the asset and rewards incidental to the ownership of the asset and the cost of the asset is
not fully amortized during the primary lease period. The lesser provides services (other than
the financing of the purchase price) attached to the leased asset, such as maintenance,
repair and technical advice. For this reason, operating lease is also called? 'Service lease'.
The lease rentals in an operating lease include a cost for the 'services' provided and the
lesser does not depend on a single lessee for recovery of his cost. Operating lease is
generally used for computers, office equipments, automobiles, trucks, some others
equipments, telephones and so on.
(3) SaIe and Lease Back: t is an indirect form of leasing. The owner of an equipment/asset
sells it to a leasing company (lesser) which leases it back to the owner (lessee). A classic
example of this type of leasing is the sale and lease back of safe deposits vaults by the
banks under which bank sell them in their custody to a leasing company at a market price
substantially higher than the book value. The leasing company in turn offers these lockers
on a long-term basis to the bank. The bank sub-leases the lockers to its customers.
(4) Direct Lease: n direct lease, the lessee and the owner of the equipment are two different
entities. A direct lease can be of two types: Bipartite and Tripartite lease.
(i) Bipartite Lease: There are two parties in the lease transaction namely equipment
supplier-cum-lesser and (b) lessee. Such a type of lease is typically structured as an
operating lease with inbuilt facilities, like up gradating the equipment, addition to the
original equipment configuration and so on. The lesser maintains the asset and if
necessary, replace it with similar equipment in working conditions.
(ii) Tripartite Lease: Such type of lease involves three different parties in the lease
agreement: equipment supplier, lesser and lessee.
(5) SingIe Investor Lease: There are only two parties to the lease transaction: the lesser and
lessee. The leasing company (lesser) funds the entire investment by an appropriate mix of
debt and equity funds, The debts raised by the leasing company to finance the asset are
without recourse to the lessee, that is, in the case of default in servicing the debt by the
leasing company the lender is not entitled to payment from the lessee.
(6) Leverage Lease: There are three parties to the transactions: (i) lesser (equity investor) (ii)
lender and (iii) lessee. n such type of lease, the leasing company (equity investor) buys the
asset through substantial borrowing with full recourse to the lessee and without any
recourse to it. The lender (loan participant) obtains an assignment of the lease and the
rentals to be paid by the lessee and a first mortgaged asset on the leased asset. The
transaction is routed through a trustee who looks after the interest of the lender and lesser.
On receipt of the rentals from the lessee, the trustee remits the debt-service component of
the rental to the loan participant and the balance to the lesser.
(7) Domestic Lease: A lease transaction is classifieds domestic if all parties to the agreement,
namely, equipment supplies, lesser and the lessee are domiciled in the same country.
(8) InternationaI Lease: f the parties to the lease transaction are domiciled indifferent
countries, it is known international lease. This type of lease is further sub-classified into (i)
mport Lease and (ii) Cross Border Lease.
(i) Import Lease: n an import lease, the lesser and the lessee is domiciled in the same
country but the equipment supplier is located in a different country. The lesser imports
the asset and leases it to the lessee.

(ii) Gross Border Lease: When the lesser and the lessee are domiciled in different
countries, the lease is classified as cross-border lease. The domicile of the supplier is
in material.
Advantages of Leasing
(A) To te Lessee: Lease financing has following advantages to the lessee:-
(B) Financing of apitaI Goods: Lease financing enables the lease to have finance for huge
investments in land, building, plant, machinery, heavy equipments, and so on, upto 100 per
cent, without requiring any immediate down payment. Thus the lessee is able to commence
his business virtually without making any initial investment (of course, he may have to invest
the minimal sum of working capital needs).
(2) AdditionaI Source of Finance: Leasing facilitates the acquisition of equipment; plant and
machinery, without the necessary capital outlay and thus, has a completive advantage of
mobilizing the scarce financial resources of the business enterprise. t changes the working
capital position and makes available the internal accruals for business operations.
(3) Less ostIy: Leasing, as a method of financing is less costly than other alternatives
available.
(4) Ownersip Preserved: Leasing provides finance without diluting the ownership or control
of the promoters. As Against it, other modes of long-term finance, for example, equity or
debentures normally dilute the ownership of the promoters.
(5) FIexibiIity in Structuring of RentaIs: The lease rental can be structured to accommodate
the cash flow position of the lessee, making the payment of rentals convenient to him. The
lease rentals are so tailor made that the lessee is able to pay the rentals from the funds
generated from operation. The lease period is also chosen so as to suit the lessees'
capacity to pay rentals and considering the operating life-span of the asset.
(6) SimpIicity: A lease finance agreement is simple to negotiate and free from cumbersome
procedures with faster and simple documentation. As against it, institutional finance and
term loans require compliance of covenants and formalities and bulk of documentation,
causing procedural delays.
(7) Tax Benefits: By suitable structuring of lease rentals a lot of tax advantage can be derived.
f the lessee is in a tax paying position the rental may be increased to lower his taxable
income.
(8) ObsoIescence Risk is Averted: n a lease arrangement, the lessor being the owner bears
the risk of obsolescence and the lessee is always free to replace the asset with latest
technology.
B) To te Lesser: A lesser has the following advantages:-
(1) FuII Security: The laser's interest is fully secured since he is always the owners of the
leased asset and can to be repossession of the asset if they lessee defaults. As against it,
realizing an asset secured against a loan is more difficult and cumbersome.
(2) Tax benefit: The greatest advantage for the lesser is the tax relief by way of depreciation. f
the lesser is in high tax bracket, he can lease out assets with high depreciation rates and,
thus, reduce his tax liability substantially. Besides, the rentals can be suitably structured, to
pass on some tax benefit to the assessed.
(3) Hig ProfitabiIity: The leasing business is highly profitable since the rate of return is more
than what the lesser pays on his borrowings. Also the rate of returns in more than in case of
lending finance directly.

(4) Trading on Eigty: Lesser usually carry out their operations with greater financial leverage.
That is they have a very low equity capital and use a substantial amount of borrowed funds
and deposits. Thus, the ultimate return on equity is very high.
(5) Hig Growt PotentiaI: The leasing industry has a high growth potential. Lease financing
enables the lessees to acquire equipment and machinery even during a period of
depression, since they do not have to invest any capital. Leasing, thus, maintains the
economic growth even during recessionary period.

Limitations of Leasing: Lease financing suffers from certain limitations too:-
(1) Restriction on use of equipment: A lease arrangement may impose certain restrictions on
use of the equipment or require compulsory insurance, and so on. Besides, the lessee is not
free to make additions or alteration to the leased asset to suit his requirement.
(2) Limitations of FinanciaI Lease: A financial lease may entail higher payout obligations, if
the equipment is found not useful and the lessee opts for premature termination of the lease
agreement. Besides, the lessee is not entitled to the protection of express or implied
warranties since he is not the owner of the asset.
(3) Loss of ResiduaI VaIues: The lessee never becomes the owner of the leased asset. Thus,
he is deprived of the residual value of the asset and is not even entitled to any
improvements done by the lessee or caused by inflation or otherwise, such as appreciation
in value of leasehold land.
(4) onsequences of DefauIt: f the lessee defaults are complying with any terms and
conditions of the lease contract, the lesser may terminate the lease and take over the
possession of the leased asset. n case of finance lease, the lessee may be required to pay
for damages and accelerated rental payments.
(5) DoubIe SaIes-Tax: With the amendment of sale-tax law of various states, a lease financing
transaction may be charged to sales-tax twice-once when the lesser purchases the
equipment and again when it is leaded to the lessee.

Hire Purcase
Hire-purchase is made of financing the price of the goods to be sold on a future date. n a
hire-purchase transaction, the goods are lot on hire, the purchase price is to be paid in installments
and the hirer is allowed an option to purchase the goods by paying all the installments. A hire-
purchase agreement is defined as peculiar kind of transaction in which the goods are let on hire
with an option to the hirer to purchase them, with the following stipulations:-
(a) Payment to be made in installments over a specified period.
(b) The possession is delivered to the hirer at the time of entering into the contract.
(c) The property in the goods passes to hire on payment of the last installments.
(d) Each installment is treated as hire charges so that if default is made in payment of any
installment the seller becomes entitled to take away the goods, and
(e) The hirer/purchases is free to return the goods without being required to pay any further
installments falling due after the return.
Thus, a hire-purchase agreement has two aspects, firstly, an aspect of bailment of goods
subject to the hire-purchase agreement and secondly, an element of sale which fructifies
when the option to purchase is exercise by the intending purchases. Though the option to
purchase is allowed in the very beginning it can be exercised only at the end of the
agreement. The essence of the agreement is that the property in goods does not pass at the

time of the agreement but remains in the intending seller and only passes later when the
option is exercised by the intending purchaser.
The finance (hire-purchase) company purchase the equipment from the equipment
supplier and lets it on hire to the hirer to use it who is required to make a down payment of
say, 20-25 percent of the cost and pay balance with interest in Equated Monthly nstallments
(EMT) in advance or arrears spread over 36-48 months. Alternatively, in place of the margin
in the down-payment plan, under a deposit linked plan, the hirer has to put an equal amount
as a fixed plan, the hirer has to put an equal amount as a fixed deposit with the finance
company which provides the entire finance on hire purchase terms repayable with interest
as EM over 36-48 months. The deposit together with the accumulated interest is returned to
the hirer after the payment of the last installment.
Partier in Hire-purcase
(1) Hire Purcaser: He is the customer who obtains possession of the goods at the outset and
can use it, while paying for it by installments over an agreed period of time.
(2) Hire Vendor: The time of ownership of the goods remains with the seller called hire vendor
until the hire purchase has made all the payment.
Types of Hire Purcase
(1) onsumer InstaIIment redit: Consumer nstallment credit is finance offered to consumers
for acquiring consumer durables. nstallment credit may be in the form of a personal loan
credit sale, rental or conditional sale in the form of hire purchase. The consumer acquires
goods by utilizing the funds being advanced under the hire purchase agreement. Retail hire
purchase may be different forms depending upon the mode of collection. t may be in the
form of direct collection, agency collection or block discounting.
(2) IndustriaI and ommerciaI redit: n industrial and commercial fields, finance may be
provided through loans, credit sales, leasing, factoring or hire purchase. The financing
house, desirous of financing a commercial concern for the purchase of equipments, itself
purchase. The financing house, desirous of financing a commercial concern for the
purchase of equipments, itself purchases the equipment from the manufacturer or dealer
through hire purchase and lets it on hire purchase to the said commercial concern instead of
lending money.
Advantages of Hire Purcase
(1) Spread te ost of Finance: Whilst choosing to pay in cash is preferable, this might not be
possible for consumer on a tight budget. A hire purchase agreement allows a consumer to
made monthly payments over a pre-specified period of time.
(2) Interest-Free redit: Some merchants offer customers the opportunity to pay for goods and
service on interest free credit. This is particularly common when making a new car purchase
or on white goods during an economic downturn.
(3) Higer Acceptance Rates: The rate of acceptance on hire purchase agreements is higher
than other forms of unsecured borrowing because the lenders have collateral security.
(4) SaIes: A hire purchase agreement allows a consumer to purchase sale items when they are
not in a position to pay in cash. The discounts secured will save many families money.
(5) Debt soIutions: Consumers that buy on credit can purchase a debt solution, such as debt
management plan, if they experience money problems further down the line.

Disadvantages of Hire Purcase
(1) Encourages Lavis Expenditure: On account of the easy payment facility, consumers go
in for articles, which may be beyond their means.
(2) Future Income is Mortgaged: As consumer have to pay installments over a period of time.
their future income is mortgaged.

(3) Higer instaIIment Price: The installment price is higher than the cash-down price.
(4) DifficuIty in re-saIe of goods: Even though the hire-sellers has the right to reposes the
articles in case of default, to sell them again is difficult as they are second hand goods.
(5) PersonaI Debt: A hire purchase agreement is yet another form of personal debt. t is
monthly payment commitment that needs to be paid each month.
(6) FinaI Payment: A consumer does not have legitimate title to the goods until the final
monthly payment has been made.
(7) Bad redit: All hire purchase agreements will involve a credit check consumers that have a
bad credit rating will either be turned down or be asked to pay a high interest rate.




Difference Between Leasing and Hire Purcase
Basis of Difference Leasing Hire-Purcase
1) Ownership Ownership is not
transferred to the lessee
Ownership is transferred to the
hirer on payment of last
installment.
2) Tax Deductibility Entire lease rentals are
tax-deductable expenses.
Only the interest component
and not the entire installment is
deductable.
3) Depreciation and Other
allowances
Cannot be claimed by the
lessee.
Can be claim by the hirer.

4) Salvage Value Lessee cannot realize
salvage value of the asset
on the expiry of the lease
of life of the asset.
Hirer can realize the salvage
value of the asset after payment
of last installment and expiry of
the life of the asset.
5) Magnitude The magnitude of funds
involved in the lease
finance is very large, for
ex. for the purchase of
aircrafts, ships and
machinery air conditioning
plants and so on.
The cost of acquisition in hire
purchase is relatively low, that
is, automobiles, office
equipments and generators and
soon is generally hire
purchased.
6) Margin Money Lease financing is
invariably 100 per cent
financing. t requires no
margin money or
immediate cash-down
payment by the lessee.
n a hire-purchase transaction
typically a margin equal to 20-
25 percent of the cost of the
equipment is required to be
paid by the hire.

7) Maintenance n case of finance lease
only the maintenance of
the leased assets is the
responsibility of the
lessee.
The cost of maintenance of
hire-dessert is to be born
typically by the hirer himself.


Factoring
The word 'factoring' has its origin from Latinword 'factor/ which means 'doer'. The Webster's
New Collegiate Dictionary defines a factor as, "one that lends many to producers and dealers on
the security of accounts receivables."
Factoring is financial transaction whereby a business sells its accounts receivables (i.e.,
invoices) to a third party (called a factor) at a discount in exchange for immediate money with which
to finance continued business.
So Factoring can broadly be defined as an agreement in which receivables arising out of
sale of goods, services are sold by a firm (client) to the factor (a financial intermediary) as result of
which the title to the goods/services represented by the said receivables passes on to the factor.
Hence, forth the factor accounting and debt collection from the buyers (s). n a full service factoring
(without recourse facility), if any of the debtor fails to pay the dues as a result of his financial
inability/insolvency/bankruptcy, the factor has to absorb the lesser.
Features of Factoring
(1) The period of factoring is 40 to 150 days some factoring companies allow even more than
15 days.
(2) Factoring is considered to be a costly source of finance compared to other sources of short-
term borrowings.
(3) Credit rating is not mandatory. But the factoring companies usually carry out of credit risk
analysis before entering into the agreement.
(4) Factoring is a method off balance sheet financing.
(5) ndian firms offer factoring for involvers as law as 1000 Rs.

Functions of a Factor
Depending on the type/form of factoring, the main functions of a factor, in general terms, can
be classified into five categories:-
(1) Maintenance/Administration of SaIes Ledger: The factor maintains the client's sales
ledger. On transacting a sales deal, an invoice is sent by the client to the customer and a
copy of the same is sent to the factor. The factor also gives periodic (fortnightly, weekly
depending on the volume of transaction) reports to the client on the current status of his
receivables, receipts of payments from the customers and other useful information.
(2) Provision of oIIection FaciIity: The factor undertakes to collect the receivables on behalf
of the client reliving him of the problems involved in collection and enables him to
concentrate on other important functional areas of the business. This also enables the client
to reduce the cost of collection by way of savings in manpower, time and efforts.
(3) Financing Trade Debts: The unique feature of factoring is that a factor purchases the book
debts of his client at a price and the debts are assigned in favour of the factor that is usually
willing to grant advances to the extent of 80-85 percent of the assigned debts. The balance
15-20 percent is retained as a factor reserve. Where the debts are factors with recourse, the
finance provided would become refundable by the client in case of non-payment by the
buyer. However, where the debts are factored without recourse, the factor's delegation to
the seller becomes absolute on the due date of the invoice whether or not the buyer makes
the payment.

(4) redit ontroI and redit Protection: Assumption of credit risk is one of the important
functions of a factor. This service is provided where debts are factored without recourse.
The factor in consultation with the client fixes credit limits for approved customers.
(5) Advisory Services: These services are spin-offs of the close relationship between a factor
and a client. By virtue of their specialized knowledge and experience in finance and credit
dealings and access to extensive credit information, factors can provide a variety of
incidental advisory services to their clients. Sc as:-
(a) Customer's perception of the client's product, changes in marketing strategies, emerging
trends and so on.
(b) Audit of the procedures followed for invoicing, delivery and dealing with sales returns.
(c) ntroduction to the credit department of a bank/ subsidiaries of banks engaged in
leasing, hire-purchase, merchant banking and so on.
Working/Mecanism of Factoring
The below mechanism of factoring can be explained as follows:-
(1) Customer places an order with the client for goods and or service on credit, client delivers
the goods and sends invoice to customers.
(2) Client assigns invoice to factor.
(3) Factor makes pr-payment upto 80 percent and sends periodical statements.
(4) Monthly statement of accounts to customer and follows-up
(5) Customer makes payment to factor.
(6) Factor makes balance 20 percent payment on realization to the client.


Working/Mecanism of Factoring



( 2) (3) (1)
Assign Payment Send nvoice
invoice upto 80% (6) Balance 20% to customer
to factor on realization

( 4) Statement to customer


(5 ) Payment to Factor

Types/Forms of Factoring
(1) Recourse Factoring: Under a recourse factoring arrangement, the factor has because to
the clients (firm) if the debt purchased/receivables factored turns out to be irrecoverable. n
other words, the factor does not assume credit risks associated with the receivables. f the
customer defaults in payment, the client has to make good the loss incurred by the factor.
The factor is entitled to recover from the client the amounted paid in advance in case the
customer does not pay on maturity. The factor charges the client for maintaining the sales
ledger and debt collection services and also for the interest for the period on the amount
drawn by the client.
(2) Non-Recourse Factoring: The factor does not have the right of recourses in the case of
non-recourse factoring. The loss arising out of irrecoverable receivables is borne by him, as
a compensation for which he charges a higher commission. The additional fee charges by
him as a premium for risk-bearing is referred to as a debt cruder commission. Additionally,
C||ent
Iactor

Customer

he is actively associated with the process of grant of the credit and the extension of line of
credit to the customers of the client.
(3) Advance Factoring: The factor pays a pre-specified portion, ranging between three-fourths
to nine-tenths, of the factored receivables a advance, the balance being paid upon
collection/on the guaranteed payment date. A drawing limit, as a pre-payment is made
available by the factor to the client as soon as the factored debts are approved the invoices
are accounted for. The client has to pay interest (discount) on the advance/repayment
between the date of such payment and the date of actual collection from the customer or the
guaranteed payment date.
(4) Maturity Factoring: The maturing factoring is also known as Collection Factoring. Under
such arrangements, the factor does not make a pre-payment to the client. The payment is
made either on guaranteed payment date or on the date of collection. The guaranteed
payment date is generally fixed taking into account the previous ledger experience of the
client and a period for slow collection after the due date of the invoice.
(5) FuII Factoring: This is the most comprehensive form of factoring combining the features of
almost all the factoring service specially those of non-recourse and advance factoring. t is
also known as old line factoring. Full Factoring provides the entire spectrum of services,
namely collection, credit protection, sales ledger administration and short-term finance.
(6) DiscIosed Factoring: n disclosed factoring, the name of the factor is disclosed in the
invoice by the supplier manufacturer of the goods asking the buyer to make payment to the
factor.
(7) UndiscIosed Factoring: The name of the factor is not disclosed in the invoice in
undisclosed factoring although the factor maintains the sales ledger of the supplier company
but all control remains with the factor. He also provides short term finance against sales
invoices.
(8) Export/ross Border/InternationaI Factoring: There are usually four parties to a cross-
border factoring transaction. They are: () exporter (client), (ii) importer (customer), (iii) export
factor and (iv) import factor.

Forfeiting
Forfeiting is a form of financing of receivables of pertaining to international trades. t denotes
the purchase of trade bills/promissory notes by a bank/financial institution without recourse to the
seller. The purchase is in the form of discounting the documents covering the entire risk of
nonpayment in collection. All risks and collection problems are fully the responsibility of the
purchaser (forfeiter) who pays cash to seller after discounting the bills/notes.
aracteristics of Forfeiting:-
(1) Forfeiting is 100 percent financing without recourse to the exporter. This means that the
exporter is insulated against the possibility of default in payment by the importer.
(2) Trade receivables are usually evidenced by bills of exchange, promissory notes, or a letter
of credit.
(3) The trade receivables are required to be denominated in a freely convertible currency. The
most common currency denominations are the US Dollar and Euro.
(4) Credit periods can range from 60 days to 10 years.
(5) An importer's obligation is normally supported by a local bank guarantee.
(6) Forfeiting is suitable for high value exports such as capital goods, consumer durables,
vehicles, consultancy and construction contracts, project exports and bulk commodities.


by scan Working Mechanism of Forfeiting (Figure) (Page 97 of Register)










1) At the request of the exporter, and normally nearer the time of shipment, the forfeiter
provides the exporter with a written commitment to purchase the debt from him on a without
recourse basis.
2) The exporter and the importer sign the commercial contract.
3) The goods under the contract are then dispatched to the importer.
4) The importer's bank provides guarantee at the request of the importer.
5) The Guarantee is forwarded by the importer to the exporter.
6) The exporter then assigns the guarantee in favour of the forfeiter and forwards other
documents relating to forfeiting.
7) On receipt of complete documentation, the forfeiter makes the payment to the exporter on a
without recourse basis.
8) On maturity, the forfeiter presents the documents to the importers bank for payment.
9) The importer makes the payment to his guaranteeing bank.
10) The importer's bank guaranteeing the transaction makes the payment to the forfeiter on due
date.

























Difference between Forfeiting and Factoring


Basis of Difference Forfeiting Factoring
1) Nature n forfeiting, the complete
sales ledger of the
exporter is not handled by
the forfeiter Forfeiting,
structuring and costing is
tailor-make and on a
case-to-case basis
Under factoring, the factor
handles the entire sales ledger
at a predetermined price.
Factoring requires the
assignment of whole turnover
with a buyer on a continuous
basis.
2) Recourse/
Non- Recourse
Forfeiting is 100 percent
financing without recourse
to the exporter.
Factoring can be with recovers
or without recourse depending
on the terms of transaction
between the seller and the
factor.
3) Parties nvolved n forfeiting there is a
forfeiter and involved in
the transaction.
n nternational factoring there
is two factor
4) Cost Bearer n forfeiting, the cost
(charges) consists of
three elements-discount
rate, commitment fees,
and handling fees, which
are ultimately borne by
the importer.
The cost of factoring is usually
borne by the seller.

5) Term of Maturing Forfeiting is usually for
international credit
transactions of long term
maturity between 90 days
and upto 5 years
Factoring is for transactions of
short-term maturities not-
exceeding six months.



BiII Discounting
A bill discounting or a bill of exchange is a short term, negotiable and self-liquidating money-market
instrument. The Bill of Exchange (BE) is used for financing a transaction in goods which means
that it is essentially a trade-related instrument.
Bill discounting is a major activity with some of the small Banks. Under this type of lending,
Bank takes the bill drawn by borrower on his (borrower's) customer and pays him immediately
deducting some amount as discount/commission. The bank then presents the bills to the borrower's
customer on the due date of the bill and collects the total amount. f the bill is delayed, the borrower
on his customer pays the Banks a pre-determined interest depending upon the terms of transaction,
According to the ndian Negotiable nstruments Act, 1881, "The bill of exchange is in instrument in
writing containing an unconditional order, signed by the maker, directing a certain person to pay a
certain sum of money only to, or to the order of, a certain person, or the bearer of that instrument."
Parties to a BiII of Excange
(1) Drawer: The person who draws a bill of exchange is called the drawer.
(2) Drawee: The person on whom the bill of exchange is drawn is called the drawer. He is also
called as an acceptor of the Bill.

(3) Payee: The person named in the instrument to whom or to whose order the money is
directed to be paid by the instrument, is called the payee.
Suppose a seller sells goods or merchandise to a buyer. n most cases, the seller
would like to be paid immediately but the buyer would like to pay only after some time, that
is, the buyer would like to pay only after some time, that is, the buyer would wish to
purchase on credit. To solve this problem the seller draws a BE of a given maturity on the
buyer. The seller has now assumed the role of a creditor, and is called the drawer of the bill.
The buyer who is the debtor is called the drawer. The seller then sends the bill to the buyer
who acknowledges his responsibility for the payment of the amount on the terms mentioned
on the bill by writing his acceptance on the bill. The acceptance could be the buyer himself
or any third party willing to take on the credit risk of the buyer.

Working of Discounting of BiIIs
Following steps are involved in the discounting of commercial bills:-
(1) Examination of BiII: The banker verifies the nature of the bill and the transaction. The
banker then ensures that the customer has supplier all required documents along with the
bill.
(2) rediting ustomer Account: After the examining the genuineness of the bill, the banks
grants a credit limit, either on a regular or on ad hoc basis. The customer's account is
credited with the net amount of the bill, i.e., value of bill minus discount charges. The
amount of discount is the income earned by the bank on discounting/purchasing. The
amount of the bill is taken as advance by the bank.
(3) ontroI over Accounts: To ensure that no customer borrows more than the sanctioned
limit, a separate register is maintained for determining the amount availed by each
customer. Separate columns are allotted to show the names of customers, limit sanctioned,
bills discounted, Bills collected, loans granted and loans repaid. Thus at any given point in
time the extent of limit utilized by the customer can be readily known.
(4) Sending biIIs for coIIection: The bill, together with documents duly stamped by the banker,
is sent to the banker's branch (or some other bank's branch if the banker does not have a
branch of its own) for presenting the bill for acceptance or payment in accordance with the
instructions accompanying the bill.
(5) Action by te Branc: On receipt of payment, the collecting banker remits the payment to
the banker which has sent the bill for collection.
(6) Disonor: n the event of dishonor, the dishonor advice is sent to the drawer of the bill. t
would be appropriate for the collecting banker to the get the bill protected for dishonor. For
this purpose, the collecting banker or branch of the bank maintains a separate register in
which details such as date on which the bills are to be presented, the party to whom it is to
be presented, etc., are recorded. The banker then presents them for acceptance or
payment, as required. The banker debits the customers' (drawer/borrowers) account with
the amount of the bill and also all charges incurred due to dishonor of the bill. Such a bill
should not be purchased in the event of its being presented again. However, the banker,
may agree to accept it for collection.

Advantages of Discounting of BiIIs
(A) To Investors:-
(1) Short term sources of finance.
(2) Bills discounting being in the nature of a transaction is outside the purview of Section 370 of
the ndian Companies Act, 1956, that restricts the amount of loans that can be given by
group companies.

(3) Since it is not a lending, no tax source is deducted while making the payment charges which
is very convenient, not only from cash flow point of view, but also from the point of view of
companies that do not envisage tax liabilities.
(4) Rates of discount are better than those available on DCs.
(5) Flexibility, not only in the quantum of investments but also in the duration of investments.

(B) To Banks:
(1) Safety of Funds: The greatest security for a banker is that a BE is a negotiable instrument
bearing signatures of two parties considered good for the amount of bills, so he can enforce
his claim easily.
(2) ertainty of Payment: A BE is a self-liquidating asset with the banker knowing in advance
the date of its maturity, Thus, bill finance obviates the need for maintaining large unutilized,
ideal cash balances as under the cash credit system. t also provides banks greater control
over their drawls.
(3) ProfitabiIity: Since the discount on a bill is front-ended, the yield is much higher than in
other loans and advances, where interest is paid quarterly or half yearly.
(4) Evens out Inter-Bank Liquidity ProbIems: The development of healthy parallel bill
discounting market would have stabilized the violent fluctuations in the call money market as
banks could buy and sell bills to even out their liquidity mismatches.
(5) Discount Rate and Effective Rate of Interest: Banks and finance companies discounting
bills prefer to discount LC (letter of credit) backed bills compared to clean bills. The rate of
discount applicable to LC-based bills. The bills are generally discounted up-front, that is, the
discount is payable in advance. As consequences, the effective rate of interest is higher
than the quoted rate (discount). The discount rate varied from time to time depending upon
the short-term interest rate.


onsumer redit/onsumer Finance
Consumer credit includes all asset-based financing plans offered to primarily individulas to acquire
durable consumer goods. Typically, in a consumer credit transaction the individual-consumer-buyer
pays a fraction of the cash purchase price at the time of delivery of the asset and payes the balance
with interest over a specified period of time.
The consumer credit refers to the activities involved in granting credit to consumers to
enable them. Possess own goods meant for everyday use. t is known by several names such as
credit merchandising, differed payments installment buying, hire purchase, pay-out of income
scheme, pays-as-you earn scheme, easy payment, credit buying, installment credit plan etc.
According to E.R.A. Seligman, an authority on consumer credit, "The term consumer credit
refers to a transfer of wealth, the payment of which is diferred on whole or in part, to future, and is
liquidated piecemeal or in successive fractions under a plan agreed upon at the time of the
transfer."

Features of onsumer redit
The salient features of consumer credit are:-
(1) Parties to te Transaction: The parties to a consumer credit transaction depend upon the
nature of the transaction.
(i) Bipartite Arrangement: A bipartite arrangement, there are two parties, namely,
borrower-consumer-customer and dealer-cum-financer.

(ii) Tripartite Arrangement: A tripartite arrangement where the parties are dealer,
financer and the customer. The dealer in this type of arrangement arranges the credit
from the financer.
(2) Structure of te Transaction: A consumer credit arrangement can be structured in three
ways:
(i) Hire-Purcase: The customer has the option to purchase the assets. But he may
not exercise the option and return the goods according to the terms of agreement.
Most of the tripartite consumer credit transactions are of this type.
(ii) onditionaI SaIe: The ownership is not transferred to the customer until the total
purchase price including the credit charge is paid. The customer cannot terminate
the agreement before the payment of the full price.
(iii) redit SaIe: The ownership is transferred to the customer on payment of the grist
installment. He cannot cancel the agreement.
(3) Mode of Payment: Form the point of view of payment, the consumer credit arrangements
fall into two groups:-
(i) Down Payment Scemes: The down payment may range between 20-25 percent of
the cost.
(ii) Deposit-Linked Scemes: The deposit may vary between 15-20 percent of the
amount financed at compound rate of interest.
(4) Payment Period and Rate of Interest: A wide range of options are available. Typically, the
repayment period ranges between 12-16 monthly installments. The rate of interest is
normally expressed at a flat rate; the effective rate of interest is generally not disclosed. n
some schemes, the rate of interest is not disclosed; instead the EM associated with the
different repayment periods is mentioned. Most of the schemes provide for easy
repayments. They also provide for either a rebate for prompt payment and charge for
delayed payment.
(5) Security: Security is generally in the form of a first charge on the asset. The consumer
cannot sell/pledge/hypothecate the asset.

Types of onsumer redit: There are several types of credit facility available to consumers.
They are briefly explained below:-
(1) RevoIving redit: An on-going credit arrangement similar to a bank overdraft, whereby the
financier, on a revolving basis, grants credit, is called 'revolving credit'. The consumer is
entitled to avail credit to the extent sanctioned as the credit limit; an ideal example of credit
is credit cards.
(2) Fixed redit: t is like a term loan whereby the financier provide loan for a fixed period of
time. The credit has to be squared off within a stipulated period. Examples of fixed credit
include monthly installment loan, hire purchase etc.
(3) as Loan: Under this type of credit, banks and financial institutions provide money with
which the consumer buy articles for personal consumption, three the lender and the seller
are different. The lender does not have the responsibilities of s seller.
(4) Secured Finance: When the credit granted by a financial institution is secured by collateral,
it takes the form of 'secured finance'. The collateral is taken by the creditor in order to satisfy
the debt in the event of default by the borrower. The collateral may be in the form of
personal property, real property or liquid assets.
(5) Unsecured Finance: Where there is no secured offered by the consumer against which
money is generated by financial institutions it takes the form of 'unsecured finance.'
(6) Non-InstaIIment: Non-installment Credit is the simplest form of credit and is usually for a
very short term, such as thirty days. The buyer makes one payment at or before the end of
the credit period. This kind of credit enables consumers to take possession of property

immediately and pay for it within a short time. Many departmental stores offer non-
installment credit to their regular customers, this enables the store to make sales and gets
the money in the near future, thus generating better cash flow for the business that might
otherwise occur.
(7) InstaIIment Iosed-End redit: t is another form, where only a specified amount of money
is lent to the consumer, typically the total purchase price of the goods. This kind of credit is
also used by departmental stores for the sale of large items and by auto dealers for the sale
of automobiles.

Uses/Benefits of onsumer redit
Consumer credit plays an important role in the mass production and distribution of consumer
durables such as motorcars, refrigerators, TV sets, radio, typewriters, sewing machines, electrical
appliances and many other goods. Offering credit is a great convenience to consumers. Further,
credit has come to occupy an important place in the modern competitive market.
(1) Enjoying Possession: An important benefit of consumer credit is that it allows people to
enjoy the possession of goods without having to pay for them immediately. The user doesn
not have to wait and save money for purchasing a dream product.
(2) ompuIsory Saving: Consumer Credit allows for a mechanism of compulsory saving. This
has the effect of inducing people into using their income more wisely. t promotes thrift
among people and enables people with limited means to acquire goods.
(3) Meeting Emergency: Consumer Credit is useful in meeting emergencies, such as illness,
accident and death, which involve unexpected expenses. This also helps save the esteem
of the consumer in dire circumstances.
(4) Maximization of Revenue: Consumer credit facilitates speedy disposal of goods, which
would have remained unsold in the absence of credit facility to customers. Credit induces
more business. This is quite true with regard to non-essential or luxury goods, such as motor
cars, trucks, refrigerators typewriters, all kinds of electric appliances etc.
(5) ReaIization of Dreams: Consumer credit is a boon for a consumer who can enjoy the
possession of goods without paying for them immediately. The installments can be
conveniently paid, spread over a fixed future period. Consumers are in a position to budget
for the purchase of even expensive capital items out of their regular, fixed and limited
income.

PIastic Money
Plastic Money was introduced in the 1950s and is now an essential form of ready money
which reduces the risk of handling a huge amount of cash. t includes debits cards, ATMs smart
cards etc. The cards are introduced in the world to resolve the issue of carrying huge cash. These
cards are known as plastic money. The usage of plastic money (cards) has increased in the mode of
payment of huge amount and time by time there are lots of different types of plastic money has been
introduced which enhanced the features of plastic money like we can use it to anywhere in the world,
New the world is becoming globalize so every card is accepted everywhere with the power of VSA
which interconnect the different countries.
Plastic Money entered the ndian market, promising a cashless society. But if we evaluate it
after a decode, certain deviations are easily seen, like the change in focus from cashless society to
plastic money as a debt instrument. As a new product, people used to flash colorful cards. However,
the present plastic money definitely locks sufficient infrastructure.
Plastic money was designed to help society overcome the hassles of carrying too much cash.
But it seems the multinational banks came here with a mission of targeting the emerging and
enormous middle-class segment (around 200 million people).

Types of PIastic Money


1) redit ard: A credit card is plastic money that is used to pay for products and services at
over 20 million locations around the world. All is need to do is produce the card and sign a
charge slip to pay for the purchases. The institution which issues the card makes the
payment to the outlet on customer behalf customer will pay this 'loan' back to the institution
at a later date.
2) Debit ard: (i) Debit cards are substitutes for cash or check payments, much the same way
that credit cards are. However, banks only issue them when the customers have an account
with the. When a debit card is used to make a payment, the total amount charged is
instantly reduced from bank balance.
(ii) A debit card is only accepted at outlets with electronic swipe-machines that can check and
deduct amounts from the bank balance online.
3) arge ard: A charge card is a means of obtaining to very short-term (usually around one
month) loan for a purchase. t is similar to a credit card, except that the contract with the
card issue requires that the cardholder must pay charges each months made to it in full-
there is no "minimum payment" other than the full balance. Since there is no loan, there is
no official interest. A partial payment (or no payment) results in a severe late fee (as much
as 5% of the balance) and the possible restriction of future transactions and risk of potential
cancellation of the card.
4) Amex ard: nternational visa and Master cards are commonly used by the travelers to bear
their expenses on their trips. Believe it or not, most of travelers finance their trips with their
business credit cards. One of the major reasons because of which this practice has become
common among the travelers is currency.
t becomes difficult for the travelers to go to currency exchange bureaus and
exchange their currencies at very low rates. Therefore, when American Express was
founded in 1850, its growth was very rapid because of the demand of international travelers
for American Express Cards.
5) Master ard/WorIdwide: Master Card worldwide is a multinational corporation based in
New York, United States. Throughout the world, its principal business is to process
payments between the banks of merchants and the banks of purchasers that use its "Master
Card" brand debit and credit cards to make purchases. Master Card Worldwide has been a
Publicly traded company since 2006. Prior to its initial public offering, Master Card
Worldwide war membership organization owned by the 25,000+financial institutions that
issue its card.
6) Smart ard: A smart card is a plastic card embedded with a computer chip that stores and
transacts data between users. This data is associated with either value or information or
both and is stored and processed within the cards chip, either a memory or micro processor.
The card data is transacted via a reader that is part of a computing system. Smart card
enhanced systems are in use today throughout several key applications, including
healthcare, banking, entertainment and transportation. To various degrees, all applications
can benefit from the added features and security that smart card provide. Thus, having a
smart card is like having a PC in wallet. With their ability to stores up to 80 times more
information than magnetic strips cards, smart cards will allow card companies to deliver
more personalized products and services providing consumers with custom-tailored cards to
suit their individual lifestyle.
7) Dinner Iub ard: Dinner Club nternational, originally founded as Dinner Club, is a charge
card company formed in 1950 by Frank X McNanara, Ralph Scheider and Motty Simmons.
When it first emerged, it became the first independent credit card company in the world.
(i) Card is good for dinners only
(ii) Card must be signed by Club members on front.

(iii) Card must be signed and dated by wait staff for each dinner purchased.
(iv) Offer not good for corporate members.
8) Poto ard: f customer photograph is imprinted on a card then it is known as a photo card.
t helps in identifying the use of the credit card and is therefore considered safer. Besides, in
many cases, photo card can function as identity card as well.
9) GIobaI ard: A very special Gold Visa Card with all its prestige and additional services
especially designed for people looking for peace of mind in their second home.
10) o-Branded ards: Co-branding is essentially two major brands converging to enhance the
usefulness and image of the product. n the case of a credit card, it is a partnership between
the issues, say, City bank and a retail service provides or a goods provider to meet
customer demand more efficiently. A card issued through a partnership between a bank and
another company or organization is called a co-branded card. The card would have both the
bank name and the store name on it. Many co-branded cards are also rebate cards that
provide the consumer with benefits such as extra services, cash or merchandised every time
the card is used.


Advantages of PIastic Money
1) Offer free use of funds, provided the customer to pay full balance in time.
2) t is more convenient to carry than cash.
3) Helps in establishing a good credit history.
4) Provide a convenient payment method for purchases made on the internet and over the take
phone.
5) Give incentives, such as reward points, that we can redeem.

redit ards
The growing credit card awareness has made this age of plastic money. With a credit card
one can buy almost anything on credit. Credit cards are innovations aimed to aid certain conscious
customers of the higher income group worldwide to enhance their purchasing power. A credit card
system is a type of retail transaction settlement and credit system, named after the small plastic
card issued to users of the system. A credit card is different from a debit card in that the credit card
issues loans the consumer money rather than having the money removed from an account. Most
credit cards are the same shape and size, as specified by the SO 7810 standard.
A Credit card is plastic card bearing an account number assigned to a cardholder with a
credit limit that can be used to purchase goods and services and to obtain cash disbursement on
credit for which a card holder is subsequently billed by an issue for repayment of the credit
extended at once or on an installment basis.

Features of redit ard
1) Al credit cards provide cash availing facility.
2) Apart from member establishments, most of the cards are honored in a number of other
establishments, including the airlines, railways, car rentals, petrol pumps, hotels, shops,
restaurants, departmental stores and hospitals.
3) Most of the cards provide for personal accident insurance coverage.
4) All the credit cards generally provide free credit period.
5) Most of the cards have associate relationship with international credit card companies like
Diner's Club, Master Card and Visa nternational.
6) Most of the cars provide Automated Teller Machine (ATM) facility.
7) Service charge is levied.

8) nstallment credit facility is provided by many of the cards.



Types of redit
1) Bank issued cards: Bank issued cards are usually linked to either the Master Card or VSA
organizations. For example, Citibank, CC, Standard Chartered, ANZ Grind lays etc. VSA
and Master Card is bank owned payment institution which facilitate the exchange and
settlement of transactions.
2) JB: The JCB card is issued by the Japan Credit Bureau and has developed into an
international payment card.
3) GoId ards: Gold cards function is exactly the same way as any other payment card. t can
be used to pay for goods and services and to obtain cash.
4) Affinity ards: Affinity Cards are issued by banks and linked to a particular group of people
or organization. Affinity cards can be aimed at groups both large and small, ranging from
5,000 people up to two million.
5) Store ard: Store cards have two way arrangements where the card issues are normally
the card acceptor. The card can usually be used in shops within the store group only. They
are a mean of payment and a source of credit, but it cannot be used to obtain cash.
6) EIectronic Debit ards: f these cards are used in conjunction with a bank overdraft, they
provide access to revolving credit in the same way as a credit card.
7) FueI ards: Fuel cards are issued by petrol companies, primarily to operators of company
car fleets for distribution to their drivers. These cards allow the holder access to credit in
order to buy petrol, the cost of which may then subsequently be met by their employer.
8) Add-on ards: Most of the credit card issues offer add-on cards in the name of the spouse
and children of the cardholder. The adden cards are offered at a subsidized rate compard to
the original cards.

Working of redit ards
A credit card user is issued the card after approval from a provider (often a general bank) in
which they will be able to make purchases from merchants supporting that credit card upto a pre-
negotiated credit limit. When a purchase is made, the credit card user indicates their consent to
pay, usually by signing a receipt with a record of the card details and indicating the amount to be
paid. More recently, electronic verification systems have allowed merchants (using a strip of
magnetized material on the card holding information is a similar manner to magnetic tape or a
floppy disk) to verify that the cards valid and the credit card customer has sufficient credit to cover
the purchase in a few seconds, allowing the verification to happen at time of purchase. Some
services can be paid for over the help phone by credit card merely by quoting the number
embossed onto the card (the credit card number), and they can be used in a similar manner to pay
for purchases from online vendors.
Each month the credit card user is sent a statement indicating the purchases undertaken
with the card, and the total amount owing. The cardholder must then pay a minimum proportion of
the bill by a due date, and may choose to pay more or indeed pay the entire amount owing. The
credit provider changes interest on the amount owing (typically, a fairly high rate much higher than
most other forms of debt). Typically, credit card issuers will waive interest charges if the balance is
paid in full each month, which allows the credit card to serve as a form of revolving credit.
As well as profits through interest, card companies charge merchant fear for money transfer.
When the companies formally or informally prevent these fees from being passed on to credit card
uses but instead require them to be spread among all customers, this raises the possibility of a
harmful market imperfection through the mechanism of the Tragedy of the commons, especially as
some credit providers give their users incentives such as frequent flier miles or gift certificates.
Australia is currently acting to reduce this by allowing merchants to apply surcharge for credit card

users. Credit card companies generally do provide a guarantee the merchant will be paid on
legitimate transactions regardless of whether the consumer pays their credit card bill. However the
credit card companies generally will not pay a merchant if the consumer challenges the legitimacy
of the transaction and will fine merchants who have a large number of chargeback's.
The credit card was the successor of a variety of merchant credit schemes. The concept of
paying merchants using a card was invented in 1950 with Diners Club's invention of the charge
card, which is similar but required the entire bill to be paid with each statement. Credit card service
was first offered in 1951.
Advantages of redit ard
1) Money from transactions credited into supplier's account within 2-4 days.
2) No cash involved.
3) Enable customers to buy expensive products immediately and make 'impulse' purchases.
4) Enable customers to make a payment over the telephone or over the internet.
5) Once transaction confirmed payment to supplier guaranteed.
6) Credit card holders can use card to obtain cash from a cash machine-although they pay
interest on withdraws from the moment they make the transaction.
7) Credit card holders have additional protection if goods are faulty, provided each item cost
over a minimum amount.
Disadvantages of redit ards
1) Risk of fraud, the through the use of stolen cards.
2) Cost of installing and paying for an electric terminal.
3) Card holders may spend more than they can afford.
4) Cost of processing the transactions.
5) nterest can be high if card is not paid-off in full each month-and cash withdrawals are
expensive.
6) Because the method of calculating interest is complicated people may find the interest
charge higher than they first thought.

Debit ards
Debit Cards are substitutes for cash or cheque payments much the same way that credit
cards are. However, banks only issue them to people if they hold an account with them. When a
debit card is used to make a payment, the total amount charged is instantly reduced from the bank
balance. A debit card is only accepted at outlets with electronic swipe-machines that can check and
deduct amounts from the bank balance on-line.
SO 7810 card which physically resembles a credit card and like a credit card is used as an
alternative to cash when making purchases. However, when purchaser is made with a debit card,
the funder is withdrawn directly from the purchaser's checking or savings account at a bank.
Features of Debit ards
1) Obtaining a debit card is often easier than obtaining a credit card.
2) Using a debit card instead of writing cheques saves from showing identification or giving out
personal information at the time of the transaction.
3) Using a debit card means, no longer have to stock-up on traveler's cheques or cash while
traveling.
4) Using a debit card means, no longer have to stock-up on traveler's cheques or cash while
traveling.
5) Debit cards may be more readily accepted by merchants than checks especially in other
states or countries wherever the card brand is accepted.
6) The debit card is a quick, 'pay now' product, giving no grace period.

7) Returning goods or cancelling services purchased with a debit card in treated as if the
purchase were made with cash or cheque.
Types of Debit ards
1) OnIine Debit ards: Online debit cards use the same underlying technology as ATMs that
dispense cash; authentication may consist of the use of a numeric PN known only to the
cardholder. PNs can be used only where the POS (point of sale) terminal is prosperity
equipped; in particular, a separate keypad is needed to allow the customer to enter his or
her PN and select the account from which funds should be drawn. This is the only method
used in some countries, particularly Canada.
2) OffIine Debit ard: Offline debit cards carry the logo types of and can be used in a manner
nearly identical to, major credit cards (for example, visa or master card). The use of a debit
card in this manner may have a daily limit, with the maximum limit being the amount of
money on deposit. A debit used in this manner is similar t a secured credit card.
3) Prepaid Debit Card: n the 1990s, credit card companies incurred heavy losses because of
money credit card users defaulted on their payments. Thus, credit card companies had to
come up with a new way to collect debts. t was during this period that credit card
companies began offering secured credit cards and prepaid debit cards. Today, most credit
card companies such as Visa, Master card and American Express issue prepaid debit cards.
A prepaid debit card works similar to a prepaid phone card.
Advantages of Debit ard
1) No need to carry cash.
2) No need to make a trip to the bank every time the customer needs to withdraw money.
He/she can use the card just about anywhere he/she goes, and can access money at an
ATM machines any time of day or night.
3) t is accepted more readily than cheque, especially when out to state.
4) No interest is paid on purchases.

Disadvantages of Debit ards
1) There is no grace period to pay the bill.
2) Debit cards do not have as much protection as credit cards.
3) Not all debit cards may be helping to build the credit score.
4) Some banks are now charging over-limit fees or non-sufficient funds fees based upon pre-
authorization and even attempted but refused transactions by the merchant (some of which
may not even be known).
5) Since debit cards are typically linked to bank accounts, if a debit card and PN number is
stolen, the entire bank account could be drained of funds.