Financial Services and Market CBMFM4T05

Syllabus topics (RTMNU)

• The financial market system and its nature and scope
• Factors affecting the stability of the financial system
• Development of money market vs. capital market
• Financial intermediaries

The Financial Market System: Nature and Scope

Financial system is the network of financial institutions, financial markets, financial instruments and financial services that collects savings from people and moves them to those who need funds for investment.

Financial market: A financial market is a place or mechanism where financial assets such as shares, bonds, bills and loans are created and traded.

Components of the financial system:

1. Financial institutions – banks, NBFCs, insurance companies, mutual funds.
2. Financial markets – money market and capital market (primary and secondary), also forex and derivatives markets.
3. Financial instruments – shares, debentures, T-bills, commercial paper, deposits.
4. Financial services – leasing, factoring, merchant banking, credit rating.
5. Regulators – RBI, SEBI, IRDAI, PFRDA.

Nature (features):

• Link between savers and investors – mobilises household savings for industry and government.
• Deals in financial claims, not physical goods.
• Price discovery – interest rates and share prices are set by demand and supply.
• Provides liquidity – investors can sell assets quickly.
• Reduces cost of searching and transacting.
• Highly regulated to protect investors.

Scope: it covers mobilisation of savings, allocation of funds, credit creation, payment and settlement (UPI, NEFT, RTGS), risk sharing through insurance and derivatives, and support to economic growth and government borrowing.

Factors Affecting the Stability of the Financial System

Financial stability means banks, markets and payment systems work smoothly and can absorb shocks without a crisis.

1. Health of banks – high bad loans (NPAs) weaken banks and reduce lending.
2. Capital adequacy – banks with enough capital can absorb losses.
3. Quality of regulation and supervision by RBI, SEBI, IRDAI.
4. Macroeconomic conditions – inflation, fiscal deficit, growth rate, exchange rate.
5. Interest rate and liquidity shocks – sudden rise in rates or a cash shortage.
6. Asset price bubbles – sharp rise and fall in share or property prices.
7. Global factors – foreign crises spread through capital flows (e.g. the 2008 global crisis).
8. Failure of a large institution – e.g. the IL&FS default in 2018 hurt NBFC funding.
9. Corporate governance and frauds, cyber risks and investor confidence.

Development of Money Market vs. Capital Market

Money market is the market for short-term funds (up to one year). Capital market is the market for long-term funds.

Development of the Indian money market: Earlier it was narrow, with only call money and T-bills. After the Chakravarty Committee (1985) and Vaghul Committee (1987), new instruments came: commercial paper, certificates of deposit, 182-day T-bills, repo. DFHI (Discount and Finance House of India) was set up in 1988 to make the market deeper. Today the call market is mainly for banks, and RBI uses repo and reverse repo under the Liquidity Adjustment Facility (LAF) to control liquidity.

Development of the Indian capital market: BSE (1875) is Asia's oldest stock exchange. SEBI got statutory powers in 1992, the Controller of Capital Issues was abolished, and companies could price issues freely. NSE (1992) brought screen-based trading; depositories (NSDL 1996, CDSL 1999) brought demat shares; T+1 settlement and UPI-based IPO applications made the market faster and safer.

Financial Intermediaries

Definition: A financial intermediary is an institution that stands between savers and borrowers – it collects funds from savers and lends or invests them in borrowers.

Functions:

1. Mobilisation of savings from many small savers.
2. Maturity transformation – short-term deposits become long-term loans.
3. Risk reduction through diversification.
4. Size transformation – small deposits pooled into big loans.
5. Lower transaction cost and expert credit appraisal.
6. Payment services and liquidity to savers.

Likely exam questions

1. (Long, 8/16 marks) What is a financial system? Explain the nature and scope of the financial market system in India.
2. (Long, 8/16 marks) Distinguish between money market and capital market. Describe the development of both markets in India.
3. (Short, 4 marks) What is meant by financial stability? State any four factors affecting it.
4. (Short, 4 marks) Define financial intermediary.
5. (Short, 4 marks) State the functions of financial intermediaries.

Syllabus topics (RTMNU)

• RBI
• Central banking
• Commercial banks
• Public and the private sectors
• Structure and comparative performance
• Bank capital
• Adequacy norms and capital market support
• Non-Banking financial institutions
• Control by RBI and SEBI
• A perspective on future role
• Commercial paper: features and advantages

RBI – Central Banking

Reserve Bank of India (RBI) is India's central bank. It was set up on 1 April 1935 under the RBI Act, 1934, on the recommendation of the Hilton Young Commission. It was nationalised on 1 January 1949. Its head office is in Mumbai.

Central bank – definition: A central bank is the apex monetary authority of a country that issues currency, controls credit and money supply, and supervises banks in the public interest.

Functions of RBI:

1. Issue of currency – sole right to issue notes (except ₹1 notes and coins, issued by the Government).
2. Banker to the Government – manages accounts and public debt of Centre and States.
3. Banker's bank – keeps cash reserves (CRR) of banks; lender of last resort.
4. Monetary policy – uses repo rate, reverse repo, CRR, SLR, open market operations to control inflation (the Monetary Policy Committee fixes the repo rate; check the latest RBI figure).
5. Regulator and supervisor of banks and NBFCs under the Banking Regulation Act, 1949 and RBI Act.
6. Manager of foreign exchange under FEMA, 1999.
7. Payment systems – oversees NEFT, RTGS, UPI (through NPCI).
8. Developmental role – financial inclusion, priority sector lending, financial literacy.

Commercial Banks – Public and Private Sectors

Commercial bank: A bank that accepts deposits from the public, repayable on demand or otherwise, and lends money for profit (Banking Regulation Act, 1949).

Functions: accepting deposits (savings, current, fixed), giving loans and advances (cash credit, overdraft, term loans), discounting bills, agency services (collecting cheques, paying bills), and general utility services (lockers, remittances, digital banking).

Structure of Indian banking:

• Scheduled banks (in the Second Schedule of RBI Act) – public sector banks, private sector banks, foreign banks, regional rural banks, small finance banks, payments banks, scheduled co-operative banks.
• Non-scheduled banks – a few small local and co-operative banks.

History: SBI formed in 1955; 14 major banks nationalised in 1969 and 6 more in 1980; private banks allowed again after 1993; mergers in 2019–2020 reduced public sector banks to 12.

Structure and Comparative Performance

Bank Capital – Adequacy Norms and Capital Market Support

Bank capital is the owners' money plus reserves that protects depositors if the bank suffers losses.

Capital adequacy ratio (CAR/CRAR) = Capital ÷ Risk-weighted assets × 100. It shows whether a bank has enough capital for the risk it takes.

Basel norms: International standards by the Basel Committee on Banking Supervision. Basel I (1988), Basel II (2004), Basel III (after the 2008 crisis). RBI follows Basel III with stricter limits:

Tier 1 = equity capital, reserves (core capital). Tier 2 = revaluation reserves (partly), subordinated debt, general provisions (supplementary capital).

Capital market support: Banks raise capital from the capital market through public issues, FPOs, Qualified Institutional Placements (QIPs), rights issues, and bonds such as AT1 and Tier 2 bonds. Public sector banks also received capital from the Government (recapitalisation) and later raised funds from the market. A well-functioning capital market therefore helps banks meet Basel III norms.

Non-Banking Financial Institutions – Control by RBI and SEBI – Future Role

NBFC: A company registered under the Companies Act that lends, invests in securities, leases or hires assets, but cannot accept demand deposits or issue cheques. Examples: Bajaj Finance, Shriram Finance, Muthoot Finance.

Control by RBI: registration (Certificate of Registration) under Section 45-IA of the RBI Act; minimum net owned funds; prudential norms on capital, NPAs and provisioning; deposit-taking rules; Scale Based Regulation (2021) with Base, Middle, Upper and Top layers.

Control by SEBI: NBFCs that raise money from the market (NCDs, IPOs) or act as market intermediaries – merchant bankers, brokers, mutual funds, venture capital funds – follow SEBI rules on disclosure and investor protection.

Future role: last-mile credit to MSMEs and rural areas, vehicle and gold loans, digital lending and fintech partnerships, co-lending with banks, and micro-finance – with tighter regulation to avoid crises like IL&FS (2018).

Commercial Paper – Features and Advantages

Commercial paper (CP) is an unsecured short-term money market instrument issued as a promissory note by highly rated companies, NBFCs and financial institutions. It was introduced in India in 1990.

Features: (1) unsecured; (2) issued at a discount and redeemed at face value; (3) maturity from 7 days to 1 year; (4) minimum denomination ₹5 lakh and multiples; (5) credit rating is compulsory; (6) issued in demat form; (7) regulated by RBI.

Advantages: cheaper than bank loans for good companies; quick and flexible; no security needed; gives investors (mutual funds, banks) a safe short-term investment; deepens the money market.

Likely exam questions

1. (Long, 8/16 marks) Explain the functions of the Reserve Bank of India as the central bank of the country.
2. (Long, 8/16 marks) Compare the structure and performance of public sector and private sector banks in India. Explain the capital adequacy norms for banks.
3. (Short, 4 marks) What is commercial paper? State its features.
4. (Short, 4 marks) Explain the control of RBI and SEBI over NBFCs.
5. (Short, 4 marks) What is capital adequacy ratio?

Syllabus topics (RTMNU)

• A brief historical perspective
• An update on the performance of ICIC, IDIBI, IFCI and SFCs
• The insurance industry and its regulation
• Efficiency and the structure of the insurance industry
• Pension funds
• Pension plans today

The Financial Institutions: A Brief Historical Perspective

Development Financial Institutions (DFIs) are specialised institutions that give medium- and long-term finance for industry, agriculture, housing and infrastructure, which ordinary banks were not able to give in the early years after Independence.

• Phase 1 (1948–1964): IFCI (1948), SFCs under SFC Act 1951, ICICI (1955) and IDBI (1964) were set up to fund industrialisation under the Five-Year Plans.
• Phase 2 (1964–1990): Specialised DFIs: EXIM Bank (1982), NABARD (1982), SIDBI (1990). DFIs got cheap funds from RBI and the Government.
• Phase 3 (after 1991): Liberalisation stopped cheap funds; DFIs had to borrow at market rates. The Narasimham Committee and the Khan Working Group (1998) suggested that DFIs should become banks or NBFCs. So ICICI and IDBI became banks.
• Recent: To fund infrastructure again, the Government set up NaBFID (National Bank for Financing Infrastructure and Development) under an Act of 2021.

An Update on the Performance of ICICI, IDBI, IFCI and SFCs

Reasons for weak performance of old DFIs: loss of cheap funds after 1991, high NPAs from large industrial loans, competition from banks and the bond market, and asset–liability mismatch (short-term borrowing for long-term loans).

The Insurance Industry and Its Regulation

Insurance is a contract in which the insurer promises to pay for a loss in return for a premium. It spreads the risk of a few over many.

History:

• 1956 – life insurance nationalised; LIC formed.
• 1972 – general insurance nationalised by the General Insurance Business (Nationalisation) Act; GIC and four subsidiaries.
• 1993 – Malhotra Committee set up to suggest reforms; it recommended opening the sector to private firms.
• 1999 – Insurance Regulatory and Development Authority (IRDA) Act passed; private and foreign joint ventures allowed (FDI limit 26%).
• FDI limit later raised to 49% (2015) and 74% (2021); check the latest limit.

Regulation by IRDAI: registration of insurers, solvency margin (insurers must keep a solvency ratio of at least 150%), approval of products, protection of policyholders' interests, regulation of agents, brokers and web aggregators, investment norms, grievance redressal (Bima Bharosa portal) and the Insurance Ombudsman.

Efficiency and the Structure of the Insurance Industry

Efficiency measures:

1. Claim settlement ratio – percentage of claims settled.
2. Expense ratio – management expenses compared with premium.
3. Combined ratio (general insurance) – claims plus expenses ÷ premium; below 100% means underwriting profit.
4. Solvency ratio – ability to meet all claims.
5. Persistency ratio (life) – policies continued without lapse.
6. Insurance penetration and density – premium as % of GDP and premium per person; India's penetration is still low compared to developed countries.

Effects of privatisation: more products, better service, wider use of bancassurance and online sales, faster claims – but also mis-selling problems, which IRDAI tries to control.

Pension Funds – Pension Plans Today

Pension fund: A fund that collects regular contributions during a person's working life, invests them, and pays a regular income (pension) after retirement.

Regulator: Pension Fund Regulatory and Development Authority (PFRDA), statutory under the PFRDA Act, 2013. EPFO is under the Ministry of Labour.

Main pension plans in India today:

1. National Pension System (NPS) – started for new Central Government employees from 1 January 2004; opened to all citizens in 2009. Defined contribution; money managed by pension fund managers; part can be withdrawn at 60 and the rest buys an annuity.
2. Unified Pension Scheme (UPS) – an option for Central Government employees under NPS, effective from 1 April 2025, giving an assured pension.
3. Atal Pension Yojana (APY) – started in 2015 for unorganised sector workers; fixed pension of ₹1,000 to ₹5,000 a month from age 60.
4. Employees' Provident Fund (EPF) and Employees' Pension Scheme (EPS, 1995) – for organised sector employees under EPFO.
5. Pension plans of insurers – annuity and pension policies of LIC and private insurers.
6. PM Shram Yogi Maan-dhan (2019) – for unorganised workers.

Importance: old-age income security, long-term funds for infrastructure and capital markets, and lower burden on government.

Likely exam questions

1. (Long, 8/16 marks) Give a brief historical perspective of development financial institutions in India and explain the present position of IFCI, ICICI, IDBI and SFCs.
2. (Long, 8/16 marks) Describe the structure of the insurance industry in India and explain its regulation by IRDAI.
3. (Short, 4 marks) What is a pension fund? Name any three pension plans in India.
4. (Short, 4 marks) Write a short note on the National Pension System.
5. (Short, 4 marks) State any four measures of efficiency of an insurance company.

Syllabus topics (RTMNU)

• Range of services: Characters
• Financial services
• UTI and mutual funds organisations
• Hire purchase finance
• Lease finance
• Housing finance organisations
• Venture capital financing
• Evaluation of factoring and forfeiting
• Functions and advantages
• Credit rating agency

Financial Services: Range of Services and Characteristics

Financial services are activities of financial firms that help people and businesses raise, use, protect and manage money – they are services, not physical goods.

Characteristics:

1. Intangible – cannot be seen or touched; trust and image matter.
2. Customer-oriented – designed for each customer's need.
3. Inseparable – produced and delivered at the same time.
4. Perishable – cannot be stored.
5. Dynamic – change with markets, laws and technology (fintech, UPI).
6. Regulated by RBI, SEBI, IRDAI, PFRDA.

Range of services:

• Fund-based (asset-based): leasing, hire purchase, housing finance, venture capital, factoring, forfaiting, bill discounting, consumer credit.
• Fee-based (advisory): merchant banking, credit rating, portfolio management, mutual funds, stock broking, depository services, underwriting.

UTI and Mutual Fund Organisations

Mutual fund: A trust that pools money from many investors and invests it in shares, bonds and money market instruments as per a stated objective; profits are shared in proportion to units held.

UTI: The Unit Trust of India was set up in 1964 under the UTI Act, 1963 – India's first mutual fund. Its famous scheme was US-64. After problems in 2001, UTI was split in 2003 into SUUTI (holding old assured-return schemes) and UTI Mutual Fund (now regulated by SEBI like other funds).

Organisation of a mutual fund (SEBI (Mutual Funds) Regulations, 1996):

1. Sponsor – the promoter who sets up the fund.
2. Trust / Trustees – hold the assets for investors and supervise the AMC.
3. Asset Management Company (AMC) – manages the money and schemes.
4. Custodian – keeps the securities safely.
5. Registrar and Transfer Agent (RTA) – keeps investor records.

AMFI (Association of Mutual Funds in India) is the industry body. Types: open-ended and close-ended; equity, debt, hybrid, index funds, ETFs; investing through SIP is popular.

Hire Purchase Finance and Lease Finance

Hire purchase: An agreement in which goods are given on hire and the hirer pays in instalments; ownership passes to the hirer when the last instalment is paid. In practice it is governed mainly by the hire purchase agreement and the Indian Contract Act, 1872.

Lease: A contract in which the owner (lessor) gives the right to use an asset to the user (lessee) for a period in return for periodic rent.

Types of lease: financial lease (long-term, non-cancellable, covers most of the asset life), operating lease (short-term, cancellable), sale and lease-back, leveraged lease.

Housing Finance Organisations

Housing finance is long-term loans for buying, building or repairing houses. Providers: commercial banks (largest share), housing finance companies (HFCs) such as LIC Housing Finance and PNB Housing Finance, co-operative housing societies. HDFC Ltd (1977), India's first specialised HFC, merged into HDFC Bank in 2023.

National Housing Bank (NHB) was set up in 1988 as the apex housing finance institution. Since 2019, RBI regulates HFCs and NHB supervises them and refinances housing loans.

Government support: PMAY (Pradhan Mantri Awas Yojana), tax benefits on home loan interest and principal.

Venture Capital Financing

Venture capital is equity or equity-linked finance given to new, high-risk, high-growth businesses (start-ups), usually along with management advice.

Features: high risk–high return, long-term (5–10 years), equity participation, active involvement of the investor, exit through IPO or sale to another investor.

Stages: seed → start-up → early growth → expansion → bridge/pre-IPO.

In India venture capital funds are regulated by SEBI as Alternative Investment Funds (AIF Regulations, 2012). Examples: SIDBI Venture Capital, and the Government's Fund of Funds for Startups managed by SIDBI.

Evaluation of Factoring and Forfaiting – Functions and Advantages

Factoring: A firm sells its book debts (receivables) to a factor, who pays an advance immediately and collects the money from customers later. Regulated by the Factoring Regulation Act, 2011. RBI's TReDS platforms help MSMEs discount their invoices.

Functions of a factor: immediate finance, sales ledger management, collection of debts, credit protection (in non-recourse factoring), advisory on customers' credit.

Forfaiting: An exporter sells its export receivables (bills) to a forfaiter at a discount, without recourse, and gets 100% cash at once. EXIM Bank promoted forfaiting in India.

Advantages: better cash flow, lower collection cost, protection from bad debts (non-recourse), exporter freed from foreign exchange and political risk (forfaiting), and focus on core business. Limitations: cost (discount/commission), may hurt customer relations, limited availability for small firms.

Credit Rating Agency

Credit rating is an opinion by an independent agency about the ability and willingness of a borrower to repay a debt instrument on time, shown by symbols like AAA, AA, BBB.

In India: CRISIL (1987), ICRA (1991), CARE (1993), and others such as India Ratings, Acuité, Brickwork and Infomerics. They are regulated by SEBI (Credit Rating Agencies) Regulations, 1999.

Functions and advantages: helps investors judge risk; lets good companies borrow at lower cost; compulsory for instruments like commercial paper and public debt issues; improves market discipline and transparency.

Limitations: rating is an opinion, not a guarantee; conflict of interest (issuer pays fee); ratings can change suddenly, as in the IL&FS case (2018).

Likely exam questions

1. (Long, 8/16 marks) What are financial services? Explain their characteristics and the range of fund-based and fee-based financial services in India.
2. (Long, 8/16 marks) Explain factoring and forfaiting. Distinguish between them and state their functions and advantages.
3. (Short, 4 marks) Distinguish between hire purchase and leasing.
4. (Short, 4 marks) What is venture capital? State its features.
5. (Short, 4 marks) What is credit rating? Name any three credit rating agencies in India.