Indian Financial System

Indian Financial System

Financial Markets:

A financial market can be defined as a market where financial assets can be created or transferred.

It is basically classified as primary and secondary markets. But more often financial market s are classified as money markets and capital markets.

Money market deals with all transactions in short term instruments (with a period of maturity of one year or less, like treasury bills, bills of exchange etc.)

Capital Market deals with all transaction in long term instruments (with a period of maturity above one year like corporate debentures, govt. bonds etc.) and stocks.

Money Market:

The important function of money market is to channel savings in to short term productive investments like working capital.

Call Money Market

It is a part of national money market where day to day surplus funds, mostly of banks, are traded. The maturity period of the call money loans vary from 1- 15 days.

The money that is lent for one day is known as “call money” and if it exceeds one day it is referred as “notice money”.

Call Rates: The interest paid on call loans are known as call rates. It reflects the day to day availability of funds. It is largely influenced by the forces of supply and demand of funds.

High call rate indicates the tightness of liquidity in the financial system and low rate indicates an easy liquidity position in the market.

The rate is usually high in the first week as banks try to meet the CRR requirements and subside gradually.

Commercial Paper(CPs)

 It is an unsecured usance money market instrument issued in the form of a promissory note at a discount, and is transferable by endorsement and delivery and is of fixed maturity.

It is introduced by in 1990 enabling highly rated corporate borrowers, to diversify their source of short term borrowings and to provide an additional instrument to investors.

A corporate would be eligible to issue CP provided

         I.            The tangible net worth of the company is not less than Rs.4 crore as per the latest audited balance sheets.

        II.            Company has been sanctioned working capital limit by bank/s or all India financial institutions.

      III.            The borrowed account of the company is classified as standard asset by banks/institution.

Issue Expenses:  The stamp duty on a primary issue of CP is 0.25 percent for all other investors, with a concession rate of 0.05 percent for banks. Secondary market transactions do not attract any stamp duty.

Certificates of Deposits (CDs)

 Certificate of Deposit  is a negotiable promissory note, secure and short term in nature. It is issued at a discount to the face value, the discount rate being negotiated between the issuer and the investor.

CDs were introduced in India in 1989 based on the Vaghul Committee recommendations.

The minimum amount of a CD an investor can subscribe should not be less than Rs.1 Lakh, it should be a multiple of Rs.1 Lakh & there after. 

The maturity period for CDs should not be less than 7days and not more than 1year.

Money Market Mutual Funds (MMMFs)

MMMFs are mutual funds that invest primarily in money market instruments of very high quality and of very short maturities.

Two types of schemes offered by MMFs

1.       Open-ended Scheme: In this case the units available for purchase on a continuous basis and the MMMF will be willing to repurchase the units.

2.       Closed-ended Scheme: In this case the units available for subscription for a limited period and is redeemed at maturity.

The guide line on MMMFs specifies a minimum lock-in period of 15 days during which the investor cannot redeem his investment. The guidelines also stipulate the minimum size of the MMMFs to be Rs.50 crore and this should not exceed 2% of the aggregate deposits of the latest accounting year in the case of banks and 2% of the long –term domestic borrowings in the case of public financial institutions.

Capital Market:

The capital market functions as an institutional mechanism to channel long-term funds for those who save, for those who need them for productive purposes.

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Rates of Reserve Bank of India

Repo (Repurchase) Rate

Repo rate is the rate at which banks borrow funds from the RBI to meet the gap between the demand they are facing for money (loans) and how much they have on hand to lend.

If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.

Reverse Repo Rate

This is the exact opposite of repo rate.

The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the reverse repo rate. The RBI uses this tool when it feels there is too much money floating in the banking system

If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI (which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk)

Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy

Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo signifies the rate at which liquidity is injected.

Bank Rate

This is the rate at which RBI lends money to other banks (or financial institutions .

The bank rate signals the central bank’s long-term outlook on interest rates. If the bank rate moves up, long-term interest rates also tend to move up, and vice-versa.

Banks make a profit by borrowing at a lower rate and lending the same funds at a higher rate of interest. If the RBI hikes the bank rate (this is currently 6 per cent), the interest that a bank pays for borrowing money (banks borrow money either from each other or from the RBI) increases. It, in turn, hikes its own lending rates to ensure it continues to make a profit.

Call Rate

Call rate is the interest rate paid by the banks for lending and borrowing for daily fund requirement. Si nce banks need funds on a daily basis, they lend to and borrow from other banks according to their daily or short-term requirements on a regular basis.

CRR

Also called the cash reserve ratio, refers to a portion of deposits (as cash) which banks have to keep/maintain with the RBI. This serves two purposes. It ensures that a portion of bank deposits is totally risk-free and secondly it enables that RBI control liquidity in the system, and thereby, inflation by tying their hands in lending money

SLR

Besides the CRR, banks are required to invest a portion of their deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements. What SLR does is again restrict the bank’s leverage in pumping more money into the economy.

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