MBFI Lecture Note # 01 Financial Services & Institutions - An Introduction

Financial Services: Financial services refer to services provided by the finance industry. Movement of money Converting currencies Facilitating business Facilitating import export Travelers Cheques Deposits Loans Facilitating issue of securities Facilitating trading of securities Investing in securities Advising companies in financial matters Provide risk cover Advise in risk management areas Regulators

Financial Institutions Commercial Banks Investment Banks Consumer finance companies Investment funds Mutual funds Stock brokerages Stock exchanges Credit card companies Insurance companies 1

MBFI Lecture Note # 01

Financial Institutions can be defined as entities whose assets are almost entirely financial assets. And, Financial Assets can be defined as claims on others such as individuals, firms, companies, institutions and the government (claims such as receivables sundry debtors are generally not considered as financial assets). However, in India, the legal definition [Section 45-I of the RBI Act 1934] is as follows. "Financial Institution" means any non-banking institution which carries on as its business or part of its business any of the following activities, namely:a) the financing, whether by way of making loans or advances or otherwise, of any activity other than its own; b) the acquisition of shares, stock, bonds, debentures or securities issued by a government or local authority or other marketable securities of a like nature; c) letting or delivering of any goods to a hirer under a hire-purchase agreement as defined in clause (c ) of section 2 of the Hire-Purchase Act, 1972; d) the carrying on of any class of insurance business; e) managing, conducting or supervising, as foreman, agent or in any other capacity, of chits or kuries as defined in any law which is for the time being in force in any State, or any business, which is similar thereto; f) collecting, for any purpose or under any scheme or arrangement by whatever name called monies in lump sum or otherwise, by way of subscriptions or by sale of units, or other instruments or in any other manner and awarding prizes or gifts, whether in cash or kind, or disbursing monies in any other way, to persons from whom monies are collected or to any other person. But does not include any institution, which carries on as its principal business,a) agricultural operations; or b) industrial activity; or; 2

MBFI Lecture Note # 01 c) the purchase or sale of any goods (other than securities) or the providing of any services; or d) the purchase, construction or sale of immovable property, so however, that no portion of the income of the institution is derive from the financing of purchases, constructions or sales of immovable property by other persons; The whole set of financial institutions are, for various reasons, seen as comprising two sub-sets viz., Banks and Non Banking Financial Institutions. Such a distinction is made because of the critical nature of banks in the financial system in the economic system and the consequent imperative of close monitoring and intensive regulation of banks.

Commercial Banking and Investment Banking Banking, the oldest of all financial service professions, started as a money changing business safe keeping of wealth. It has then started providing services facilitating payments and remittances both personal and business related. In due course it evolved into a profession offering a whole range of financial services. Two major categories of services are the commercial banking and investment banking. While commercial banking refers to the business of taking deposits and making loans, investment banking is used for the activity related assisting corporations in raising funds in the capital markets. In recent years the lines dividing the two have blurred, especially as commercial banks have started offering more investment banking services to becoming a one-stop service provider. The exact structure varies from country to country and depends on local regulations.

MBFI Lecture Note # 01 Commercial banks Banks are financial institutions with a key difference that sets them apart from other such institutions in that they are authorized to accept deposits payable on demand. Because of this unique character of banks, they are both highly regulated and have a restrictive legal definition in all countries. In India banking has been defined in the Banking Regulation Act 1949 {Sec 5 (b) }. According to the BR Act banking means the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise. In the US, a bank has been defined as an organization that makes loans, has FDIC (Federal Deposit Insurance Corporation) insured deposits and has been granted banking powers either by the State or by the Federal Government

Basic Functions Performed by Commercial Banks

Payment System o Checking Accounts or Current Accounts When a customer deposits his/her money in a bank, the bank typically opens an account in his/her name. The account could be of three different types a current account or account meant for facilitating every day transactions, both receipts and payments. Such accounts are usually favoured by businessmen/commercial entities unlike savings bank accounts favoured by individuals for their savings or fixed deposits wherein the money is locked in for a specific period. In most countries no interest is paid on current and savings accounts. In India, however, while no interest is paid on balances in current accounts, banks pay interest (presently 3.5%) on balances in savings bank accounts. Both are checking accounts in the sense that account holders 4

MBFI Lecture Note # 01 can draw checks and banks have to honour these cheques provided they have funds or balance in their accounts. o Movement of funds DD, TT, MT & EFT Banks facilitate the movement of funds from one place to another by issuing what are known as demand drafts (DD), telegraphic transfers (TT), mail transfers (MT) and electronic fund transfers (EFT). A customer in Chennai who wants to send money to someone in Mumbai, for instance, can simply tell his banker to issue a DD/TT favouring that person payable in Mumbai. Financial Intermediation o Banks enable financial intermediation ie they intermediate between those who have money/savings (Savers) and those who need money/investors/entrepreneurs (Borrowers) o Efficient allocation of capital is crucial for an economy to ensure that resources put to best and efficient use o Economic growth depends on savings and efficient use of saving

MBFI Lecture Note # 01 Indian Financial System Historical Perspective Financial systems evolve over a period of time and are influenced by the politico economic environment. And, economic development is accompanied by growth of financial organizations. Upto 1951 Post independence and before the Five Year Plans started Closed character of industrial entrepreneurship Not well organized securities and capital market Lack of intermediaries Lack of institutional infrastructure Bank lending security and collateral based The Plans period (up to the late eighties) Pursuance of goals of accelerated economic growth with social justice Adoption of the mixed economy model and use of Five Year Plans Need felt for alignment of financial system with the priorities of governments economic policy Government control over distribution of credit & finance Emphasis shifted from Business to Development

Directed bank lending loans only for desired sectors Fortification of the institutional structure New institutions : development banks UTI

Insurance companies Public / government ownership to direct savings into desired sectors Nationalization of major banks in 1969

Control over corporate management of banks 6

MBFI Lecture Note # 01 Cap on voting rights of shareholders Approval of RBI required over appointment of the Chairman managing Director and other Directors of the Board of Directors Micro regulation by RBI Problems in this period PSU banks Concentration on deposit mobilization, branch expansion and following ministry/RBI directives Lack of competition Bureaucratization Not profit oriented, NPAs, overstaffing Non-uniform accounting Low capitalization Development Financial Institutions (DFIs) DFIs acted as mere canalizing agencies- channeling money from the government to borrowers Accumulated mountains of debt NPAs and no prudential norms Became dens of corruption

BOP Crisis of the early 1990s led to structural changes and reforms leading to a the present liberalized and deregulated environment

MBFI Lecture Note # 01 Indian Financial System An Overview Financial Banks D F Is NBFCs Institution s Services Merchant / Investment Bankers Mutual Funds Credit Rating Agencies

Insurance

Life Insurance Companies General Insurance Companies

RBI Regulators SEBI IRDA Primar y Capital Market Markets Money Market Foreign Exchange Market Secondar y

Shares Equity Instruments Hybrid Debt Convertible Debentures G-Secs, Bonds, Debentures, CDs, CPs, Call Money, ICDs 8 Debt

MBFI Lecture Note # 01 Banking Scenario in India Types of Banks in India Commercial Banks Cooperative Banks Regional Rural Banks Local Area Banks

Scheduled Banks o RBI , after being satisfied that a bank conforms to certain standards, gives recognition to it by including it in the Second Schedule to the Reserve Bank of India Act 1934 o Importance Status Certain privileges such are refinance etc Support from RBI in case of trouble Stricter regulation and supervision by RBI

o As of now, all commercial banks, RRBs, State cooperative Banks and most Urban Cooperative banks are scheduled Commercial Banks Companies which have been granted banking license by RBI Doing commercial banking Public Sector Banks Old Private Sector Banks New Private Sector Banks Foreign Banks ( branches of banks incorporated outside India) RBI treats all commercial banks on the same footing

MBFI Lecture Note # 01 Cooperative Banks Financial Institutions set up in the cooperative mode State Cooperative Banks District / Central Cooperative Banks Urban Cooperative Banks / Primary Credit Societies

Primarily under the Registrar of Cooperative Societies Banks regulated by RBI - brought under RBI regulation in 1966 Though the ownership pattern id different, thye are an important segment of the financial (& payment) system Recently difficulties in some of the banks in this sector created problems in the entire banking system currently the dual control is an area of concern

Regional Rural Banks 196 in number set up in 1976 to provide credit and other facilities in the rural area o local area of operations o manned by local people (hence low cost and local knowledge) o sponsored by a public sector bank o ownership GOI 50%, State 15% and bank 35% o all RRBs have been granted the scheduled bank status o supervision is by NABARD Local Area Banks guidelines issued in 1996 Minimum Capital Rs 5 crs (promoter not less than 2 crs) Commercial banking but limited to three contiguous districts 7 approved 5 issued licenses

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MBFI Lecture Note # 01 New Private Sector Banks opened up in 1993 minimum capital 100 crs ( 25 % by promoters) minimum capital revised in 2001 to Rs 200 crs (40% by promoters) conversion of NBFCs allowed o should have AAA rating o CRAR not less than 12% o Net NPA not more than 5%

Current Issues and Challenges o Competition o Lower margins o Market determined interest rates - volatile interest rates o More sophisticated and knowledgeable customers o Increasing banking activity o Asset quality issues & NPAs o Securitization o Technological advances o Introduction of Basel II Norms

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