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Prepared by- Rajat Panwan

INDIAN FINANCIAL SYSTEM There are areas or people with surplus funds and there are those with a deficit. A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. A Financial System is a composition of various institutions, markets, regulations and laws, practices, money manager, analysts, transactions and claims and liabilities.

The word "system", in the term "financial system", implies a set of complex and closely connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. The financial system is concerned about money, credit and finance-the three terms are intimately related yet are somewhat different from each other. Indian financial system consists of financial market, financial instruments and financial intermediation.


A Financial Market can be defined as the market in which financial assets are created or transferred. As against a real transaction that involves exchange of money for real goods or services, a financial transaction involves creation or transfer of a financial asset. Financial Assets or Financial Instruments represents a claim to the payment of a sum of money sometime in the future and /or periodic payment in the form of interest or dividend. Money Market- The money market ifs a wholesale debt market for low-risk, highly-liquid, short-term instrument. Funds are available in this market for periods ranging from a single day up to a year. This

Prepared by- Rajat Panwan

market is dominated mostly by government, banks and financial institutions. Capital Market - The capital market is designed to finance the long-term investments. The transactions taking place in this market will be for periods over a year.

FUNCTIONS OF FINANCIAL MARKET Financial markets play an important role in the allocation of scarce resources in an economy by performing the following four important functions. 1. Mobilization of Savings and Channeling them into the most Productive Uses: A financial market facilitates the transfer of savings from savers to investors. It gives savers the choice of different investments and thus helps to channelise surplus funds into the most productive use. 2. Facilitate Price Discovery: You all know that the forces of demand and supply help to establish a price for a commodity or service in the market. In the financial market, the households are suppliers of funds and business firms represent the demand. The interaction between them helps to establish a price for the financial asset which is being traded in that particular market. 3. Provide Liquidity to Financial Assets: Financial markets facilitate easy purchase and sale of financial assets. In doing so they provide liquidity to financial assets, so that they can be easily converted into cash whenever required. Holders of assets can readily sell their financial assets through the mechanism of the financial market. 4. Reduce the Cost of Transactions: Financial markets provide valuable information about securities being traded in the market. It helps to save time, effort and money that both buyers and sellers of a financial asset would have to otherwise spend to try and find each other. The financial market is thus, a common platform where buyers and sellers can meet for fulfillment of their individual needs. Financial markets are classified on the basis of the maturity of financial instruments traded in them. Instruments with a maturity of less than one year are traded in the money market. Instruments with longer maturity are traded in the capital market. MONEY MARKET: The money market is a market for short term funds which deals in monetary assets whose period of maturity is up to one year. These assets are close substitutes for money. It is a market where low risk, unsecured and short term debt instruments that are highly liquid are issued and actively traded every day. It has no physical location, but is an activity conducted over the telephone and raising of short-term funds for meeting the temporary shortages of cash and obligations and the temporary deployment of excess funds for earning returns. The major participants in the market are the Reserve Bank of India the money market is a market for short term funds which deals in monetary assets whose period of maturity is up to one year. These assets are close substitutes for money. It is a market where low risk, unsecured and short term debt instruments that are highly liquid are issued and actively traded every day. It has no physical location, but is an activity conducted over the telephone and through the internet. It enables the raising of short-term funds for meeting the temporary shortages of cash and

Prepared by- Rajat Panwan

obligations and the temporary deployment of excess funds for earning returns. The major participants in the market are the Reserve Bank of India. FUNCTIONS OF MONEY MARKET 1. Financing Trade: Money Market plays crucial role in financing both internal as well as international trade. Commercial finance is made available to the traders through bills of exchange, which are discounted by the bill market. The acceptance houses and discount markets help in financing foreign trade.

2. Financing Industry: Money market contributes to the growth of industries in two ways: (a) Money market helps the industries in securing short-term loans to meet their working capital requirements through the system of finance bills, commercial papers, etc. (b) Industries generally need long-term loans, which are provided in the capital market. However, capital market depends upon the nature of and the conditions in the money market. The short-term interest rates of the money market influence the long-term interest rates of the capital market. Thus, money market indirectly helps the industries through its link with and influence on long-term capital market.

3. Profitable Investment: Money market enables the commercial banks to use their excess reserves in profitable investment. The main objective of the commercial banks is to earn income from its reserves as well as maintain liquidity to meet the uncertain cash demand of the depositors. In the money market, the excess reserves of the commercial banks are invested in near-money assets (e.g. short-term bills of exchange) which are highly liquid and can be easily converted into cash. Thus, the commercial banks earn profits without losing liquidity.

4. Self-Sufficiency of Commercial Bank: Developed money market helps the commercial banks to become self-sufficient. In the situation of emergency, when the commercial banks have scarcity of funds, they need not approach the central bank and borrow at a higher interest rate. On the other hand, they can meet their requirements by recalling their old short-run loans from the money market.

Prepared by- Rajat Panwan

5. Help to Central Bank: Though the central bank can function and influence the banking system in the absence of a money market, the existence of a developed money market smoothens the functioning and increases the efficiency of the central bank. Money market helps the central bank in two ways: (a) The short-run interest rates of the money market serves as an indicator of the monetary and banking conditions in the country and, in this way, guide the central bank to adopt an appropriate banking policy, (b) The sensitive and integrated money market helps the central bank to secure quick and widespread influence on the sub-markets, and thus achieve effective implementation of its policy.

MONEY MARKET INSTRUMENTS Following are some of the important money market instruments or securities. (a) Call Money: Call money is mainly used by the banks to meet their temporary requirement of cash. They borrow and lend money from each other normally on a daily basis. It is repayable on demand and its maturity period varies in between one day to a fortnight. The rate of interest paid on call money loan is known as call rate. (b)Treasury bill: A treasury bill is a promissory note issued by the RBI to meet the short-term requirement of funds. Treasury bills are highly liquid instruments that means, at any time the holder of treasury bills can transfer of or get it discounted from RBI. These bills are normally issued at a price less than their face value; and redeemed at face value. So the difference between the issue price and the face value of the Treasury bill represents the interest on the investment. These bills are secured instruments and are issued for a period of not exceeding 364 days. Banks, Financial institutions and corporations normally play major role in the Treasury bill market. (c) Commercial Paper: Commercial paper (CP) is a popular instrument for financing working capital requirements of companies. The CP is an unsecured instrument issued in the form of promissory note. This instrument was introduced in 1990 to enable the corporate borrowers to raise short-term funds. It can be issued for period ranging from 15 days to one year. Commercial papers are transferable by endorsement and delivery. The highly reputed companies (Blue Chip companies) are the major player of commercial paper market. (d) Certificate of Deposit: Certificate of Deposit (CDs) are short-term instruments issued by Commercial Banks and Special Financial Institutions (SFIs), which are freely transferable from one party to another. The maturity period of CDs ranges from 91 days to one year. These can be issued to individuals, cooperatives and companies.

Prepared by- Rajat Panwan

(e) Trade Bill: Normally the traders buy goods from the wholesalers or manufactures on credit. The sellers get payment after the end of the credit period. But if any seller does not want to wait or in immediate need of money he/she can draw a bill of exchange in favour of the buyer. When buyer accepts the bill it becomes a negotiable instrument and is termed as bill of exchange or trade bill. This trade bill can now be discounted with a bank before its maturity. On maturity the bank gets the payment from the drawee i.e., the buyer of goods. When trade bills are accepted by Commercial Banks it is known as Commercial Bills. So trade bill is an instrument, which enables the drawer of the bill to get funds for short period to meet the working capital needs.

CAPITAL MARKET Capital Market may be defined as a market dealing in medium and long-term funds. It is an institutional arrangement for borrowing medium and long-term funds and which provides facilities for marketing and trading of securities. So it constitutes all long-term borrowings from banks and financial institutions, borrowings from foreign markets and raising of capital by issue various securities such as shares debentures, bonds, etc. In the present chapter let us discuss about the market for trading of securities. The market where securities are traded known as Securities market. It consists of two different segments namely primary and secondary market. The primary market deals with new or fresh issue of securities and is, therefore, also known as new issue market; whereas the secondary market provides a place for purchase and sale of existing securities and is often termed as stock market or stock exchange. COMPONENT OF CAPITAL MARKET PRIMARY MARKET/NEW ISSUE MARKET: The primary market is also known as the new issues market. It deals with new securities being issued for the first time. The essential function of a primary market is to facilitate the transfer of investible funds from savers to entrepreneurs seeking to establish new enterprises or to expand existing ones through the issue of securities for the first time. The investors in this market are banks, financial institutions, insurance companies, mutual funds and individuals. A company can raise capital through the primary market in the form of equity shares, preference shares, debentures, loans and deposits. Funds raised may be for setting up new projects, expansion, diversification, modernisation of existing projects, mergers and takeovers etc.

FUNCTIONS OF PRIMARY MARKET 1. The prime function of the new issue market is to facilitate the transfer of funds from the willing investors to the entrepreneurs setting up new enterprises or going in for expansion, diversification, growth and modernization. 2. The organization of new issue market is not complete without the specialised agencies, intermediarie issue of new securities and helping in selling, transferring and underwriting etc.

Prepared by- Rajat Panwan

3. As the NIM directs the flow of saving into long term investment it is of paramount importance for the economic growth and industrial development of a country. SECONDARY MARKET: The secondary market known as stock market or stock exchange plays an equally important role in mobilizing long-term funds by providing the necessary liquidity to holdings in shares and debentures. It provides a place where these securities can be encashed without any difficulty and delay. It is an organized market where shares, and debentures are traded regularly with high degree of transparency and security. In fact, an active secondary market facilitates the growth of primary market as the investors in the primary market are assured of a continuous market for liquidity of their holdings. The major players in the primary market are merchant bankers, mutual funds, financial institutions, and the individual investors; and in the secondary market you have all these and the stockbrokers who are members of the stock exchange who facilitate the trading.

The process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors. The process can encompass any type of financial asset and promotes liquidity in the marketplace.
Securitization is a process by which identified pools of receivables, which are usually illiquid on their own, are transformed into marketable securities through suitable repackaging of cashflows that they generate. The broader meaning of securitization: Securitization is the process of commoditization. The basic idea is to take the outcome of this process into the market, the capital market. Thus, the result of every securitization process, whatever might be the area to which it is applied, is to create certain instruments, which can be placed in the market. Securitization is the process of integration and differentiation: The entity that securitizes its assets first pools them together into a common hotchpot (assuming it is not one asset but several assets, as is normally the case). This process of integration. Then, the pool itself is broken into instruments of fixed denomination. This is the process of differentiation. Securitization is the process of de-construction of an entity. If we think of an entitys assets as being composed of claims to various cash flows, the process of securitization would split apart these cash flows into different units .We classify these units, and sell these classified units to different investors as per their needs. Therefore, securitization breaks the entity into various sub-sets. We will discuss further the present-day meaning of securitization after some more understanding of generic meaning of the term. The process of converting an asset or a relationship into a security or a commodity.

Prepared by- Rajat Panwan

Need for securitization: The generic need for securitization is similar to that of organized financial markets. From the distinction between a financial relation and a financial transaction earlier, we understand that a relation invariably needs the coming together and remaining together of two entities. Not that the two entities would necessarily come together of their own, or directly. They might involve a number of financial intermediaries in the process, but a relation involves fixity over a certain time. Financial relations are created to back another financial relation, such as a loan being taken to acquire an asset, and in that case, the needed fixed period of the relation hinges on the other that it seeks to back-up. Financial markets developed in response to the need to involve a large number of investors. As the number of investors keeps on increasing, the average size per investors keeps on coming down, because growing number means involvement of a wider base of investors. The small investor is not a professional investor. He needs an instrument, which is easier to understand, and provides liquidity and legal sanction. These needs set the stage for evolution of financial instruments which would convert financial claims into liquid, easy to understand and homogenous products. They would be available in small denominations to suit even a small investor. Therefore, securitization in a generic sense is basic to the world of finance, and it is right for us to say that securitization envelopes the entire range of financial instruments, and the range of financial markets. Reasons for Growth of securitization 1. Financial claims often involve large sums of money, which is outside the reach of the small investor who lacks expertise. In order to cater to this need development of financial intermediation. In a simple case an intermediary such as a bank obtains resources of the small investors and uses the same for the larger investment need of the user. 2. Small investors are typically not in the business of investments, and hence, liquidity of investments is most critical for them. Underlying financial transactions need fixity of investments over a fixed time, ranging from a few months to may be a number of years. This problem could not even be sorted out by financial intermediation, since, the intermediary provided a fixed investment option to the seeker, and itself requires funds with an option for liquidity. Or else, it would be into serious problems of a mismatch. Hence, the answer is a marketable instrument. 3. Generally, instruments are easier understood than financial transactions. An instrument is homogenous, usually made in a standard form, and generally containing standard issuer obligations. Hence, it can be understood generically. Besides, an important part of investor information is the quality and price of the instrument, and both are difficult to be ascertained.

Prepared by- Rajat Panwan

The need for securitization was almost inescapable, and present days financial markets would not have been what they are, unless some standard thing that market players could buy and sell, that is, financial securities, were available. Therefore, there is large scope for development in this area. Capital markets are today a place where we can trade, claims over entities, claims over assets, risks, and rewards. Let us consider certain types of securitization.

Securitization acts as a financial instrument to pass on the debt to interested investors where residential mortgages, commercial mortgages, auto loans and credit card debt obligations can be modified as collateralized mortgage obligation in the form of bonds which are passed as securities.

The securities backed with mortgages are called mortgage backed securities and others are called asset backed securities. There is high risk involved as standards of underwriting could be compromised on issuing the securities to a particular firm in the current competitive securities market even for low credit worthy firms. This was also one of the reasons for U.S. sub-prime crisis.

Securitisation is a relatively new concept in India but is gaining ground quite rapidly.CRISIL rated the first securitisation program in India in 1991 when Citibank securitised a pool from its auto loan portfolio and placed the paper with GIC Mutual Fund (a case study of one of Citibanks subsequent deals is discussed later in detail). Since then, securitisation ofassets has begun to emerge as a clear option of fund raising by corporates and a few transactions of well-rated companies have taken place in the country. While some of the securitisation transactions which took place earlier involved sale of hire purchase or loan receivables of non-banking financial companies (NBFCs), arising out of auto-finance activity, many manufacturing companies and service industries are now increasingly looking towards securitising their deferred receivables and future flows also. Information on pastdeals is not readily available, as most of them have been bilateral one-to-one and unrated transactions. In the context of rated transactions, CRISIL has rated about 50 transactions till date, with volume aggregating to well over Rs 4,500 crore. Other rating agencies in India, viz., ICRA, DCR and CARE have also been actively involved in the process. The majority of these being in the nature of outright sales of auto loan portfolios without subsequent issue of securities and do not amount to securitisation in the real sense. There has till date been no instance of downgrading of the rating assigned to any of these transactions. As per an estimate, out of the total asset securitisation attempted between 1992 and 1998, as much as35 % relates to hire purchase receivables of truck and auto loan segment. The car loan segment of the auto loans market has been more successful than the commercial vehicle loan segment mainly because of factors such as perceived credit risk, higher volumes and homogeneous nature of receivables. Other types of receivables for which securitisation has been attempted include property rental receivables, power receivables, telecom receivables, lease receivables etc. However, while several ABS transactions may have assumed a form similar to that of securitisation,

Prepared by- Rajat Panwan

the absence of marketable securities available for distribution to several investors would imply that in substance all these transactions partake of the essential characteristics of a structured loan deal rather than of a securitisation transaction. So far, Securitisation in India was meant to imply any of the following distinct activities: Structured obligations against receivables (whether loans or debentures/bonds) Outright sale of financial/trade receivables without issue of securities Securitisation transactions involving assignment of receivables to an SPV and issue of securities backed by these receivables In the first type, there is no legal true sale of receivables. The lenders/investors rely on a structured payment mechanism for timely servicing of their dues and not on the performance of the assets. Further, the receivables do not go off the balance sheet of the Originator and the lenders/investors continue to have full recourse to the Originator. In the second type, while the Originator would get the benefit of off-balance sheet funding, it fails to satisfy a basic requirement of securitisation i.e. issue of securities backed by these receivables. Securitisation is incomplete unless it involves an issue of (marketable) securities whereby the risks and rewards are channeled into the capital market (at least into the wholesale segment). Thus, only the third type of activity falls under the category of true securitisation as understood internationally. The first two types are already witnessing some activity from certain lending institutions. Other players in the reckoning are multinationals like GE Capital and Citibank who have been acquiring asset portfolios generated by local NBFCs like Ashok Leyland Finance, 20th Century Finance and other companies like TELCO. The third type of activity, which would involve issue of tradable securities either in the form of PTCs or structured debentures, is the one that is expected to see larger volumes in the long run. This segment would comprise within it, both corporates willing to raise funds against their assets as also FIs wanting to securitise their loan portfolios. In fact, organisations like HUDCO and Rural Electrification Corporation have already evinced interest in creating a securitisation structure for their future investments in the infrastructure area. 4.6.2 Some of the pioneering transactions that have either been concluded or are being structured in this regard are described in the following sections. (a) Housing Loans Housing loan portfolios are considered to be high quality assets with diversified risk and attractive returns. They are by their nature amenable to securitisation. In India however, in spite of outstanding to the tune of Rs 12,000iii crore in the organised sector, no transaction has yet achieved successful completion. This needs to be analysed in light of the experience in the US markets, where the overwhelming majority of securitisation deals have been of housing loans or MBS. However, of late there has been a perceptible positive orientation of Government policiestowards securitisation for the housing sector. The five-year Plan documents have repeatedlyemphasised the need for

Prepared by- Rajat Panwan

developing a secondary mortgage market (SMM) for bridging the resource constraint confronting the housing sector. The Ninth Five-Year Plan has strongly recommended securitisation as an important source of funds for the housing sector and has envisaged Rs. 2500 crore to come by way of securitisation. The National Housing Policy (1992) of the Government of India also identified securitisation as an essential measure for generating resources for housing. In particular, it has emphasised the development of a SMM in the country in order to channelise funds from wide range of investors and help integrate the housing finance system with overall finance system, especially the capital market. That securitisation has come to represent a major policy plank of the Government, is further manifested in the recently announced National Habitat and Housing Policy (1998), which lays emphasis on the National Housing Bank (NHB) playing a lead role in mortgage securitisation and development of a SMM in the country. NHB has taken up the issue of securitisation with state Governments through the Ministry of Urban Development. NHB is now proposing a pilot issue of MBS, as a prelude to the development of a SMM in the country. The pilot project involves securitising a pool of housing loans originated by four Housing Finance Companies. The pool would include unencumbered loans given to individuals for residential houses, in the states of Maharashtra, Tamil Nadu, Gujarat and Karnataka, with maximum loan to value ratio (LTV) of 80%. NHB would act as the SPV and facilitate the transaction. The issue is proposed to be launched in FY 1999 2000 and is expected to be a path-breaking issue for MBS transactions in the country. All the major procedural, legal, and taxation issues are in the process of being resolved in this transaction, thus paving the way for classical securitisation transactions to take off in the country. As with the rest of the world, the potential for mortgage securitisation is enormous. In the case of mortgage securitisation there are specific issues that stymie the process. These are the long tenure of loans, low spreads, cumbersome foreclosure procedures, prepayment risks etc., all of which have led to its tardy progress. A major hurdle in India is simplified foreclosure norms. Once this happens, housing finance institutions (HFIs) will be able to tackle delinquencies effectively and will be willing to lend with less stringent credit evaluation. This is expected to enlarge volumes in the formal sector, helping a wider section of society (who would otherwise have approached the unorganised sector) to borrow at lower rates. (b) Auto loans Citibank Case Citibank assigned a cherry-picked auto loan portfolio to Peoples Financial Services Ltd. (PFSL), an SPV floated for the purpose of securitisation by paying the required amount of stamp duty (0.1%) to ensure true sale. This is a limited company and can act only as SPV for asset securitisation. This SPV is owned and managed by a group of distinguished legal counsels. PFSL then proceeded to issue Pass Through Certificates to investors. These certificates were rated by CRISIL and listed on the wholesale debt market of the National Stock Exchange (NSE), with HG Asia and Birla Marlin as the market makers. Global Trust Bank acted as the Investors Representative. Citibank played the role of servicer. The certificates are freely transferable and each of the transfer will have a stamp cost of 0.10%. The coupon of the security was high in spite of good quality of the underlying asset portfolio, because investors expected a premium to compensate for their unfamiliarity with the certificates. The investor base was limited mostly to MFs. FIs were hesitant because of the unsecured nature of

Prepared by- Rajat Panwan

the instrument and the absence of clarity on whether the certificates could be treated on par with other debt securities in their investment policy. Although the certificates were listed on the NSE, there was very little secondary market activity because there was absence of adequate amount of alternative security of similar risk profile.Besides Citibank, NBFCs like Ashok Leyland Finance, 20th Century Finance etc. have securitised their auto loan portfolio, though, of course, these transactions involved assignment of receivables only and not issuance of securities. The asset portfolios were bought by one or two large institutions. TELCO has also reportedly sold over Rs 550 crore of its auto loan portfolio in multiple tranches through this route.++