Financial Institutions and Markets

Financial Markets and Institutions

BASIC CONCEPTS & TERMS
 Market – Place for trading of goods and services.
 Financial market– Markets in which funds are transferred from people
who have an excess of available funds to people who have a shortage of
funds.
 Security– A claim on the issuer’s future income.
 Bond–Debt security that promises to make payments periodically for a
specified period.
 Interest rate– Cost of borrowing or the price paid for the rental of funds.
 Common stock/ stock– A share of ownership in a corporation.
 Foreign exchange market– Funds are converted from one currency into
another. It determines the foreign exchange rate.
 Financial intermediaries– institutions that borrow funds from people who
have saved and make loans to other people.
 E-Finance– Delivering financial services electronically.
 Banks –Financial institutions that accept deposits and make loans.
 Reverse split- A stock split which reduces the number of outstanding
shares and increases the per-share price proportionately. This is usually
an attempt by a company to disguise a falling stock price, since the actual
market capitalization of the stock does not change at all. For example, if a
company declares a one-for-ten reverse split, then a person who
previously held 20 shares valued by the market at $1 each will then have
2 shares worth $10 each.
 Float - The number of shares of a security that are outstanding and
available for trading by the public. The amount of money or time
represented by checks that are in transit between deposit and payment, or
credit card purchases that are between the purchase and the payment.
 Double taxation- Taxation of the same earnings at two levels. One
common example is taxation of earnings at the corporate level and then
again at the shareholder dividend level. Another example is taxation of
foreign investments in the country of origin and then again upon
repatriation, although many countries have signed agreements to prevent
this latter type of double taxation.
 Market maker-A brokerage or bank that maintains a firm bid and ask
price in a given security by standing ready, willing, and able to buy or sell
at publicly quoted prices (called making a market). These firms display
bid and offer prices for specific numbers of specific securities, and if
 these prices are met, they will immediately buy for or sell from their own
accounts.

Unit – 1 – Financial System

Meaning of Financial System

 Financial System of a country consists of a network of an interconnected

system of markets, institutions and services.
 This system contributes to the economic development of a country.
 The main function of the financial system are to encourage savings and to
transfer them efficiently into investments.
 Various components of financial system are:
 Financial Institutions
 Financial Markets
  Financial Instruments
 Financial Services
A financial system is a system that allows the exchange of funds between
financial market participants such as lenders, investors, and borrowers.

Financial systems operate at national and global levels.

A financial system is the set of global, regional, or firm-specific institutions and

practices used to facilitate the exchange of funds.

Financial systems can be organized using market principles, central planning,

or a hybrid of both.

A financial system is a combination of people, institutions, businesses, and

processes that facilitate financial transactions.
Formal and Informal Financial Sector
 In simple terms, formal finance is financing capital that has been
sourced from banks and other formal financial intermediaries, whereas
informal finance is the capital which has been sourced from friends,
family, relatives or private moneylenders.
Formal Financial Sector : The financial sector is a section of the
economy made up of firms and institutions that provide financial
services to commercial and retail customers. This sector comprises a
broad range of industries including banks, investment companies,
insurance companies, and real estate firms.
Informal Financial Sector : Companies and individuals seeking
higher return than interest on bank deposits are able to earn higher returns
by placing funds in the informal financial sector. This sector thus acts as
an alternative intermediary to banks and other formal institutions and
also performs the functions of risk management and monitoring.
• Components of the formal financial system
A financial system consists of individuals like borrowers and lenders
and institutions like banks, stock exchanges, and insurance companies actively
involved in the funds and assets transfer. It gives investors the ability to grow
their wealth and assets, thus contributing to economic development.
There are several financial system components to ensure a smooth
transition of funds between lenders, borrowers, and investors.
 Financial Institutions
 Financial Markets
 Tradable or Financial Instruments
 Financial Services
 Currency ( Money )
1. Financial Institutions Financial institutions act as intermediaries between
the lender and the borrower when providing financial services. These
include:
Banks (Central, Retail, and Commercial)
Insurance Companies
Investment Companies
Brokerage Firms
2. Financial Markets
These are places where the exchange of assets occurs with borrowers
and lenders, such as stocks, bonds, derivatives and commodities. Financial
markets help businesses to grow and expand by allowing investors to
contribute capital. Investors invest in company stock with the expectation of
it producing a return in the future. As the business makes a profit, it can then
pass on the surplus to the investors.
3. Financial Instruments
Tradable or financial instruments enable individuals to trade within the
financial markets. These can include cash, shares of stock ( representing
ownership), bonds, options, and futures.
4. Financial Services
Financial services provide investors a way of managing assets and
offer protection against systemic risk. These also ensure individuals have the
appropriate amount of capital in the most efficient investments to promote
growth. Banks, insurance companies, and investment services would be
considered financial services.
5. Currency ( Money )
 A currency is a form of payment to exchange products, services, and
investments and holds value to society.
Functions of Financial Systems
A financial system allows its participants to prosper and reap the benefits.
It also helps in borrowing and lending when needed. In simpler words, it will
circulate the funds to different parts of an economy. Here are some of the
financial system functions:
 Payment
Savings Liquidity
System

Risk Government
Management Policy

Payment System – An efficient payment system allows businesses and

merchants to collect money in exchange for their products or services.
Payments can be made with cash, checks, credit cards, and even crypto
currency in certain instances.
Savings – Public savings allow individuals and businesses to invest in
a range of investments and see them grow over time. Borrowers can
use them to fund new projects and increase future cash flow, and
investors get a return on investment in return.
Liquidity – The financial markets give investors the ability to reduce
the systemic risk by providing liquidity. It thus allows for easy buying
and selling of assets when needed.
Risk Management – It protects investors from various financial risks
through insurances and other types of contracts.
Government Policy – Governments attempt to stabilize or regulate an
economy by implementing specific policies to deal with inflation,
unemployment, and interest rate.
Elements of a Financial System

The elements of a financial system make up several key parts of an economy.

A financial system involves all of the businesses, regulations and systems that
handle money in that economy.
While financial systems may seem complicated, the elements of financial
systems are regular parts of everyday life that, when working well, combine
to create and facilitate large-scale economic impacts.

The six elements of a financial system are lenders and borrowers, financial
intermediaries, financial instruments, financial markets, money creation and
price discovery.

These financial-system components keep money flowing between people and

businesses in an organized manner.
Lenders and Borrowers

Lenders loan money to borrowers.

Although people can be lenders on a private basis, lenders in a

 financial system are typically financial institutions.

A homebuyer often finances the purchase of their home through a

mortgage loan, making them a borrower.

Businesses also take out loans from financial institutions.

One characteristic of a good financial system is regulation

surrounding lending.
Financial Intermediaries

Financial intermediaries act in between two financial

 institutions to make the entire financial system more stable.

Think of a financial intermediary as a "middle man."

Financial intermediaries rarely own the money they hold.

Rather, these businesses and organizations move funds from one

part of the financial system to the next.

Banks are one example of a financial intermediary.

Financial Instruments

A financial instrument is a contract for trading a financial asset.

Financial instruments are an important part of a financial system because they
allow wealth to keep moving throughout the system.

Checks, bonds, certificates of deposit, stock trades and stock options contracts
are all examples of financial instruments.

Financial Markets
A financial market is any marketplace, physical or virtual, where financial
instruments can be traded between people and financial institutions.

The stock market is a financial market.

Other examples of financial markets include the real estate market, the bonds
market, the commodities market and the foreign exchanges market.
 Categorization of Financial Market-
 Debt and Equity Market
  Primary and Secondary Market and
 Exchanges and Over the Counter Market
 Money and Capital market

Money Creation

Financial systems rely on money circulating throughout them.

A government may introduce new money to the market by printing it.

In the United States, the Federal Reserve makes decisions regarding the creation

of money.
Different financial systems may have different forms of money creation, but

there must be an adequate amount of money circulating to keep the system

going.

In regards to crypto currency, money creation happens when a new type of

currency is created.
Price Discovery

Price discovery is the process of setting a price for goods, services, or even

financial instruments.

Price discovery is based on a variety of factors, such as supply and demand.

 Items that are unwanted or plentiful often have cheaper prices.

Although it may not always seem this way to consumers, price discovery is a

collaborative effort between buyers and sellers.

Sellers must price their goods in order to make a profit, and buyers must be

willing to pay that price.

Nature and Role of Financial Intermediaries

Financial intermediaries serve as middlemen for financial transactions,
generally between banks or funds.

A non-bank financial intermediary does not accept deposits from the

general public.
The intermediary may provide factoring, leasing, insurance plans, or other
financial services.

The overall economic stability of a country may be shown through the

activities of financial intermediaries and the growth of the financial
services industry.

Financial intermediaries move funds from parties with excess capital to

parties needing funds.
 Benefits of Financial Intermediaries

Through a financial intermediary, savers can pool their funds, enabling them to
make large investments, which in turn benefits the entity in which they are
investing.

At the same time, financial intermediaries pool risk by spreading funds across a
diverse range of investments and loans.

 Financial intermediaries also provide the benefit of reducing costs on several

fronts.

For instance, they have access to economies of scale to expertly evaluate the credit
profile of potential borrowers and keep records and profiles costeffectively.

Last, they reduce the costs of the many financial transactions an individual investor
would otherwise have to make if the financial intermediary did not exist.
Meaning of Financial Markets
A Financial Market is referred to space, where selling and buying of

financial assets and securities take place.

It allocates limited resources in the nation's economy.

It serves as an agent between the investors and collector by mobilizing

capital between them.

In a financial market, the stock market allows investors to purchase and

trade publicly companies share.

The issue of new stocks are first offered in the primary stock market,

and stock securities trading happens in the secondary market.

Importance of Financial Market in an Economy
The markets make it easy for buyers and sellers to trade their financial

holdings.

The stock market is just one type of financial market.

Financial markets are made by buying and selling numerous types of

financial instruments including equities, bonds, currencies, and

derivatives.

Financial markets rely heavily on informational transparency to ensure

that the markets set prices that are efficient and appropriate.
 The market prices of securities may not be indicative of their intrinsic

value because of macroeconomic forces like taxes.

The Role of Financial Markets
Financial markets have a crucial role in our economic system; they
allow global commerce to transact smoothly and continuously, with no breaks,
while reducing price shocks. Discover everything you need to know about
financial markets.

Capital markets

Stock markets

Money markets

Forex markets
Bond markets

Commodities markets

Derivatives markets
Types of Financial Markets
Over the Counter (OTC) Market: They manage the public stock exchange, which is not
listed on the NASDAQ, American Stock Exchange, or New York Stock Exchange. The
OTC market deals with companies that are usually small, can be traded cheaply, and have
less regulation.

Bond Market: A financial market is a place where investors loan money on bonds as
security for a set period of time at a predefined rate of interest. Bonds are issued by
corporations, states, municipalities, and federal governments across the world.

Money Markets: They trade high liquidity and short maturities and lend securities that mature
in less than a year.
Derivatives Market: They trade securities that derive their value from their primary asset.
The derivative contract value is regulated by the market price of the primary item in the
derivatives market, including futures, options, contracts-for-difference, forward contracts,
and swaps.

Forex Market: It is a financial market where investors trade in currencies. In the entire world,
this is the most liquid financial market.
Functions of Financial Market
Mentioned below are the important functions of the financial
market.
It mobilizes savings by trading it in the most productive methods.

It assists in deciding the securities price by interaction with the investors and

depending on the demand and supply in the market.

 It gives liquidity to bartered assets.

Less time-consuming and cost-effective as parties don’t have to spend

extra time and money to find potential clients to deal with securities. It

also decreases cost by giving valuable information about the securities

traded in the financial market.

The Structure of the Financial System

The financial system consists of many institutions, instruments, and markets.

Financial institutions range from pawnshops and moneylenders to banks,

pension funds, insurance companies, brokerage houses, investment trusts, and
stock exchanges.
Financial instruments range from the common coins, currency notes, and
checks; mortgages; corporate bills; bonds; and stocks; to the more exotic
futures and swaps of high finance.

Markets for these instruments may be organized formally (as in stock or bond
exchanges with centralized trading floors) or informally (as in over-thecounter
or curb markets).

For analytical purposes, the system can be divided into users of financial
services and providers.
Classification of the Financial System In India
The Indian financial system is broadly classified into two broad
groups:
i.Organized sector and (ii) Unorganized sector.
 The financial system is also divided into users of financial
services and providers.
Financial institutions sell their services to households,
businesses and government. They are the users of the financial
services. The boundaries between these sectors are not always
clear cut.
In the case of providers of financial services, although financial
systems differ from country to country, there are many similarities.
(i) Central bank (ii) Banks (iii) Financial institutions (iv) Money and
capital markets and (v) Informal financial enterprises.
Organized Indian Financial System
The financial system is a critical element in a well-functioning economy.

The organized financial system comprises of an impressive network of banks,

other financial and investment institutions and a range of financial
 instruments, which together function in fairly developed capital and money
markets.

Short-term funds are mainly provided by the commercial and co-operative

banking structure.

Nine-tenth of such banking business is managed by twenty-eight leading banks

which are in the public sector.

With around two-third share in the total assets in the financial system, banks
play an important role.
Organized Financial System Comprises
The organized financial system comprises the following
sub-systems:
 Banking system
 Co-operative system
 Development Banking system
 Public sector
 Private sector
 Money markets and
 Financial companies/institutions. Microfinance institutions
 Slide 31

Important Source of Surplus Funds in an Economy

The most important source of surplus funds in an economy tends to
be the households, but sometimes business enterprises, governments
(central, state or local) as well as foreigners also sometimes have excess
funds and so they also lend them out. The most important borrowerspenders
are various businesses and governments at different levels; however, at
times the households and foreigners may also borrow to finance their
spending.
The finance could be of two types:
 Direct Finance: In this case the borrower directly borrow funds from the
lender in the financial markets by selling them securities ( also called
financial instruments), which are claim on the borrower’s future
income/assets or
 Indirect Finance: In this case the role of channelising the funds from the
savers to borrowers is done through financial intermediaries (example
commercial banks, such as HDFC Bank, Canara Bank etc.; and non-bank
financial institutions such as LIC, IDBI, Mutual Funds etc.).
 Slide 32

 It is important to understand that Securities are assets for person/firm who buys them but
liabilities/debts (or IOUs) for individual/firm that sells (issues) them.

One may ask why it is important to channelise the funds from savers to borrowers.

The answer is as follows: the people who have surplus funds are generally not the people
who have the idea about the profitable investment opportunities.

In the absence of financial markets the savers and borrowers would find it very hard to
transfer funds from a person who has surplus funds but does not have the profitable
opportunities to invest to one who and lacks adequate funds.

Financial markets, thus, are essential in promoting economic efficiency in any economy.
Financial markets significantly contribute to higher production, efficiency, and consumer
well-being by enabling better purchase timing and maximizing their potential for societal
economic welfare.
Types of Financial Intermediary
 Slide 33

Financial intermediaries have a lot of variety across different countries.

Typically the financial intermediaries can be:
Commercial Banks; e.g. State Bank of India, HDFC Bank, ABN AMRO Bank, Citibank, HSBC Bank,

etc.

Development Banks, e.g. IDBI, ICICI, NABARD, SIDBI, etc.

Financial adviser or broker;

Insurance Companies; GIC, AIG, Tokio, Peerless etc.

Life Insurance Companies; LIC, Allianz, AIG

Mutual Funds; Standard Chartered Mutual Fund, Morgan Stanley Mutual Fund, SBI Mutual Fund etc.

Pension Funds; e.g. CalPERS (California Public Employee Retirement System), EPF

(Employees Provident Fund), PPF (Public Provident Fund) Building

Societies; HDFC, HUDCO etc.

Credit Unions;
 Slide 34

Summary

We found that the financial system, among other things helps to provide liquidity and reduce

risks.

Following this study explained the idea of financial intermediation and listed the main

intermediaries.

Structural Reform of the Financial Sector Executive Summary The U.S. financial

system is critical to the functioning of the economy as a whole and banks are central to

the financial system.

In addition to providing substantial employment, finance serves three main purposes:
Credit provision

Credit fuels economic activity by allowing businesses to invest beyond their cash on hand,

households to purchase homes without saving the entire cost in advance, and governments to
smooth out their spending by mitigating the cyclical pattern of tax revenues and to invest in
infrastructure projects.

Banks directly provide a substantial amount of credit in the U.S., but, unlike in almost any other

economy, financial markets are the ultimate providers of most credit.

Liquidity provision.

• Businesses and households need to have protection against unexpected needs for cash.

• Banks are the main direct providers of liquidity, both through offering demand deposits that can be

withdrawn any time and by offering lines of credit.

• Further, banks and their affiliates are at the core of the financial markets, offering to buy and sell

securities and related products at need, in large volumes, with relatively modest transaction costs.
• This latter role is particularly important in the U.S., given the dominance of markets, but is often

under-appreciated

Risk management services

Finance allows businesses and households to pool their risks from exposures to
financial market and commodity price risks.

Much of this is provided by banks through derivatives transactions.

These have gotten a bad name due to excesses in the run-up to the financial
crisis but the core derivatives activities provide valuable risk management
services.

Many argue that the U.S. financial system grew overly large in the bubble period
and is still too large today.
We agree that some of the activities that took place in the bubble period
involved taking on excess amounts of risk, but it is extremely hard to
determine the right size of the financial system based on well-grounded
economic theories.
Financial Institutions and Markets
Unit - II
1. Financial Markets
Financial Markets include any place or system that provides
buyers and sellers the means to trade financial instruments, including
bonds, equities, the various international currencies, and derivatives.
Financial markets facilitate the interaction between those who need
capital with those who have capital to invest.
2. The Money Markets
They provide a means for lenders and borrowers to satisfy their
short-term financial needs.
Money markets were once seen as low-volatility segments of the

financial system, providing safe, liquid investments for funds like banks
and borrowers.
The global financial crisis highlighted the differences among different

segments, with some exhibiting resilience while others were fragile.

 Price
Determination

Funds
Capital Formation
Mobilization

Functions of
Financial Markets
Reduction in
Transaction Costs
Liquidity
and Provision of
the Information

Easy Access Risk sharing

I. Price Determination
The financial market performs the function of price discovery of the different financial
instruments traded between the buyers and the sellers on the financial market.

The prices at which the financial instruments trade in the financial market are determined by
the market forces, i.e., demand and supply.

So the financial market provides the vehicle by which the prices are set for both financial
assists which are issued newly and for the existing stock of the financial assets.

II. Funds Mobilization

Along with determining the prices at which the financial instruments trade in the financial
market, the required return out of the funds invested by the investor is also determined by
participants in the financial market.

The motivation for persons seeking the funds is dependent on the required rate of return, which
the investors demand.
 III. Liquidity
The liquidity function of the financial market provides an opportunity for the
investors to sell their financial instruments at their fair value prevailing in the market at any time
during the working hours of the market.
IV. Risk sharing
The financial market performs the function of risk-sharing as the person who
is undertaking the investments is different from the persons who are investing their fund
in those investments. With the help of the financial market, the risk is transferred from
the person who undertakes the investments to those who provide the funds for making
those investments.
V. Easy Access
The industries require the investors to raise funds, and the investors require the
industries to invest their money and earn the returns from them. So the financial market platform
provides the potential buyer and seller easily, which helps them save their time and money in finding
the potential buyer and seller.
 VI. Reduction in Transaction Costs and Provision of the Information
The trader requires various types of information while doing the transaction of buying
and selling the securities. For obtaining the same time and money is required. But the financial
market helps provide every type of information to the traders without the requirement of spending
any money by them. In this way, the financial market reduces the cost of the transactions.
VII. Capital Formation
Financial markets provide the channel through which the new investors’ savings
flow in the country, which aids in the country’s capital formation.
4. Efficiency and Instruments
Efficiency of the Instrument Mortgage Instrument means any mortgage, deed of
trust or deed to secure debt executed by a Credit Party in favor of the Administrative Agent,
for the benefit of the Secured Parties, as the same may be amended, modified, extended,
restated, replaced, or supplemented from time to time. Market efficiency refers to the degree
to which market prices reflect all available, relevant information.

MONEY MARKET :
Money market is a specialized market geared to cater to the short term needs. It is
a market for short term financial assets which near substitutes for money.
Characteristics :
• Over-the-phone market.
• Dealings with or without the help of brokers.
• Short term financial assets that are close substitutes for money.
• Period generally up to one year.
• Financial assets which can be converted into money with ease, speed, without
loss and with minimum transactions cost are regarded as close substitutes for
money or near-money.
• Consists sub markets such as commercial paper market, treasury bills market, etc.
Commercial paper market: is a money-market security issued by large corporations to obtain
funds to meet short-term debt obligations (for example, payroll) and is backed only by an issuing bank
or company promise to pay the face amount on the maturity date specified on the note
1. Call money, also known as money at call, is a short-term financial loan that is payable immediately, and in full, when the lender
demands it.
2. Treasury bills (T-bills) are short-term debt instruments issued by the U.S. Department of the Treasury to help finance government spending.
They are considered one of the safest investments because they are backed by the full faith and credit of the U.S. government. Here are
some key points about the T-bill market:
a. Maturity Periods: T-bills are typically issued with maturities of 4 weeks, 8 weeks, 13 weeks, 26 weeks, and 52 weeks.
b. Discount Pricing: T-bills are sold at a discount to their face value. Investors receive the face value upon maturity, with the difference
representing the interest earned. For example, if a T-bill with a face value of $1,000 is sold for $950, the investor earns $50 when it
matures.
c. Auction Process: T-bills are sold through a competitive bidding process at regular auctions held by the Treasury. Investors can submit bids,
either competitively (specifying the yield they wish to receive) or non-competitively (agreeing to accept whatever yield is determined at
auction).
d. Liquidity: The T-bill market is very liquid, making it easy for investors to buy and sell them in the secondary market.
e. Safety: As government securities, T-bills are considered virtually risk-free, making them a popular choice for conservative investors and
institutions.
3. The commercial bill market refers to a sector of financial market where short -term debt instruments, known as
commercial bills, are bought and sold. These bills are typically iss ued by companies and financial institutions to manage
their short-term funding needs. Here’s a brief overview of its key aspects:

A. Short-term Financing: Commercial generally have maturities ranging from a few days to up to a year, making them a popular choice for
needing quick access to funds.
B.
Discounted Instruments: These bills are often sold at to their face value, which means investors earn the difference between the purchase
price and the face value at maturity.
C. Liquidity: The commercial bill market is considered liquid, allowing investors to buy and sell bills relatively easily.
D. Participants: The market includes various participants, such as corporations, banks, financial institutions, and individual investors.
E. Risk: While generally seen as low-risk investments, the credit risk of the issuer is a factor. Investors must assess the financial stability of the
issuing company.
F. Economic Indicator: The activity in the commercial bill market can serve as an economic indicator, reflecting the short-term borrowing
needs and overall economic conditions.
 4. A Certificate of Deposit (CD) is a financial product offered by banks and credit unions that allows individuals to deposit a fixed sum of money for
a specified period of time, earning interest on that amount.
5. A short term loan is a type of loan that is obtained to support a temporary personal or business capital need.
6. repurchase agreement**, often abbreviated as a **repo**, is a financial transaction in which one party sells securities to another party with
the agreement to repurchase those same securities at a later date, typically at a slightly higher price. This mechanism serves as a form of short-
term borrowing, with the securities themselves acting as collateral.

Objectives of money market:

• Provides an equilibrating mechanism for evening out short term surpluses and
deficits.
• Provides a
for central bank intervention for influencing liquidity in the economy.
• Provides reasonable access to users of short term money to meet their
requirements at a realistic price
Prerequisites for an efficient money market:
• It should be wide and deep – Large number of participants.
• There should be well diversified mix of money market instruments suited to the
requirements of borrowers and lenders.
• Active secondary markets in these instruments.
• Strong central bank for regulation, direction and facilitation is required.
• Well organized commercial banking system.
• Full scope for play of market forces in determining demand and supply of funds
and the rate of interest.
• Number of inter related and intra related sub markets like call money market,
commercial bill market, etc.
• Competition between each sub-market and between different sub markets.
• Adequate amount of liquidity in the form of large amounts maturing with in a
short period.
• A large demand and supply of funds
Money Market instruments:
• Money at call and short notice (Call loans).
• Treasury Bills (TBs) – 14 day TBs (introduced in MAY 1997), 28 day TBs
(introduced in October 1997), 91 day TBs, 182 day TBs (auction discounted) and
364 day TBs.
• Bills Rediscounting Scheme (BRS). •
Certificates of Deposits (CDs). • Commercial Papers (CPs).
• Repurchase Options or Ready Forward (REPOs or RF).
• Inter Bank Participation Certificates (IBPCs) on a risk sharing basis or without risk
sharing basis
• Securitized Debts.
• Options.
• Financial Futures.
• Forward Rate Agreements
• Swaps.
• Collateralised Borrowing and Lending Obligations (CBLO).
Capital Market:
• Capital Market is generally understood as the market for long term funds.
• However, sometimes the term is used in broad sense to include also the market for
short term funds.
• But in most of the cases, the term Capital Market is used to refer to the market for
long term loanable funds as distinct from money market.
• Money Market & Capital Market are in fact inter dependent markets.

Capital Market: Constituents

• Marketable Securities includes:-
Government Securitie.
Corporate securities
P.S.U. Bonds- Mutual Funds
• Non-Marketable securities includes:-
Bank Deposits-
Deposit with Companies
Loans & advances of Banks and FIs.
Post Office Certificates and Deposits
The Primary markets and Secondary market
Primary Markets.
The primary market is where securities are created, while the secondary market is where those securities are traded by

investors.

In the primary market, companies sell new stocks and bonds to the public for the first time, such as with an initial public

offering (IPO).

A primary market is a source of new securities.

Often on an exchange, it's where companies, governments, and other groups go to obtain financing through debt-based or

equity-based securities.

Primary markets are facilitated by underwriting groups consisting of investment banks that set a beginning price range for

a given security and oversee its sale to investors.

Secondary market
For buying equities, the secondary market is commonly referred to as the "stock market."
The defining characteristic of the secondary market is that investors trade among themselves.

That is, in the secondary market, investors trade previously issued securities without the issuing companies' involvement.

For example, if you go to buy Amazon ) stock, you are dealing only with another investor who owns shares in Amazon.

Amazon is not directly involved with the transaction.

The Derivative market
The derivatives market is the financial market for derivatives, financial instruments like futures
contracts or options, which are derived from other forms of assets.

The market can be divided into two, that for exchange-traded derivatives and that for over-the counter
derivatives.

Derivatives market is the financial market for derivatives which are a group of products including
futures and options whose value is derived from and/or is dependent on the value of a different
underlying asset such as commodities, currency, securities etc.

Common examples of derivatives include futures contracts, options contracts, and credit default
swaps.
Beyond these, there is a vast quantity of derivative contracts tailored to meet the needs of a diverse
range of counterparties.

The debt market

The debt market, or bond market, is the arena in which investment in loans are bought and sold.

There is no single physical exchange for bonds. Transactions are mostly made between brokers or
large institutions, or by individual investors.

The Financial Regulation

Financial regulation refers to the rules and laws firms operating in the financial
industry, such as banks, credit unions, insurance companies, financial brokers and
asset managers must follow. However financial regulation is more than just having
rules in place - it's also about the ongoing oversight and enforcement of these rules.

The Central Bank of Ireland regulates and supervises over 10,000 financial service
providers operating in Ireland. Since 2014, the responsibility for supervising banks
 is shared between the Central Bank of Ireland and the European Central Bank
(ECB).

Most of the laws governing the financial system are made by politicians in the
House of the Oireachtas or the European Union. The Central Bank then oversees
how these rules are complied with, sometimes issuing additional guidance. These
rules have strengthened significantly since the financial crisis.
Financial Regulation Important
All of us depend on the financial system in one way or another. For example,
savers rely on banks to have their money available when they need it.
Businesses need to be able to borrow to maintain and develop their business.
Consumers taking out a mortgage or insurance may need to get advice on the
best product for them. In the case of insurance companies, policyholders rely
on getting claims paid when something goes wrong.
Poorly regulated financial institutions have the potential to undermine the
stability of the financial system, harm consumers and can damage the
prospects for the economy. That's why strong financial regulation is important
- to put rules in place to stop things from going wrong, and to safeguard the
wider financial system and protect consumers if they do go wrong.
RBI Guidelines (RESERVE BANK OF INDIA)

RBI Guidelines refer to guidelines, circulars, notifications,

regulations, and decisions relating to taxation, monetary union,

capital adequacy, income recognition, asset classification,

 liquidity, reserve requirements, special deposit cash ratio, capital

asset requirements, and banking or monetary control.

These guidelines are issued by competent authorities, including

those related to small finance banks in the private sector.

SEBI Guidelines
SEBI stands for Securities and Exchange Board of India. It is a statutory regulatory body
that was established by the Government of India in 1992 for protecting the interests of
investors investing in securities along with regulating the securities market. SEBI also
regulates how the stock market and mutual funds function.

Purpose of SEBI
 The purpose for which SEBI was setup was to provide an environment that paves
the way for mobilization and allocation of resources. It provides practices, framework and
infrastructure to meet the growing demand.

It meets the needs of the following groups:

 Issuer: For issuers, SEBI provides a marketplace that can utilized for raising funds.

 Investors: It provides protection and supply of accurate information that is maintained on a regular
basis.

 Intermediaries: It provides a competitive market for the intermediaries by arranging for proper
infrastructure.
THE CAPITAL MARKET.
Introduction Objectives
Main Content.
1. Evolution of the Capital Market
2. Meaning of the Capital Market
3. Segment of the Capital Market
4. Functions of Active Capital Market.

INTRODUCTION.
In the last unit, you learnt about the money market, the participants in money
markets, features of a developed money market, reasons for the establishment of the
Nigerian money market, functions of the money market and common money market
instruments. This unit will extensively discuss the capital market.
Meaning of the Capital Market.
The capital market refers to a collection of financial institutions set up for the
purpose of granting long-term loans. It is a market for long-term instrument which
include market for government securities, market for corporate bonds, market for
corporate shares (stocks) and market for the mortgage loans. That is to say that, it is
the market for the mobilisation and utilisation of long-term funds for development of
the financial system. You should note that the capital market is composed of the
inner capital market (market for new securities) and the outer capital market
(including insurance companies, building societies, saving banks and other bodies
not directly concerned with the issue of new securities, but which are engaged in the
business of long-term borrowing and lending upon which the issue of new securities
depends). Included in the outer capital market are the special financial companies set
up to help in providing medium and long-term capital for industry. Consequently,
the capital market embraces both the new issues (primary) market and the secondary
(seasoned securities) market, whether such securities are raised in an organised
market such as the stock exchange or not. In this sense, it involves consortium
underwriting, syndicated loans and project financing; it involves formal stock
exchanges and the unlisted securities market. Thus, it is the mechanism whereby
economic units desirous to invest their surplus funds, interact directly or through
financial intermediaries with those who wish to procure funds for their businesses. In
the Nigerian stock exchange, discount houses, development banks, investment
banks, building societies, stock broking firms, insurance and pension organisations,
quoted companies, the government, individuals and the NSEC.
Segment of the Capital Market.
You should note that there are two segments of the capital markets. These are
primary and secondary markets, which are discussed briefly as follows;
1. Primary market: This is a market that deals with issue and sales of new
securities of companies which are not previously quoted on the stock exchange
market. Methods of raising funds in the capital market will be discussed below.
The instruments used in the primary market are:
a. Offer for sale: In a capital market, the company sells the entire issue of shares or
debentures to an issue house or merchant banker at an agreed price, which is
 normally below the par value. The shares or debentures are then resold by issue
house/merchant bankers to be public.
b. Obtaining term loans: In capital market, companies can additionally raise long
term cash by obtaining long-term loans, mostly from financial institutions. Term
loans are also referred to as ‘term finance’ which represent a source of debt
finance and is generally repayable in more than one year but less than 10 years.
c. Right issue: In capital market, rights issue means selling securities in primary
market by issuing shares to existing shareholders
d. Private placing: The capital issue is sold directly to a small group of investors.
Mainly institutional investors like insurance companies, banks, mutual funds,
few private investors, etc.
e. Public issue: In a capital market, company can borrow funds from primary
market by way of public issue of shares and debentures. To manage its issue a
company can take the help of merchant bankers. The cost of raising funds
through public issue is high as compared to other methods
2. Secondary market: This is a market for trading of second hand securities. In
this market holders of existing shares who wish to sell them can have contact
with individuals or institutions interested in buying
Functions of Active Capital Market.
The following are functions of an active capital market:
a. The promotion of rapid capital formation.
b. The provision of sufficient liquidity for any investor or group of investors.
c. The creation of built-in operational and allocation efficiency within the financial
system to ensure that resources are optimally utilized at relatively little costs.
d. The mobilisation of savings from numerous economic units for economic
growth and development
e. The encouragement of a more efficient allocation of new investment through the
pricing mechanism
f. The provision of alternative sources of fund other than taxation for government.
g. The broadening of the ownership base of assets and the creation of healthy
private sector.
h. The encouragement of a more efficient allocation of a given amount of tangible
wealth through changes in wealth ownership and composition.
i. Provision of an efficient mechanism for the allocation of savings among
competing productive investment projects.
j. It is machinery for mobilising long-term financial resources for industrial
development.
k. It is a necessary liquidity mechanism for investors through a formal market for
debts and equity securities.

The Nigerian Securities and Exchange Commission (NSEC)

The Nigerian Securities and Exchange Commission (NSEC) is next key
institution in the capital market after the CBN. Formerly called the Capital
Issues Committee (1962-1972), and the Capital Issue Commission (1973-1979),
NSEC was established by the NSEC Act of 27th September, 1979 which was re-
enacted by the NSEC Decree of 1988. The NSEC as an apex regulatory organ of
the capital market has the objectives of promoting an orderly and efficient
capital market in Nigeria by providing a conducive environment for savings and
investment necessary for economic development; ensuring fair and appropriate
price for stocks and shares; and ensuring adequate protection of the investing
public. Mention must however, be made that unlike the CBN, NSEC does not
participate in the capital market as a buyer or seller of securities. Generally,
NSEC’s primary functions
1. Determination of price and time at which companies’ securities are to be sold

;
2. Registering all securities proposed to be offered privately with the intention

that they would be held ultimately other than by those to whom the offers
were made;
3. Registering all securities dealers (stockbrokers), investment adviser, registrars

and market places in the industry such as stock exchange branches with a
view to maintaining proper standards of conduct and professionalism in the
securities business.
4. Maintaining overall surveillance of the market to ensure orderly, fair and

equitable dealings and to forestall or take steps to forestall illegal and

unethical dealings, such as insider training at the expense of the public;
5. Determining the basis for allotment of securities offered to the market to

ensure spread and equity; and

6. Determining the volume of issue coming to the market with a view to
preventing the market from being over flooded with issues.
 Financial Institutions
Unit : III
Financial Institutions
A financial institution (FI) is a company engaged in the business of dealing with financial and
monetary transactions such as deposits, loans, investments and currency exchange.

Financial institutions encompass a broad range of business operations within the financial
services sector including banks, trust companies, insurance companies, brokerage firms, and
investment dealers.

Virtually everyone living in a developed economy has an ongoing or at least periodic need for
the services of financial institutions.
Understanding Financial Institutions ( FIs )
Financial institutions serve most people in some way, as financial operations are a critical
part of any economy, with individuals and companies relying on financial institutions for
transactions and investing.

Governments consider it imperative to oversee and regulate banks and financial institutions
because they do play such an integral part in the economy. Historically, bankruptcies of
financial institutions can create panic.

Types of Financial Institutions

Financial institutions offer a wide range of products and services

for individual and commercial clients. The specific services offered vary

widely between different types of financial institutions.

a) Commercial Banks
 b) Investment Banks

c) Insurance Companies

d) Brokerage Firms
Development financial institutions
 Development financial institutions provide long-term credit for
capitalintensive investments spread over a long period and low yielding rates
of return, such as urban infrastructure, mining and heavy industry, and
irrigation systems.

 They act as critical intermediaries for channelling long-term finance

required for infrastructure and realising higher economic growth.
 In India, after the 1991 reforms, major DFIs were converted into
commercial banks. However, after these there were few institutions in the
country which could take care of industrial or infrastructure development.

 Therefore, in order to plug the infrastructure deficit, the government has

taken a positive step by making a proposal to re-establish the DFIs in India.
DFI: Background & Present Status

 Development banks are different from commercial banks, which mobilize short- to medium-term deposits and lend

for similar maturities to avoid a maturity mismatch.

 In India, the first DFI was operationalized in 1948 with the setting up of the Industrial Finance Corporation (IFC).

 DFIs in India like Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of

India (ICICI) and IFCI did play a significant role in aiding industrial development in the past with the best of the
resources made available to them.

 However, after 1991 reforms, the concessional funding they were getting from Reserve Bank of India (RBI) and the

government was no longer available in the subsequent years.

  As a consequence, IDBI and ICICI had to convert themselves into universal banks.

 While these DFIs disappeared, a new set of institutions like IDFC (1997), IIFCL (2006) and more recently, National

Investment and Infrastructure Fund (NIIF) (2015) emerged to focus on funding infrastructure.

 In budget 2021, with the initial capital base of Rs. 20,000 crore as committed by the government, the new DFI,

assuming a leverage of around 7 times, can lend up to Rs. 1.4 trillion.

Banking and Non-Banking Financial Institutions

 There are two main types of financial institutions: banking and non-banking. Banking institutions include
commercial banks, savings and loan associations, and credit unions.

 Non-banking financial institutions include insurance companies, pension funds, and hedge funds.

Banking Financial Institutions

 Banking financial institutions are in the business of taking deposits from the public and making loans. In
addition, they provide other services such as investment banking, foreign exchange, and safe deposit boxes.

 These institutions are heavily regulated by governments to protect consumers and ensure that the banking
system is stable.
 Types of Banking Financial Institutions

 There are two types of banking financial institutions: depository and non-depository.
 Depository institutions include banks, savings and loans associations, credit unions, and mutual savings banks

 Non-depository institutions include finance companies, insurance companies, and pension funds
Non-Banking Financial Institutions?
Non-banking financial institutions (NBFCs) are companies that provide financial services such as lending, insurance, and
investment banking but that are not regulated as banks. This means that they have a different set of rules and regulations to follow.

Types of Non-Banking Financial Institutions

There are a few different types of non-banking financial institutions, which include:

 Insurance companies: These companies sell insurance policies to individuals and businesses. The policies can provide coverage for
things like car accidents, medical expenses, or property damage.

 Investment banks: These banks help companies raise money by issuing and selling securities. They also provide advice on mergers
and acquisitions, and they trade stocks and bonds.

 Pension funds: These funds provide retirement income for workers. The money is invested in stocks, bonds, and other assets.
 Mutual funds: These funds pool money from investors and invest it in a portfolio of stocks, bonds, and other assets.
 Hedge funds: These funds are private investment partnerships that use a variety of investment strategies to make money.
 Private equity firms: These firms invest in private companies and help them grow. They may also take the companies public.
 Venture capital firms: These firms invest in early-stage companies with high growth potential.
Each of these non-banking financial institutions serves a different purpose, but they all work towards the ultimate goal of providing
funding for businesses and individuals.

Management of NPAs by Banks in India

Non-Performing Assets or NPA are like a cancer worm that has been destroying the banking
system of India slowly and steadily.

 NPA are bad loans with banks or other financial institutions whose interests and or principal
amounts are overdue for a long time.

 This time is usually 90 days or more. Like any other business, banks also must run on profits,
but NPA eats into that margin for banks.

Types of NPA
Substandard NPA: Those NPA that have remained overdue for a period of less than or
equal to12 months.
 Doubtful NPA: Those NPA that have remained in the substandard category for a period
of equal to or less than 12 months.

Loss Assets: This occurs when the NPA has been recognized as a loss by the bank, or
the internal or external auditor or on Reserve Bank of India (RBI) inspection but the loan
has not been forgiven completely.

Provisioning Norms
These are rules set by the RBI for all banks to set aside a certain amount

for their bad assets or NPA. They vary according to the category of the
NPA as follows:

10 percent of allowances for the total unpaid amount without making any

budget for securities or other government guarantee cover.

The NPA under substandard category would have another 10 per cent

cover making it a total of 20 per cent on the outstanding amount.

The provisional requirement for unsecured or doubtful NPA is 100

percent.
Factors contributing to NPAs
Banks’ lending to persons/corporations etc. who are not creditworthy and taking high risks.
Banks are not diminishing their losses by understanding their bank’s sufficiency on capital
and loan loss reserves at a given time;
Promoter of Companies redirecting their funds elsewhere;
Banks trying to fund non-viable projects;
In the initial part of the 1990s, Public Sector Banks started experiencing acute capital
shortage and losses. The targets set for their operation did not project the utmost need
for these corporate goals;
The banks had very little autonomy to price their products; offer products to preferred
sectors or spend money for their own profits. For example, Banks were forced to lend
 to priority sector namely agriculture due to political pressure;
Deficient means to collect and distribute credit information amongst commercial banks;
and
Efficient recovery from evasive and overdue borrowers was impeded due to
weaknesses in the existing process of debt recovery, ineffective legal provisions on and
bankruptcy and problems in foreclosure the execution of court orders.
Mutual funds
Mutual fund investing is a scheme that is processed by gathering money from
different people and is invested in a variety of assets. This kind of collected
money is generally invested in marketable securities like shares, stock, and
money-market instruments.

Nowadays, most individuals prefer investing in mutual funds to meet their

specific financial goals. Therefore, mutual fund investments are emerging as
the most preferred option for investment.
A team of research analysts, along with a professional fund manager, guides
the investment decisions of the investors who have funded into a particular
scheme.

Further, the personal scheme charges expenses to the investor towards costs
related to funding management, distribution expenses, etc.
Types of mutual fund schemes
Open-ended- In this scheme, the investor can buy and sell
units freely and is open for investment at any point in time.

Close-ended- These units can be listed on the stock

exchange, and investors can trade them. It is accessible only
for a limited duration.
Interval scheme- This scheme is another version of
closeended; it can be reopened for a short time during the
scheme’s tenure, where the investors can sell back their
units.
Mutual Funds Investors
A mutual fund is a company that pools money from many investors and invests
the money in securities such as stocks, bonds, and short-term debt.

The combined holdings of the mutual fund are known as its portfolio.
Investors buy shares in mutual funds.
Mutual funds let you pool your money with other investors to mutually buy
stocks, bonds, and other investments. They're run by professional money
 managers who decide which securities to buy (stocks, bonds, etc.) and when
to sell them.

You get exposure to all the investments in the fund and any income they generate.

In terms of MF penetration to the total population, India has just 2.5% of its total
population invested in mutual funds.
Investment
The purpose behind investing is to gradually build your wealth over an
extended period of time. This is done through the buying and holding of a
portfolio of stocks, mutual funds, bonds and other investment instruments.

Generally, investments are held for a period of years or even decades. This
enables the investors to take advantage of benefits like interest and dividends
along the way.
Trading
On the contrary, trading deals with more frequent transactions like- buying and
selling of stocks, commodities and other instruments.

The goal here is to make short term gains by buying at lower prices and selling
at higher prices. This is done within a relatively short period of time.
Mutual Funds of Organization
The structure of mutual funds in India is a three-tier one with few other significant

components. The three-tier structure comprises the fund sponsor, trustees and the asset
management company.

Not only different banks or AMCs create or float mutual fund schemes. There are other

entities involved that play a significant role in the structure of mutual funds. Moreover,
the structure of mutual funds came into existence under SEBI Mutual Fund
Regulations,1996. It plays the role of primary watchdog for all transactions. Thus, the
 inception of these regulations has revolutionized the structure of mutual funds, and all
entities are regulated under it.

Mutual fund is managed either trust company board of trustees. Board of trustees &

trust are governed by provisions of Indian trust act. If trustee is a company, it is also
subject Indian Company Act. Trustees appoint AMC in consultation with the sponsors
& according to SEBI regulation.

TYPES OF MUTUAL FUND SCHEMES

Mutual funds come in many varieties, designed to meet different investor
goals. Mutual funds can be broadly classified based on – Organisation
Structure – Open ended, Close ended, Interval

Management of Portfolio – Actively or Passively

Investment Objective – Growth, Income, Liquidity

Underlying Portfolio – Equity, Debt, Hybrid, Money market instruments, Multi
Asset

Thematic / solution oriented – Tax saving, Retirement benefit, Child welfare,

Arbitrage

Exchange Traded Funds

Overseas funds

Fund of funds
Role of Insurance
Insurance has evolved as a process of safeguarding the interest of people from loss
and uncertainty. It may be described as a social device to reduce or eliminate risk
of loss to life and property.
  Insurance contributes a lot to the general economic growth of the society by
provides stability to the functioning of process. The insurance industries develop
financial institutions and reduce uncertainties by improving financial resources.

Provide safety and security:

Insurance provide financial support and reduce uncertainties in business and
human life. It provides safety and security against particular event. There is always
a fear of sudden loss. Insurance provides a cover against any sudden loss.

 For example, in case of life insurance financial assistance is provided to the family
of the insured on his death. In case of other insurance security is provided against
the loss due to fire, marine, accidents etc.
Generates financial resources:
Insurance generate funds by collecting premium. These funds are invested in government
securities and stock. These funds are gainfully employed in industrial development of a country for
 generating more funds and utilized for the economic development of the country. Employment
opportunities are increased by big investments leading to capital formation.

Life insurance encourages savings:

Insurance does not only protect against risks and uncertainties, but also provides an investment
channel too. Life insurance enables systematic savings due to payment of regular premium. Life insurance
provides a mode of investment. It develops a habit of saving money by paying premium. The insured get
the lump sum amount at the maturity of the contract. Thus life insurance encourages savings.

Promotes economic growth:

Insurance generates significant impact on the economy by mobilizing domestic savings. Insurance
turn accumulated capital into productive investments. Insurance enables to mitigate loss, financial stability
and promotes trade and commerce activities those results into economic growth and development. Thus,
insurance plays a crucial role in sustainable growth of an economy.
Medical support:
A medical insurance considered essential in managing risk in health. Anyone can be a victim
of critical illness unexpectedly. And rising medical expense is of great concern. Medical Insurance is
 one of the insurance policies that cater for different type of health risks. The insured gets a medical
support in case of medical insurance policy.

Spreading of risk:
Insurance facilitates spreading of risk from the insured to the insurer. The basic principle of
insurance is to spread risk among a large number of people. A large number of persons get insurance
policies and pay premium to the insurer. Whenever a loss occurs, it is compensated out of funds of the
insurer.

Source of collecting funds:

Large funds are collected by the way of premium. These funds are utilised in the industrial
development of a country, which accelerates the economic growth. Employment opportunities are
increased by such big investments. Thus, insurance has become an important source of capital formation.

Role of Insurance in Economic Growth

 Insurance sector in India plays a dynamic role in the wellbeing of its economy. It
substantially increases the opportunities for savings amongst the individuals,
safeguards their future and helps the insurance sector form a massive pool of funds.
 With the help of these funds, the insurance sector highly contributes to the capital
markets, thereby increasing large infrastructure developments in India.

The Indian Insurance Sector

The Indian Insurance Sector is basically divided into two categories Life Insurance
and Non-life Insurance. The Non-life Insurance sector is also termed as General
Insurance.

Both the Life Insurance and the Non-life Insurance is governed by the Insurance
Regulatory and Development Authority of India (IRDAI).
The Past of Insurance Sector In India
 In the history of the Indian insurance sector, a decade back LIC was the only life insurance provider. Other public sector

companies like the National Insurance, United India Insurance, Oriental Insurance and New India Assurance provided
non-life insurance or say general insurance in India.
  However, with the introduction of new private sector companies, the insurance sector in India gained a momentum in

the year 2000. Currently, 24 life insurance companies and 30 non-life insurance companies have been aggressive enough
to rule the insurance sector in India.

 But, there are yet many more insurers who are awaiting IRDAI approvals to start both life insurance and non-life

insurance sectors in India.

The Present of Insurance Sector In India

 So far as the industry goes, LIC, New India, National Insurance, United insurance and Oriental are the only government

ruled entity that stands high both in the market share as well as their contribution to the Insurance sector in India.

 There are two specialized insurers – Agriculture Insurance Company Ltd catering to Crop Insurance and Export Credit

Guarantee of India catering to Credit Insurance. Whereas, others are the private insurers (both life and general) who
have done a joint venture with foreign insurance companies to start their insurance businesses in India.

The Role of Insurance Intermediaries:

The importance of insurance in modern economies is unquestioned and has been recognized for
centuries. Insurance “is practically a necessity to business activity and enterprise.” But insurance also
 serves a broad public interest far beyond its role in business affairs and its protection of a large part of
the country’s wealth.

 It is the essential means by which the “disaster to an individual is shared by many, the disaster to a
community shared by other communities; great catastrophes are thereby lessened, and, it may be,
repaired.”

Insurance is an essential element in the operation of sophisticated national economies throughout the
world today.

Without insurance coverage, the private commercial sector would be unable to function.

 Insurance enables businesses to operate in a cost-effective manner by providing risk transfer

mechanisms whereby risks associated with business activities are assumed by third parties.

It allows businesses to take on credit that otherwise would be unavailable from banks and other credit-
providers fearful of losing their capital without such protection, and it provides protection against the
business risks of expanding into unfamiliar territory new locations, products or services which is critical
for encouraging risk taking and creating and ensuring economic growth.
 Insurance Regulatory Authority
 The Insurance Regulatory Authority is a statutory government agency established under the Insurance Act CAP 487
of the Laws of Kenya to regulate, supervise and develop the insurance industry. It is governed by a Board of Directors
which is vested with the fiduciary responsibility overseeing operations of the Authority and ensuring that they are
consistent with provisions of the Insurance Act.

 The Authority is the successor of the Office of the Commissioner of Insurance which came into existence with the
enactment of the Insurance Act, CAP 487 in 1986. Prior to this, insurance regulation was based on the UK legislation
under the Companies Act 1960.

 In executing our mandate, we adhere to the core principles of objectivity, accountability and transparency in
promoting not only compliance with the Insurance Act and other legal requirements by insurance/reinsurance
companies and intermediaries but also sound business practices. We therefore practice regulation and supervision
that enables industry players to be innovative and entrepreneural. Bearing in mind industry differences in terms of
size, extent and complexity, necessitating changes in operating and investment decisions helps cut down on
compliance costs. Since in the long run, this has impacts on productivity and growth of the insurance sector, the
Authority deploys significant resources in monitoring market behaviors, compliance and solvency issues.
Insurance Regulatory and Development Authority ( IRDA )
IRDA is the regulatory body in India that governs both Life insurance and
General insurance companies. India is a vast country that offers great
opportunities to varied segments one of which is the insurance sector.

Let us understand the concept of insurance regulator in a simple way. India

witnesses the concept of a joint family where the head, most commonly the
grandparents, acts as the guardian of each member. The head takes care of
everyone’s needs and maintains a balance for fair practices to keep the family
united.

He treats everyone equal and helps the family in crisis guiding them on how
to steer out of it. Now, Similar to how the head of the family plays, IRDA runs
the Indian insurance industry as per its set rules and guidelines.
The Purpose of IRDA
Insurance in India dates back to the year 1850 with the first General Insurance
company established in Calcutta. Soon, with the passage of years the market
became competitive as many insurers started emerging both in life and non-life
sectors.

Each company practiced business on its rates and rules. It made customers’
insecure which brought the credibility of the insurance market at stake. As early
as the government realized this fact, they thought of securing the customer’s
interest first and hence established an independent regulatory body called IRDA.

Over time, new demands rolled and the market got flooded with several insurance
products. Like a responsible head of the family would act to prevent the family
from any damage, IRDA monitors the development of the insurance industry and
other related activities.
Role of IRDA in the Insurance Sector In India
At one point of time, some insurance companies used to deny coverage to their
policyholders. The basis of the denial was either their choice of business to
underwrite or was their understanding of good risk and bad risk. To regulate the
market and minimize any sort of partial acts, the IRDA was established.

Like the banking system in India is regulated as per the guidelines of RBI. It restricts
the bankers to not behave unruly with the account holders.

The banking institutes are allowed to offer loans and interest as per the rates
predefined by RBI. It leaves no room for the monopoly to take over which in turn
works best for the masses.

Financial Institutes like banks and insurance companies will be successful in our
democracy until market practices are for the majority and not just for fraction of
people.
 Financial Institutions and Markets
Unit - IV
Financial Services
Financial services is a broad range of more specific activities such as banking,
investing, and insurance. Financial services are limited to the activity of
financial services firms and their professionals, while financial products are the
actual goods, accounts, or investments they provide.
The economy is made up of many different segments called sectors. These
sectors are comprised of different businesses that provide goods and services to
consumers. The variety of services offered by lending institutions, brokerage
firms, and other businesses are collectively referred to as the financial services
sector.

The financial services sector is comprised of banking, mortgages, credit cards,

payment services, tax preparation and planning, accounting, and investing.
Financial services are often limited to the activity of firms and professionals,
while financial products are the financial instruments these professionals
provide to their clients.
The Financial Services Sector
The financial services sector provides financial services to people and
corporations. This segment of the economy is made up of a variety of financial firms
including banks, investment houses, lenders, finance companies, real estate brokers,
and insurance companies.

As noted above, the financial services industry is probably the most important
sector of the economy, leading the world in terms of earnings and equity market
capitalization. Large conglomerates dominate this sector, but it also includes a
diverse range of smaller companies.

According to the finance and development department of the International

Monetary Fund (IMF), financial services are the processes by which consumers or
businesses acquire financial goods. For example, a payment system provider offers
a financial service when it accepts and transfers funds between payers and recipients.
This includes accounts settled through credit and debit cards, checks, and electronic
funds transfers.
Investment Banking
A special segment of banking operation that helps individuals or organizations raise capital and provide financial

consultancy services to them. They act as intermediaries between security issuers and investors and help new firms
to go public.

They either buy all the available shares at a price estimated by their experts and resell them to public or sell shares

on behalf of the issuer and take commission on each share.

Description

Investment banking is among the most complex financial mechanisms in the world. They serve many different

purposes and business entities.

They provide various types of financial services, such as proprietary trading or trading securities for their own

accounts, mergers and acquisitions advisory which involves helping organizations in M&As,; leveraged finance
that involves lending money to firms to purchase assets and settle acquisitions, restructuring that involves
improving structures of companies to make a business more efficient and help it make maximum profit, and new
issues or IPOs, where these banks help new firms go public.

Merchant Banking
A professional service provided by the merchant banks to their customers considering their
financial needs, for adequate consideration in the form of fee. Merchant banks are banks that
conduct fundraising, financial advising and loan services to large corporations.

These banks are experts in international trade, which makes them experts in dealing with
large corporations and industries. Merchant banking provides funds to the multinational
businesses and large business entities in the country which helps to boost the country’s
economic strength.

Merchant banks do not provide services to the general public; their services are limited to
business entities and large business corporations.

Merchant banker is a person who provides assistance for the subscription of securities. The
merchant banker plays an important role and carries a lot of responsibilities like, private
placement of securities, managing public issue of securities, stock broking, international
financial advisory services, etc.
Depository system
A depository is an organisation which holds securities (like shares, debentures, bonds,
government securities, mutual fund units etc.) of investors in electronic form at the
request of the investors through a registered depository participant. It also provides
services related to transactions in securities.

In the early times, securities used to be in the form of physical certificates leading to
settlement delays, forgery, theft, etc., which made the settlement system on the Indian
Stock Exchange inefficient. To solve these issues, the Depository Act, 1996 was passed
in India.

The purpose of this Act was to ensure the free transferability of securities with
security, accuracy, and speed. A depository is an organisation holding securities such as
bonds, shares, debentures, etc., of the investors in electronic form. The depository holds
these securities on the request of the investors through a registered Depository
Participant.
Depository System In India
The depository acts the same way as banks. Banks hold deposits whereas
depository holds various securities such as mutual funds, stocks, and bonds in
electronic form. There are two leading stock exchanges in India: NSE ( National
Stock Exchange) and BSE (Bombay Stock Exchange).

Type Of Depository
There are three major types of depository institutions in the United States.
They are commercial banks, thrifts (which include savings and loan associations and
savings banks) and credit unions.
Objective
It removes the occurrences of forgery, duplicate share certificates, and
bad deliveries. This can increase the liquidity of securities by making a way for
easy transfer. Also, it can avoid the delay caused in the transfer of securities.
Introduction to Credit Rating
 A credit rating is an opinion of a particular credit agency regarding the ability
and willingness an entity (government, business, or individual) to fulfill its financial
obligations in completeness and within the established due dates. A credit rating also
signifies the likelihood a debtor will default.

 A credit agency evaluates the credit rating of a debtor by analyzing the

qualitative and quantitative attributes of the entity in question. The information may
be sourced from internal information provided by the entity, such as audited
financial statements, annual reports, as well as external information such as analyst
reports, published news articles, overall industry analysis, and projections.
 A credit agency is not involved in the transaction of the deal and, therefore, is
deemed to provide an independent and impartial opinion of the credit risk carried by
a particular entity seeking to raise money through loans or bond issuance.
Types of Credit Ratings
Each credit agency uses its own terminology to determine credit
ratings. That said, the notations are strikingly similar among the three credit
agencies. Ratings are bracketed into two groups: investment grade and
speculative grade.

Investment grade
Ratings mean the investment is considered solid by the rating agency,
and the issuer is likely to honor the terms of repayment. Such investments are
typically less competitively priced in comparison to speculative grade
investments.
Speculative grade
Investments are high risk and, therefore, offer higher interest rates to
reflect the quality of the investments.
CRISIL and ICRA
CRISIL – Credit rating and information services of India limited

CRISIL is a global company that provides the research, rating, risk related advisory services. The main
objective of CRISIL is to rate the quality of bonds, deposits, debentures, etc. These are assessed when
companies use these tools to raise debt capital.

Thus, this rating helps an investor to understand the risk of the debt related to the company. The main
shareholder of CRISIL is Standard and Poor's. They are also one of the leading credit agency in India.

ICRA – Investment information and credit agency

ICRA limited was set up in 1991 by the investment and financial institutions. It is a
professional investment information company that provides credit rating information. Also,
the largest investor in ICRA is Moody’s investors.
They are internationally accredited rating agency. The objective of ICRA is to provide
guidance and information to individuals as well as institutions. Furthermore, it wants to
enhance the ability of issuers and borrowers to access the capital and money market. Also, it
assists in promoting transparency to the regulators in financial markets.

Housing and Micro Finance

Unit : V
Housing Finance
Most of us think of a housing finance company when we want a
home loan – and it's only logical to do so, given the specialization
that these companies have in the home loan segment.
However, housing finance companies have grown over time and
have diversified their portfolio of loan offerings to also cater to
the needs of the non housing segment.
You can approach a housing finance company for several other
types of loans – be it for purchase of non-residential
(commercial) property or for funding of business or personal
expenses.
Let's take a look at the loan options in the non housing segment
offered by housing finance companies.
Loans for Commercial Premises
Housing finance companies also offer loans for purchase,
extension, construction or improvement of commercial
premises, including built-up properties and plots.
These loans can be availed by businessmen or
professionals, including doctors, lawyers and chartered
accountants etc.
The amount of the loan can be as high as 75-90 percent of
the cost of the property, while the tenure may extend to 15
years subject to the repayment capacity of the customer, as
assessed by the lender.
Housing finance companies often provide customers with
expert legal and technical counseling to facilitate the
purchase of commercial premises.
Leasing and Hire Purchase
Leasing and hire purchase are low-risk forms of debt finance that can be used to acquire
assets for a business. Such finance options are available directly from specialist
providers, or indirectly through equipment suppliers or finance brokers.
 Leasing and hire purchase could be the perfect solution if your business needs new
equipment which would otherwise be unaffordable because of cash-flow constraints.

Because leases and hire-purchase agreements are secured wholly or largely on the asset
being financed, the need for additional collateral is much reduced.

There is more security for the user because the finance cannot be recalled during the life
of the agreement, provided the business keeps up with payments.

This means leasing and hire purchase can be useful to businesses at any stage. from start-
ups to large, established organisations.
Leasing
 A leasing company buys and owns the equipment, which the business then rents for a predetermined period.

 Typically, the lease will have a set interest rate, which fixes the outgoings on that asset. The business also has
the option to replace or update the equipment at the end of the lease period.

Concept of Leasing
 • Lease finance denotes procurement of assets through lease. The subject of leasing falls in the category of
finance.

 • Leasing has grown as a big industry in the USA and UK and spread to other countries during the present
century.

 • In India, the concept was pioneered in 1973 when first leasing company was set up in Madras and the eighties
have seen a rapid growth of business.

 • Lease as a concept involves a contract whereby ownership, financing and risk taking of any equipment or
asset are separated and shared by two or more parties.

 • Thus, the lesser may finance and lessee may accept risk through the use of it while a third party may own it.

 • Alternatively, the lesser may finance and own it while the lessee enjoys the use of it and bears the risk.
Features of Leasing
 2 Parties

 Selection of an asset

 Purchase of an asset
  Use of the asset

 Rentals and installments payment Recovering the cost of an asset.

 Option of acquiring ownership of the asset.

A lease is a contractual agreement in which:

 A party owing an asset i.e. lesser

 Provides an asset for use to another party i.e. lessee

 For an agreed period of time i.e. lease period For a consideration i.e. lease
rentals.
Lease Financing
Lease financing is one of the important sources of medium- and
longterm financing where the owner of an asset gives another person,
the right to use that asset against periodical payments.
The owner of the asset is known as lessor and the user is called lessee.

The periodical payment made by the lessee to the lessor is known as lease
rental.

Under lease financing, lessee is given the right to use the asset but the
ownership lies with the lessor and at the end of the lease contract, the
asset is returned to the lessor or an option is given to the lessee either
to purchase the asset or to renew the lease agreement.
Marketing of leasing is done by financing many kinds of assets to consumers as well as business which
includes:

 Plant and machinery.

 Business cars.
 Commercial vehicles.
  Agricultural equipments.
 Hotel equipments.
 Medical and dental equipments.
 Computers including software packages.
 Office equipments etc.

Hire purchase
If a business wants to own the equipment at the end of the agreement, but avoid the
cash flow impact of buying outright, then hire purchase is an option.

A finance company buys the equipment and the business repays the cash price plus
interest through regular repayments. These agreements are also normally at fixed interest
rates.
Meaning of Hire-Purchase
 Hire purchase is governed by the Hire Purchase Act,1972.It is a special system of credit purchase
and sale. In this buyer pays the price in installments i.e. monthly ,quarterly or yearly etc. and
also some amount of interest.
 Goods are delivered to the buyer at the time of hire purchase agreement but buyer will become
the owner of goods only on the payment of the last installment. Such installments are to be
treated as hire of these goods until a certain fixed amount has been paid ,when these goods
become the property of the hire.

 Either the buyer or the seller has a right to terminate the agreement at any time before the
property so passes. Every agreement shall be in writing and signed by all the parties thereto. • In
the case of default, in the payment by the buyer, the seller has got a right to repossess the goods,
as ownership lies with the seller, till the payment of last installment.

 The buyer cannot pledge, sell or mortgage the assets as he is not the owner of the assets till the
last payment is made.
Features of Hire Purchase

 Credit purchase

 Installment payment

 Possession at time of agreement

 Ownership till last installment

 Right to use goods as a bailer

 Termination of the agreement

 Ownership of goods after all installments payment.

Installment Credit System

 Installment credit, also called Installment Plan, or Hire Purchase Plan in business, credit that

is granted on condition of its repayment at regular intervals, or instalments, over a specified

period of time until paid in full.

 The goods are advanced to the purchaser after making initial fractional payment called a

down payment.
Financial Inclusion and Microfinance
The financial services include:
Microinsurance (inclusive insurance) with all possible variants related to insurance
(climate risk, death, etc.)
Different credit products

Pensions

Savings products

Money transfers

Non-financial services are very broad and can include:

Training (in business management, risk management, governance, etc.)

Decision support software (SIMFI, Microfact, etc.)

Advice and technical expertise

Financial education and awareness-raising measures

VI.ORGANISATION AND FUNCTIONS OF COMMERCIAL BANKS
CONTENTS.
Introduction
Objectives
Main Content.

Meaning of Commercial Banks

3.2 Organisation and Structure of Commercial Banks
3.2.1 Unit Banking
3.2.2 Branch Banking System
3.3 Functions of Commercial Banks
3.3.1 Primary Functions of Commercial Banks
3.3.2 Secondary Functions of Commercial Banks
3.4 Balance Sheet of Commercial Bank - Liabilities and Assets C
INTRODUCTION .
In this unit, the organisation and function of commercial banks shall be discussed.
With reference to; structure of commercial banks, unit banking, branch banking
system, primary and secondary functions of commercial banks.

Meaning of Commercial Banks.

The word ‘bank’ is derived from the Italian word ‘banco’ meaning bench (de
Albuquerque, 1855). The Jews in Lombardy, the early bankers, conducted their
business at benches in the market place. The Italian word banco "desk/bench"
was used during the Renaissance era by Florentine bankers, who used to make
their transactions above a desk covered by a green tablecloth (Matyszak, 2007).
However, traces of banking activity can be found even in ancient times.
Some have suggested, the word (bank) traces its origins back to the ancient
Roman Empire, where moneylenders would set up their stalls in the middle of
enclosed courtyards called macella on a long bench called a bancu, from which
the words banco and bank are derived. As a moneychanger, the merchant at the
bancu did not so much invest money as merely convert the foreign currency into
the only legal tender in Rome – that of the Imperial Mint (Matyszak, 2007).
A commercial bank is a type of bank that provides services such as accepting
deposits, making business loans, and offering basic investment products.
Commercial bank can also refer to a bank or a division of a bank that mostly deals
with deposits and loans from corporations or large businesses, as opposed to
individual members of the public (retail banking).

Organisation and Structure of Commercial Banks.

Commercial banks vary in their organisation and structure from country to
country. The two main banking systems are the unit banking and the branch
banking. The unit banking is peculiar to the USA. Branch banking, on the other
hand, is found in the majority of countries such as England, Australia, Canada, New
Zealand, and of course, Nigeria. Two other important types are the group banking
and the chain banking which are also found in the USA. These different systems
of banking are discussed below.

Unit Banking.
Unit banks are independent, one-office banks. Their operations are confined in
general to a single office. The existence of unit banking in the USA is due to legal
restrictions which prevent the growth of monopoly in banking. Some unit banks
have grown to large sizes but they operate under severe restrictions which limit
or prohibit the establishment of branches. The unit banks operate in small towns
and cities in the USA and are called county banks and city banks respectively. All
unit banks are linked together by a correspondent bank relationship. A county
bank has deposits in city banks, and city banks have deposits in branch banks in
the same and other big cities like New York and Chicago (Jhingan, 2004).

Branch Banking System

The branch banking is the most prevalent banking system in the majority of
countries. Under this system, a big bank has a number of branches in different
parts of the country and even many branches within a cosmopolitan city like
Lagos, Ibadan, Abuja, Enugu, Port Harcourt, Kaduna, Kano and Jos. In Nigeria,
banks like First Bank Nigeria Plc, Union Bank Nigeria Plc, United Bank for Africa Plc
and many commercial banks have branches spread all over the country. Small
commercial banks also carry on branch banking operations within a state or a
region. In the USA for instance, branch banking is confined to the states.
Accordingly, a number of banks have merged under a holding company to carry
on branch business efficiently and profitably.

SELF-ASSESSMENT EXERCISE.

Functions of Commercial Banks

Commercial bank being the financial institution performs diverse functions. It
satisfies the financial needs of the sectors such as agriculture, industry, trade,
communication, etc. That means they play very significant roles in a process of
economic social needs. The functions performed by banks are changing according
to change in time and recently they are becoming customer centric and widening
their functions. Generally the functions of commercial banks are divided into two
categories viz. primary functions and the secondary functions. The following chart
simplifies the functions of banks.
There are two essential functions that a financial institution must perform to
become a bank. These are: primary and secondary functions.
 Functions of commercial banks

Primary functions.
1. Accepting deposits
2. Making advances
3. Credit creation

Secondary functions.
Clearance of cheque
1. Sale/purchase of shares/bonds
2. Transfer of money
3. To work as trusty
4. To work as a representative
5. To give/accept money To provide letter of credit

Primary Functions of Commercial Banks

Commercial Banks performs various primary functions some of which include:
1. Accepting deposits: Commercial bank accepts various types of deposits from
public especially from its clients. It includes saving account deposits, recurring
account deposits, fixed deposits, etc. These deposits are payable after a certain
time period.
2. Accepting deposits: Commercial bank accepts various types of deposits from
public especially from its clients. It includes saving account deposits, recurring
account deposits, fixed deposits, etc. These deposits are payable after a certain
time period. Making advances: The commercial banks provide loans and
advances of various forms. It includes an overdraft facility, cash credit, bill
discounting, etc. They also give demand and demand and term loans to all types
of clients against proper security.
3. Credit creation: It is most significant function of the commercial banks. While
sanctioning a loan to a customer, a bank does not provide cash to the borrower
instead it opens a deposit account from where the borrower can withdraw. In
other words, while sanctioning a loan a bank automatically creates deposits. This
is known as a credit creation from commercial bank.
Secondary Functions of Commercial Banks.
Along with the primary functions each commercial bank has to perform several
secondary functions too. It includes many agency functions or general utility
functions. The secondary functions of commercial banks can be divided into agency
services and general utility services.

Agency services
A commercial bank provides a range of investment services. Customers can arrange
for dividends to be sent to their bank paid directly into their bank accounts, or for
the bank to detach coupons from bearer bonds and present them for payment and
to act upon announcements in the press of drawn bonds, coupons, payable, etc.
Orders for the purchase or sale of stock exchange securities are executed through
the banks brokers who will also give their opinions on securities or list of securities.
Similarly, banks will make applications on behalf of their customers for allotments
arising from new capital issues, pay calls as they fall due and ultimately obtain share
certificates or other documents of title. On certain agreed terms the banks will allow
their names to appear on approved prospectus or other documents as bankers for
the issue of new capital, they will receive applications and carry out their instructions.
A commercial bank undertakes the payment of subscriptions, premium, rent, etc., on
behalf of its customers. Similarly, it collects cheques, bills of exchange, promissory
notes, etc., on behalf of its customers. It also acts as a correspondent or
representative of its customers, other banks and financial corporations.
Most of the commercial banks have an ‘Executor and Trustee Department’; some
may have affiliated companies to deal with this branch of business. They aim to
provide a complete range of trustee, executor or advisory services for small charge.
The business of banks acting as trustees, executors, administrators, etc. has
continuously expanded with considerable usefulness to their customers. Most banks
will undertake on behalf of their customers the preparation of income tax returns
and claims for the recovery of overpaid tax; they also assist the customers in checking
the assessments. In addition to the usual claims involving personal allowances and
reliefs, claims are prepared on behalf of residents abroad, minors, charities, etc.

General utility services.

 These services are those in which the banks position is not that of an agent for his
customer. They include the issue of credit instruments like letters of credit and
travelers cheques, the acceptance of bills of exchange; the safe custody of valuables
and documents; the transaction of foreign exchange business; acting as a referee as
to the respectability and financial standing of customers; providing specialised
advisory service to customers; etc.

Bankers draft and letter of credit.

By selling drafts or orders and by issuing letters of credit, circular notes, travelers’
cheques, etc., a commercial bank is discharging a very important function. A bankers
draft is an order, addressed by one office of a bank to any other of its branches or by
one bank to another, to pay a specified sum to the person concerned.
A ‘letter of credit’ is a document issued by a banker, authorising some other bank to
which it is addressed, to honour the cheques of a person named in the document, to
the extent of a stated amount in the letter and charge the same to the account of
the grantor of the letter of credit. A letter of credit includes a promise by the issuing
banker to accept all bills of exchange to the limit of credit.
Circular notes, travelers’ cheques, circular cheques.
 ‘Circular Notes’ are cheques on the issuing banker for certain round sums in his own
currency. On the reverse side of the circular note is a letter addressed to the agents
specifying the nature of the holder and referring to a letter of indication in his hands,
containing the specimen signature of the holder? The note will not be honored unless
the letter of indication is presented. ‘Travelers Cheques’ are documents similar to
circular notes with the exception that they are not accompanied by any letter of
indication. ‘Circular Cheques’ are issued by banks in certain countries to their agents
abroad. These agents sell them to intending visitors to the country of the issuing
bank.

Safe custody of valuables

Another important service rendered by a modern commercial bank is that of keeping
in safe custody valuables such as negotiable securities, jewellery, documents of title,
wills deed-boxes, etc. Some branches are also equipped with specially constructed
strong rooms, each containing a large number of private steel safes of various sizes.
These may be used for a small fee. Each user is provided with the key of his/her
valuables but also retains full personal control over them. The safes are accessible at
any time during banking hours and often longer.
Night safes.
For shopkeepers and other customers who handle large sums of money after banking
hours, ‘night safes’ are available at many banks. Night safe takes the form of a small
metal door on the outside wall of the bank, accessible from the street, behind which
there is a chute connecting with the banks strong room. Customers who require this
service are provided with a leather wallet, which they lock before placing in the
chute. The wallet is opened by the customer when he calls at the bank the next day
to get the contents credited to his account.

Referee as to the responsibility and financial status of the customer

Another function of great value, both to banks and businessmen, is that of the bank
acting as referee as to the responsibility and financial status of the customer.

Balance Sheet of Commercial Bank - Liabilities and Assets

Commercial bank's balance sheet has two main sides i.e. the liabilities and the assets.
From the study of the balance sheet of a bank we come to know about a system
which a bank has followed for raising funds and allocation of these funds in different
asset categories. Bank can have other money with it. It can be in terms of
shareholders share capital, or depositors deposits. This money is the bank's liabilities.
On the other hand banks own sources of income leads to generation of assets for
bank.

1. Unsecured loan.
Unsecured loans are monetary loans that are not secured against the borrower's
assets (i.e., no collateral is involved). There are small business unsecured loans such
as credit cards and credit lines to large corporate credit lines. These may be available
from financial institutions under many different guises or marketing packages:
2. An overdraft .
An overdraft occurs when money is withdrawn from a bank account and the
available balance goes below zero. In this situation the account is said to be
"overdrawn". If there is a prior agreement with the account provider for an
overdraft, and the amount overdrawn is within the authorised overdraft limit,
then interest is normally charged at the agreed rate. If the POSITIVE balance
exceeds the agreed terms, then additional fees may be charged and higher
interest rates may apply.
Balance sheet of a commercial bank.
Bank's Liabilities
Bank's liabilities constitute five major items: The share capital, the contribution
which shareholders have contributed for starting the bank.
Reserve funds are the money, which the bank has accumulated over the years from
its undistributed profits. Deposits are the money owned by customers and therefore it
is a liability of a bank. There can be various kinds of deposits and recurring deposits.
Apart from these items a bank can borrow from central and other commercial banks.
These borrowings are also treated as bank's liabilities.
Bank's Assets
Bank's asset comprises cash, money at short notice, bills and securities discounted,
bank's investments, loans sanctioned by the bank, etc. Bank's cash in hand, cash with
other banks and cash with central bank (RBI) are its assets. When a bank makes
money available at short notice to other banks and financial institutions for a very
short period of 1-14 days it is also treated as bank's asset. Apart from these items
bank always make money available to people on the form of loans and advances.
They are also become bank's assets.
VII
EXCHANGE RATE AND CURRENCY MARKETS.
Introduction
6.2 Objectives
6.3 Concept of Exchange rate
6.4 Significance of exchange rate
6.5 Types of exchange rates
6.6 Exchange rate regimes
6.7 Determinants of exchange rate
6.8 Dynamics on the Forex market
6.9 Summary.

In finance, an exchange rate is the rate at which one currency will be exchanged for another. It is also
regarded as the value of one country’s currency in relation to another currency. For example, an interbank
exchange rate of 114 Japanese yen to the United States dollar means that ¥114 will be exchanged for each
US$1
or that US$1 will be exchanged for each ¥114. In this case it is said that the price of a dollar in relation to
yen is ¥114, or equivalently that the price of a yen in relation to dollars is $1/114.The government has the
authority to change exchange rate when needed.
6.2 Objectives:
After going through this lesson you should be able to
 Define Exchange rates;
 Explain the working of foreign exchange markets;
 Access the significance of exchange rate systems;
 Discuss the factors influencing the determinants of exchange rates.

6.3 Concept of Exchange rates:

Exchange rates are determined in the foreign exchange market, which is open to a wide range of different
types of buyers and sellers, and where currency trading is continuous: 24 hours a day except weekends,
i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers to the
current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded
today but for delivery and payment on a specific future date.
6.4 Significance of Exchange rates:
The exchange rate expresses the national currency’s quotation in respect to foreign ones. For example, if
one US dollar is worth 10 000 Japanese Yen, then the exchange rate of dollar is 10 000 Yen. If something
costs 30 000 Yen, it automatically costs 3 US dollars as a matter of accountancy. Going on with fictious
numbers, a Japan GDP of 8 million Yen would then be worth 800 Dollars. Thus, the exchange rate is a
conversion factor, a multiplier or a ratio, depending on the direction of conversion. In a slightly different
perspective, the exchange rate is a price. If the exchange rate can freely move, the exchange rate may turn
out to be the fastest moving price in the economy, bringing together all the foreign goods with it.
Types of exchange rate.
It is customary to distinguish nominal exchange rates from real exchange rates. Nominal exchange rates
are established on currency financial markets called “forex markets”, which are similar to stock exchange
markets. Rates are usually established in continuous quotation, with newspaper reporting daily quotation
(as average or finishing quotation in the trade day on a specific market). Central bank may also fix the
nominal exchange rate.
1. Real exchange rates:
Real exchange rates are nominal rate corrected somehow by inflation measures. For instance, if a country
A has an inflation rate of 10%, country B an inflation of 5%, and no changes in the nominal exchange rate
took place, then country A has now a currency whose real value is 10%-5%=5% higher than before. In
fact, higher prices mean an appreciation of the real exchange rate, other things equal. Another
classification of exchange rates is based on the number of currencies taken into account. Bilateral
exchange rates clearly relate to two countries’ currencies. They are usually the results of matching of
demand and supply on financial markets or in banking transaction. In this latter case, the central bank acts
usually as one of the sides of the relationship.
2. Bilateral exchange rates:
Bilateral exchange rates may be simply computed from triangular relationships: if the exchange rate
dollar/yen is 10 000 and the dollar/Angolan kwanza is 100 000 then, as a matter of computation, one yen
is worth 10 kwanza. No direct yen/kwanza transaction needs to take place. If, instead, a financial market
exists for yen to be exchanged with kwanza, the expectation is that actions by speculators (arbitrage
among markets) will bring the parity of 10 kwanza per yen as an effect. Multilateral exchange rates are
computed in order to judge the general dynamics of a country’s currency toward the rest of the world.
One takes a basket of different currencies, select a (more or less) meaningful set of relative weights, then
computes the “effective” exchange rate of that country’s currency.
For instance, having a basket made up of 40% US dollars and 60% German marks, a currency that
suffered from a value loss of 10% in respect to dollar and 40% to mark will be said having faced an
“effective” loss of 10%x0.6 + 40%x0.4 = 22%. Some countries impose the existence of more than one
exchange rate, depending on the type and the subjects of the transaction. Multiple exchange rates then
exist, usually referring to commercial vs. public transactions or consumption and investment imports. This
situation requires always some degree of capital controls. In many countries, beside the official exchange
rate, the black market offers foreign currency at another, usually much higher, rate.
6.6 Exchange rate regimes:
When the exchange rate can freely move, assuming any value that private demand and supply jointly
establish, “freely floating exchange rate” will be the name of currency institutional regime. Equivalently,
it is called “flexible” exchange rate as well. If the central bank timely and significantly intervenes on the
currency market, a “managed floating exchange rate regime” takes place. The central bank intervention
can have an explicit target, for example in term of a band of currency acceptable values. In “freely” and
“managed” floating regimes, a loss in currency value is conventionally called a “depreciation”, whereas
an increase of currency’s international value will be called “appreciation”. If the dollar rise from 10 000
yen to 12 000 yen, then it has shown an appreciation of 20%. Symmetrically, the yen has undergone an
8.3% depreciation. But central banks can also declare a fixed exchange rate, offering to supply or buy any
quantity of domestic or foreign currencies at that rate. In this case, one talks of a “fixed exchange rate”.
Under this regime, a loss of value, usually forced by market or a purposeful policy action, is called a
“devaluation”, whereas an increase of international value is a “revaluation”. The most stabile fixed
exchange regimes are backed by an international agreement on respective currency values, often with a
formal obligation of loans among central banks in case of necessity.
A “currency crisis” is a rupture of fixed exchange rates with an unwilling devaluation or even the end of
that regime in favor of a floating exchange rate. It can dominate the attention of the public, policymakers
and entrepreneurs, both in advance and after. For instance, people expecting a crisis can borrow inside the
country, convert in a foreign currency, and lend that money (e.g. by purchasing bonds). When the crisis
comes, they sell the bonds, convert to the national currency, pay back their loans, and gain a hefty profit.
An extreme national engagement to fixed exchange rates is the transformation of the central bank in a
mere “currency board” with no autonomous influence on monetary stock. The bank will automatically
print or lend money depending on corresponding foreign currency reserves. Thus, exports, imports and
capital inflows (e.g. FDI) will largely determine the monetary policy.
Monetary unions phase out the national currencies in favour of one (new or existing). Some further
countries can target to join the union and put in place economic and financial policies to that aim,
especially if there are explicit conditions for entering into that monetary area. Exiting a monetary union
can provoke with large devaluation of the new national currency. Depending on trade elasticity’s, on
foreign debt of the country, on how the exit is managed and on the overall institutional conditions, this
can lead to massive internal poverty or a large export led-growth.
6.7 Determinants of the exchange rates:
1. Fixed exchange rates are chosen by central banks and they may turn out to be more or less accepted by
financial markets. Changes in floating rates or pressures on fixed rates will derive, as for other financial
assets, from three broad categories of determinants: variables on the “real” side of the economy;
2. Monetary and financial variables determined in cross-linked markets;
3. Past and expected values of the same financial market with its autonomous dynamics.
Let’s see them separately for the case of the exchange rate.

Real variables
1. Exports, imports and their difference (the trade balance) influence the demand of currency aimed at
real transactions. A rising trade surplus will increase the demand for country’s currency by
foreigners, so that there should be a pressure for appreciation. A trade deficit should weaken the
currency. Were exports and imports largely determined by price competitiveness and were the
exchange rate very reacting to trade unbalances, then any deficit would imply depreciation, followed
by booming exports and falling imports. Thus, the initial deficit would be quickly reversed. Net
trade balance would almost always be zero. This is hardly the case in contemporary world economy.
 Trade unbalances are quite persistent, as you can verify with these real world data. Additionally, not
so seldom, exchange rates go in the opposite direction than one would infer from trade balance only
2. 2. An even more radical form of real determination of exchange rate is offered by the “one price
law”, according to which any good has the same price worldwide, after taken into account nominal
exchange rates. If a hamburger costs 3 US dollars in the United States and 30 000 yen in Japan, then
the exchange rate must be 10 000 yen per dollar. The forex market would passively adjust to permit
the functioning of the “one price law”. But in order to equalize the price of several goods, more than
one exchange rate may turn out to be “necessary”. Moreover the “one price law” seems to suffer
from too many exceptions to be accepted as the fundamental determinant of exchange rates. Large,
persistent and systematic violations of Purchasing Power Parity are connected to price-tomarket
decisions of firms in this paper of September 2007.

Monetary and financial variables in cross-linked markets.

1. Interest rates on Treasury bonds should influence the decision of foreigners to purchase currency in
order to buy them. In this case, higher interest rates attract capital from abroad and the currency
should appreciate. Decisive would be the difference between domestic and foreign interest rates,
thus a reduction in interest rates abroad would have the same effects. Similarly other fixed-interest
financial instruments could be objects of the same dynamics. Accordingly, an increase of domestic
interest rates by the central bank is usually considered a way to “defend” the currency. Nonetheless,
it may happen that foreigners rather buy shares instead of Treasury bonds. If this were the strongest
component of currency demand, then an increase of interest rate may even provoke the opposite
results, since an increase of interest rate quite often depresses the stock market, favouring a tide of
 share sales by foreigners. In the same “reversed” direction foreign direct investments would work: a
restrictive monetary policy usually depresses the growth perspective of the economy. If FDI are
mainly attracted by sales perspectives and they constitute a large component of capital flows, then
FDI inflow might stop and the currency weaken. Needless to say, those conditions are quite
restrictive and not so usually met. A matter of discussion would be whether the relevant interest rate
is the nominal or the real one (which, in contrast with the former, keeps into account inflation).
Usually foreign investors do not purchase bread, clothes, and the other items included in the bundle
used to compute price level and its dynamics: they do not buy anything real in the target economy.
So nominal rates are more likely to be taken into account. As a temporary conclusion, interest rates
should have an important impact on exchange rate but one has to be careful to check additional
conditions.
2. Inflation rate is often considered as a determinant of the exchange rate as well. A high inflation
should be accompanied by depreciation. The more so if other countries enjoy lower inflation rates,
since it should be the difference between domestic and foreign inflation rates to determine the
direction and the scale of exchange rate movements. All this would be implied by a weak version of
“one price law” stating that price dynamics of a good are the same worldwide after taking into
account nominal exchange rates. Thus, here not absolute level but just the percentage differences in
price are requested to be equalized. If a hamburger costs in Japan 5% more than a year ago, while in
USA it costs 8% more, then the dollar should have been depreciated this year by about 8-5=3%. But
in order to equalise the price dynamics of different goods, more than one exchange rate change may
turn out to be “necessary”. In reference to the overall price level of the economy, if exchange rates
would move exactly counterbalancing inflation dynamics, then real exchange rates should be
 constant. On the contrary, this is not true as a strict universal rule. Still, even if this weak version of
the “law” does not always hold, high inflation usually give rise to depreciation, whose exact
dimension need not match the inflation itself or its difference with foreign inflation rates.
3. The balance of payments can highlight pressures for devaluation or revaluation, reflected in large
and systematic trend of foreign currency reserves at the central bank. In particular, large inflows,
due for instance to a rise in the world price of main export items, tend to raise the exchange rate.
Conversely, a collapse in the trust of government to manage the economic conditions might provoke
a flight of capital, the exhaustion of foreign currency reserves and force devaluation / depreciation.
Dynamics on the Forex market:
Past and expected values of the exchange rate itself may impact on current values of it. The activities
of forex specialists and investors may turn out to be extremely relevant to the determination of market
exchange rate also thanks to their complex interaction with central banks. Sophisticated financial
instruments like futures on exchange rates may play an important role. Imitation and positive feedbacks
give rise to herd behaviour and financial fashions. Fears and confidence in a currency are
heterogeneosly distributed across agents, with special events (as unexpected news) realigning them and
generating large movement in the exchange rate.
Impact on other variables
Levels and fluctuations in the exchange rate exert a powerful impact
on exports, imports and the trade balance. A high and rising exchange rate tends to depress exports, to
boost import and to deteriorate the trade balance, as far as these variables respond to price stimuli.
Consumers find foreign goods cheaper so the consumption composition will change. Similarly, firms
will reduce their costs by purchasing intermediate goods abroad.
In extreme cases, local firms producing for the domestic market might go bankrupt. If the reason of
appreciation was a soaring world price of main exports (e.g. energy carriers, like oil for many oil
producing countries), the composition of the industrial texture would be starkly simplified and
concentrated to those exports. This is at odds and works in the opposite direction of the diversification
of the economy that is often the stated goal of public strategies in countries depending on too few
productions (high export concentration).
A devaluation or depreciation should work in the opposite direction, improving the trade balance
thanks to soaring exports and falling imports. If, however, imports have an elasticity to price less than
1, their values in local currency will grow instead of falling. Moreover, if the state, the citizens and / or
the enterprises have a debt denominated in a foreign currency, their principal and the interests to be
paid soar because of the devaluation. They usually squeeze other expenditures and launch a
recessionary impulse throughout the economy. Previous investors in real estate and other assets would
be hurt by devaluation, so the perspective of such a dynamics makes investors cautious and might sink
FDI.
External debt denominated in foreign currency can, if large enough, provide considerable effects on the
positive or negative impact of fluctuation. A devaluation with a large external debt provokes a larger
outflows of interest payments (expressed in local currency), possibly squeezing the economy and the
public budget, with recessionary effects. For industries where production can be flexibly exported,
devaluation offers important opportunities for growth and profitability. Conversely, industries selling
exclusively on the domestic market (e.g. the building industry) may see their costs rising while
purchasing power of their clients declines
or remains at the same level, which erodes their profits and can even lead to bankruptcies. In other
words, devaluation polarises the economy across industries. Hosting different industries, regions
usually exhibit a differentiated degree of international openness: exchange rate fluctuations will have
an uneven impact on them. Similarly, the number of job places and the working conditions may be
influenced by the degree of international competition and exchange rates levels.
Exchange rate influences also the external purchasing power of residents abroad, for example in term
of purchasing real estate and other assets (e.g. firm equity as a foreign direct investment), so by
different channels, also the balance of payments. Exchange rate devaluation (or depreciation) gives rise
to inflationary pressures: imported good become more expensive both to the direct consumer and to
domestic producer using them for further processing. In reaction to inflation (actual and feared), the
central bank can rise the interest rates, thus sending a recessionary impulse. Similiarly, a package of
fiscal austerity (expenditure cuts and selective tax increase), freezing wages and privatising loss-
generating public assets is sometimes imposed after the currency crisis. Currency crisis have a
sweeping impact on income distribution. The few rich able to borrow (because they have collateral and
the banks trust them) will get richer and the people purchasing imported goods facing inflation and
reduction of real incomes. Symmetrically, the central bank may use a fixed exchange rate as a nominal
anchor for the economy to keep inflation under control, compelling domestic producer to face tougher
competition if they were to decide to increase prices or accept to pay higher wages.
 Were adjustment perfect, as rational expectations models would normally posits, inflation would
immediately go to zero and there would be no effect on the real economy. Instead, real-world
experiences show that even when successful in taming inflation (which is not always the case) the
nominal anchor leadd to appreciation in real tirms (as the remaining inflation is not compensated by
devaluation), which over the years can provoke structural trade deficit and loss of competitiveness
(together with foreing debt with countries having a lower nominal interest rate). This conditions is
usually unsustainable in the long run. For a small economy, joining a monetary union makes the
exchange rate to fluctuate according to fundamentals and market pressures referring to a much larger
area, erratically going in directions that are (or are not) coherent with positive macroeconomic
developments.
For statistics purposes, international comparisons of current values converted to a common currency
are “distorted” by wide exchange rate fluctuations.
I. Long-term trends
Some geographical monetary areas have enjoyed long periods of stable exchange rate, with moments of
consensual realignment after divergence in inflation rates. Many countries strive to keep their currency at
a fixed level toward the dollar, the Euro (earlier the German mark) or a basket with multiple currencies.
Still, most currency progressively devaluate, especially those issued by periphery countries. The US dollar
has extremely wide fluctuations with years of “weak” and “strong” dollar.
II. Business cycle behavior
Too many elements are at work for the exchange rate to exhibit a clearlydefined business cycle behaviour.
To the extent that the exchange rate is determined by the trade balance, the exchange rate is counter-
cyclical as the latter. At peaks, the trade deficit would depress the exchange rate, forcing it to depreciate.
If it is rather the interest rate that turns out to the main driver of the exchange rate, a possible pro-cyclicity
of the interest rate would imply a pro -cyclical exchange r at e. I n this scenario, recovery and boom are
accompanied by rising interest rates and exchange rates. At peaks, we would see very strong currency.
Together with domestic demand pressures, this would be the source of a high trade deficit
If autonomous dynamics in the forex market are the main determinants of the exchange rate, then intense
micro-fluctuations and long term tides would ride the exchange rate, possibly with central bank
significant interventions.
Summary
Exchange rate is the rate at which one currency may be converted into another currency. The exchange
rate is used when simply converting one currency to another (such as for the purposes of travel to another
country), or for engaging in speculation or trading in the foreign exchange market. There are a wide
variety of factors which influence the exchange rate, such as interest rates, inflation, and the state of
politics and the economy in each country. It is also known as rate of exchange or foreign exchange rate or
currency exchange rate. Exchange depreciation is feasible. By exchange depreciation is meant a decline in
the rate of exchange of one country in terms of another's where as devaluation means a deliberate
reduction of the value of the national currency in terms of other currencies. A most commonly adopted
method consists in devaluation of the currency of a country faced with an adverse balance of payments. It
is an alternative to exchange depreciation. Hedging a particular currency exposure means establishing an
offsetting currency position such that whatever is lost or gained on the original currency exposure is
exactly offset by a corresponding foreign exchange gain or loss on the currency hedge.

6.10 GLOSSARY
* Foreign exchange market. The foreign exchange market (forex, FX, or currency market) is a form of
exchange for the global decentralized trading of international currencies. Financial centers around the
world function as anchors of trading between a wide range of different types of buyers and sellers around
the clock, EBS and Reuters' dealing 3000 are two main interbank FX trading platforms. The foreign
exchange market determines the relative values of different currencies.
* Exchange rate. Exchange rate (also known as a foreign-exchange rate, forex rate, FX rate or Agio)
between two currencies is the rate at which one currency will be exchanged for another. It is also regarded
as the value of one country's currency in terms of another currency.
* Bank rate. Bank rate, also referred to as the discount rate, is the rate of interest which a central bank
charges on the loans and advances to a commercial bank.
* GDP Gross domestic product. (GDP) is the market value of all officially recognized final goods and
services produced within a country in a given period of time.
* Inflation. Inflation is a rise in the general level of prices of goods and services in an economy over a
period of time When the general price level rises, each unit of currency buys fewer goods and services.
Consequently, inflation reflects a reduction in the purchasing power per unit of money - a loss of real
value in the medium of exchange and unit of account within the economy.
* Deflation. Deflation is a decrease in the general price level of goods and services. Deflation occurs
when the inflation rate falls below 0% (a negative inflation rate).
* International trade. International trade is the exchange of capital, goods, and services across
international borders or territories.
* Hedging. Hedging means reducing or controlling risk. This is done by taking a position in the futures
market that is opposite to the one in the physical market with the objective of reducing or limiting risks
associated with price changes.
* Futures contract. A futures contract (more colloquially, futures) is a standardized contract between two
parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today
(the futures price or strike price) with delivery and payment occurring at a specified future date, the
delivery date.
* International liquidity. International liquidity is the ability of a given country to purchase goods and
services from another country. It is a combination of a country's readily available supply of foreign
currency, and the degree to which its assets may be used as a form of payment or converted to the
currency of the country with which it is trading.
* Devaluation. Devaluation in the modern monetary policy is a reduction in the value of a currency with
respect to those goods, services or other monetary units with which that currency can be exchanged.
'Devaluation' means official lowering of the value of a country's currency within a fixed exchange rate
system, by which the monetary authority formally sets a new fixed rate with respect to a foreign reference
currency