Month: May 2020

Marine Insurance:

The marine insurance is the oldest form of insurance. Under Bottom bond, the system of credit and the law of interest were well-developed and were based on a clear appreciation of the hazard involved and the means of safeguarding against it.

If the ship was lost, the loan and interest were forfeited. The contract of insurance was made a part of the contract of carriage, and Manu shows that Indians had even anticipated the doctrine of average and contribution.

Freight was fixed according to season and was expected to be reasonable in the case of marine transport which was then very much at the mercy of winds and elements. Travelers by sea and land were very much exposed to the risk of losing their vessels and merchandise because the piracy on the open seas and highway robbery of caravans were very common.

Besides there were several risks, Many times, it might have been captured by the king’s enemies or robbed by pirates or got sunk in the deep waters.

The risk to owners of such ships were enormous and, therefore, to safeguard them the marine traders devised a method of spreading over them the financial loss which could not be conveniently borne by the unfortunate individual victims.

The co-operative device was quite voluntary in the beginning, but now in modern it has been converted into modified shape of premium.

The marine policies of the present forms were sold in the beginning of fourteenth century by the Brogans. On the demand of the inhabitants of Burges, the Court of Flanders permitted in the year 1310, the establishment in this Town of a charter of Assurance, by means of which the merchants could insure their goods, exposed to the risks of the sea.

The insurance development was not confined to the Lombard’s and to the Hansa merchants; it spread throughout Spain, Portugal, France, Holland and England. The marine form land lending prominence of Lombard’s merchants got a prominent section of the London City.

They built homes there and took the name of Lombard Street. Later on, this street became famous in insurance history. The Lloyd’s coffee-house gave an impetus to develop the marine insurance.

Fire Insurance:

After marine insurance, fire insurance developed in present form. It had been observed in Anglo- Section Guild form for the first time where the victims of fire hazards were given personal assistance by providing necessaries of life.

It had been originated in Germany in the beginning of sixteenth century. The fire insurance got momentum in England after the great fire in 1666 when the fire losses were tremendous.

About 85 per cent of the houses were burnt to ashes and property worth of sterling ten crores were completely burnt off. Fire Insurance Office was established in 1681 in England. With colonial development of England, the fire insurance spread all over the world in present form ‘Sun Fire Office was successful fire insurance institution.

In India, the general insurer started working since 1850 with the establishment of the Triton Insurance, Calcutta. Again in 1861, the North British and Mercantile catered the requirements of insurance business.

The general insurance in India could not progress much. The slow growth of joint-stock enterprise and mechanised production was another reason for the low level of general insurance business.

Difference between fire and Marine insurance

Fire and marine insurance contracts are similar in most of the cases because both these contracts are indemnity contracts. But, the following differences are observed in both the contracts.

(i) Moral Hazard:

In marine insurances, the chances of moral hazard do not exist so much as are in the fire insurance.

(ii) Insurable Interest:

The insurable interest must exist both the time, at the inception and at the completion of the contract. This is the reason fire insurance policies cannot be freely assignable. The insurable interest in marine insurance must exist at the time of loss. So, the marine policies are freely assignable.

(iii) Profit:

Marine policies generally allow certain margin of profit to be charged at the time of indemnification of loss, but the fire policies do not allow it ordinarily.

(iv) Valued Policies:

Marine insurance policies are generally valued policies and the market fluctuation is avoided; but the fire polices strictly adhere to the doctrine of indemnity and only the market value of the property at the time of loss (valuable amount) is compensated.

Bancassurance

Bancassurance is a relationship between a bank and an insurance company that is aimed at offering insurance products or insurance benefits to the bank’s customers. In this partnership, bank staff and tellers become the point of sale and point of contact for the customer. Bank staff are advised and supported by the insurance company through wholesale product information, marketing campaigns and sales training. The bank and the insurance company share the commission. Insurance policies are processed and administered by the insurance company.

This partnership arrangement can be profitable for both companies. Banks can earn additional revenue by selling the insurance products, while insurance companies are able to expand their customer base without having to expand their sales forces or pay commissions to insurance agents or brokers. Bancassurance has proved to be an effective distribution channel in a number of countries in Europe, Latin America, Asia, and Australia.

Business Models

‘Integrated models‘ is insurance activity deeply integrated with bank’s processes. Premium is usually collected by the bank, usually direct debit from customer’s account held in that bank. New business data entry is done in the bank branches and workflows between the bank and the insurance companies are automated. In most cases, asset management is done by the bank’s asset management subsidiary.

Insurance products are distributed by branch staff, which is sometimes supported by specialised insurance advisers for more sophisticated products or for certain types of clients. Life insurance products are fully integrated in the bank’s range of savings and investment products and the trend is for branch staff to sell a growing number of insurance products that are becoming farther removed from its core business, e.g., protection, health, or non-life products.

Products are mainly medium- and long-term tax-advantaged investment products. They are designed specifically for bancassurance channels to meet the needs of branch advisers in terms of simplicity and similarity with banking products. In particular, these products often have a low-risk insurance component.

Bank branches receive commissions for the sale of life insurance products. Part of the commissions can be paid to branch staff as commissions or bonuses based on the achievement of sales targets.

‘Non-integrated Models‘: The sale of life insurance products by branch staff has been limited by regulatory constraints since most investment-based products can only be sold by authorised financial advisers who have obtained a minimum qualification.

Banks have therefore set up networks of financial advisers authorised to sell regulated insurance products. They usually operate as tied agents and sell exclusively the products manufactured by the bank’s in-house insurance company or its third-party provider(s).

A proactive approach is used to generate leads for the financial advisers from the customer base, including through mailings and telesales. There is increasing focus on developing relationships with the large number of customers who rarely or never visit a bank branch.

Financial planners are typically employed by the bank or building society rather than the life company and usually receive a basic salary plus a bonus element based on a combination of factors including sales volumes, persistency, and product mix.

Following the reform of the polarisation regime, banks will have the possibility to become multi-tied distributors offering a range of products from different providers. This has the potential to strengthen the position of bancassurers by allowing them to meet their customers’ needs.

Banks, like other business firms, are profit-making institutions, though public-sector banks are also guided by broader social directives from the RBI. To earn a profit, a bank must place its funds in earning assets, mainly loans and advances and investments. While lending or investing, a bank must look at the net rate of return obtained and the associated risks of holding such earning assets. Furthermore, since a large part of its liabilities are payable in cash on demand, a bank must also consider the liquidity of its earning assets, that is, how easily it can convert its earning assets into cash at short notice and without loss.

Thus, the twin considerations of profitability and liquidity guide a bank in the selection of its asset portfolio. A bank tries to achieve the twin objectives by choosing a diversified and balanced asset portfolio in the light of institutional facilities available to it for converting its earning assets into cash at short notice and without loss and for short-term borrowing. In addition, it has also to observe various statutory requirements regarding cash reserves, liquid assets, and loans and advances. We describe below various classes of assets banks hold. They will also describe the uses of bank funds.

They are discussed in the decreasing order of liquidity and increasing order of profitability:

1. Cash

Cash, defined broadly, includes cash in hand and balances with other banks including the RBI. Banks hold balances with the RBI as they are required statutorily to do so under the cash reserve requirement. Such balances are called statutory or required reserves. Besides, banks hold voluntarily extra cash to meet the day-to-day drawals of it by their depositors.

Cash as defined above is not the same thing as cash reserves of banks. The latter includes only cash in hand with banks and their balances with the RBI only. The balances with other banks in whatever account are not counted as cash reserves.

The latter concept (of cash reserves) is useful for money-supply analysis and monetary policy, where we need to separate the monetary liabilities of the authorities from the monetary liabilities of banks. Inter-bank balances are not a part of the monetary liabilities of the monetary authority, whereas cash reserves are. These balances are only the liabilities of banks to each other. So, they are not included in cash reserves.

2. Money at Call at Short Notice

It is money lent to other banks, stock brokers, and other financial institutions for a very short period varying from 1 to 14 days. Banks place their surplus cash in such loans to earn some interest without straining much their liquidity. If cash position continues to be comfortable, call loans may be renewed day after day.

3. Investments

They are investments in securities usually clas­sified under three heads of (a) government securities, (b) other approved securities and (c) other securities. Government securities are securities of both the central and state government including treasury bills, treasury deposit certificates, and postal obligations such as national plan certificates, national savings certificates, etc. Other approved securities are securities approved under the provisions of the Banking Regulation Act, 1949. They include securities of state- associated bodies such as electricity boards, housing boards, etc., debentures of LDBs, units of the UTI, shares of RRBs, etc.

A large part of the investment in government and other approved securities is required statutorily under the SLR requirement of the RBI. Any excess investment in these securities is held because banks can borrow from the RBI or others against these securities as collateral or sell them in the market to meet their need for sh. Thus, they are held by banks because they are more liquid than and advance even though the return from them is lower than from loans and advances.

4. Loans, Advances and Bills Discounted-or Purchased

They are the principal component of bank assets and the main source of income of banks. Collectively, they represent total ‘bank credit’ (to the commercial sector). Nothing more need be added here, bank advances in India are usually made in the form of cash credit and overdrafts. Loans may be demand loans or term loans. They may be repayable in single or many installments. We explain briefly these various forms of extending hank credit.

(a) Cash Credit

In India cash credit is the main form of bank cre­dit. Under cash credit arrangements an acceptable borrower is first sanctioned a credit limit up to which he may borrow from the bank. But the actual utilization of the credit limit is governed by the borrower’s ‘withdrawing power’. The sanction of the credit limit is based on the overall creditworthiness of the borrower as assessed by the bank.

The ‘withdrawing power’, on the other hand, is determined by the value of the borrower’s current assets, adjusted for margin requirements as applicable to these assets. The current assets comprise mainly stocks of goods (raw materials, semi-manufactured and finished goods) and receivables or bills due from others. A borrower is required to submit a ‘stock statement’ of these assets every month to the bank.

This state­ment is supposed to act partly as evidence of the on-going production/ trade activity of the borrower and partly to act as a legal document with the bank, which may be used in case of default of bank advances.

To cover further against the risk of default, banks impose ‘margin require­ments’ on borrowers, that is, they require borrowers to finance a part of their current assets (offered as primary security to banks) from their owned funds of other sources. (In addition, banks ask for second surety for whatever credit is granted.)

The advances made by banks cover only the rest (on average, the maximum of about 75 per cent) of the value of the primary security. The margin requirements vary from good to good, time to time, and with the credit standing of the borrower. The RBI uses variations in these requirements as an instrument of credit control.

In Case of acute shortage of particular commodities bank financing against the inventories of such commodities can be cur­tailed by raising the margin requirements for such commodities. Keep­ing in view the importance of the cash credit system in banking India.

(b) Overdrafts

An overdraft, as the name suggests, is an advance given by allowing a customer to overdraw his current account up to agreed limit. The overdraft facility is allowed on only current accounts. The security for an overdraft account may be person shares, debentures, government securities, life insurance policies, or fixed deposits.

An overdraft account is operated in the same way as a current account. The overdraft credit is different from cash credit in two respects of security and duration. Usually, for cash credit, the security offered is current assets of business, such as inventories of raw materials, goods in process or finished goods, and receivables.

In the case of overdraft, the security is generally in the form of financial assets held by the borrower. Then, generally, the overdraft is a temporary facility, whereas the cash credit account is a longer-run facility. Also, the rate of interest on overdraft credit is somewhat lower than on cash credit because of the difference in risk and servicing cost involved. In all other respects, overdraft credit is like cash credit. In the case of overdrafts, too, interest is charged only on credit actually utilised, not on the overdraft limit granted.

(c) Demand Loans

A demand loan is one that can be recalled on demand. It has no stated maturity. Such loans are mostly taken by security brokers and others whose credit needs fluctuate from day today. The salient feature of a loan is that the entire amount of the loan sanctioned is paid to the borrower in one lump sum by crediting the whole amount to a separate loan account.

Thus, the whole amount becomes immediately chargeable to interest, whatever the amount the borrower actually withdraws from the (loan) account. This makes loan credit costlier to the borrower than (say) cash credit.

Therefore, businessmen in need of supplementing their working capital prefer to borrow on cash credit basis. On the other hand, banks prefer demand loans, because they are repayable on demand, involve lower adminis­trative costs, and earn interest on the full amount sanctioned and paid. The security against demand loans may also be personal, financial assets, or goods.

(d) Term Loans

A term loan is a loan with a fixed maturity period of more than one year. Generally this period is not longer than ten years. Term loans provide medium-or long-term funds to the borrowers. Most such loans are secured loans. Like demand loans, the whole amount of a term loan sanctioned is paid in one lump sum by crediting it to a separate loan account of the borrower. Thus, the entire amount becomes chargeable to interest.

The repayment is made scheduled, either in one installment at the maturity of the loan or in few installments after a certain agreed period. For making big term loans (of say, Rs. one crore or more) to big borrowers, banks have parted using the consortium method of financing in a few cases.

Under this method, a few banks get together to make the loan on participation basis. This obviates the dependence on multiple banking under which a borrower borrows from more than one bank to meet his credit needs. Consortium banking can make for better credit planning. Term loans as a form of bank credit are gaining rapidly in importance.

Various financial assets of a commercial bank

• Liquidity and Profitability

In order to be able to meet demands for cash as and when they are made a bank must not only arrange to have sufficient cash available but it must also distribute its assets in such a way that some of them can be readily converted into cash.

Thus, the bank’s cash reserves can be reinforced quickly in the event of heavy drawings on them. Assets which are readily convertible into cash are called liquid assets, the most liquid being cash itself. The shorter the length of a loan the more liquid because it will soon mature and be repayable in cash; the less profitable because, other things being equal the rate of interest varies directly with the loss of liquidity experienced by the lender.

Thus a bank faces something of a dilemma in trying to secure both liquidity and profitability. It satisfies these apparently incompatible re­quirements in the way it distributes its assets. These assets have been arranged in the following table with the most liquid but least profitable ones at the top and the least liquid but most profitable towards the bottom.

The rupee assets of the banks include the notes and coin held in their vaults and the bankers’ balances at the Central Bank are part of the banks’ reserves. The bankers’ balances at the Central Bank are a bit like your own deposit at a bank.

Just as you sign cheques to pay your debts or expenditures, banks will meet their balances at the Central Bank. The banks also hold some liquid assets and these are loans to financial intermediaries, government bills and other securities.

These liquid assets earn a rate of interest, but banks make the most of their money by giving loans and overdrafts to people and business. These items come under the heading of advances. The banks also make money by lending in other currencies to businesses, other banks and governments.

• Cash-in-Hand

It represents a bank’s holding of notes and coins to meet the immediate requirements of its customers. Nowadays, there is no limit set on the amount of cash which banks in India must hold and it is taken for granted that they will hold enough to maintain their depositors’ confidence. The general rule seems to be to hold something in the region of 4% of total assets in the form of cash.

• Cash at the Central Bank

It represents the commercial banks’ accounts with the central bank. When banks in India require notes or corns they obtain them from the Central Bank by drawing on their accounts there in the same way as their customers obtain it from them. The banks also use their central bank accounts for setting debts among themselves. This process is known as the clearing system.

• Money at Call and Short Notice

This consists mainly of day-to-day loans to the money market but also includes some seven-day and fourteen- day loans to the same body and to the stock exchange. This asset is by nature very liquid and enables a bank to recall loans quickly in order to reinforce its cash.

Being so very short these loans carry a very low rate of interest; consequently they are not very profitable. The money market consists of discount houses. Then, main function is to discount bills of exchange.

These bills may be commercial bills, or Treasury Bills. A bill is a promise to pay a fixed amount usually in three months’ time. Thus a firm, or the Treasury, can borrow money by issuing a promise to pay in three months. A discount house may buy such a bill at a discount, i.e., it may buy a Rs.100 bill for Rs 90.00. In this case the rate of discount is 10% (per annum).

This discount house may later sell the bill to a bank, i.e., rediscount it, but when it matures the bill will be presented for payment at its face value. The discount houses finance their operations by borrowing ‘on call or at short notice’ from the commercial banks and they make their profits out of the fractional differences between the rates of interest they have to pay the banks and the slightly higher rates they can charge for discounting bills.

• Bills Discounted

Another link between the banks and the money market lies in the way in which the banks acquire their own portfolios of bills. By agreement the banks do not tender directly for these bills but instead buy them from the discount houses when they have two months or less to run. They also buy them in such a way that a regular number mature each week, thus providing an opportunity for reinforcing their cash bases.

Thus, the money market provides two notable services to the banks. It enables them to earn some return on funds which would otherwise have to be held as cash and it also strengthens their liquidity as regards their bill portfolios.

• Government Securities with One Year or Less to Maturity

These securities consist of central government stocks and nationalised industries’ stocks guaranteed by the government. Since they are so close to the date when they are due for redemption, i.e., repayment at their face value, they can be sold for amounts very near to that value. Thus banks can sell them to obtain cash without suffering any loss. They are very liquid assets.

• Certificates of Deposit

These are receipts for specified sums deposited with an institution in the banking sector for a stated period of up to five years. They earn a fixed rate of interest and can be bought and sold freely.

• Investments

These consist mainly of government stock which is always marketable at the stock exchange, even though a loss may be involved by a sale at an inopportune moment. The classification of invest­ments as more liquid than advances can be justified by the greater ease with which investments can be converted into cash, for the latter, although they can technically be recalled at a moment’s notice, can in fact only be con­verted into cash if the borrower is in a position to repay, and, of course, at the risk of the bank losing its customer if any inconvenience is caused.

• Loans and Advances

These are the principal profit earning assets of the commercial banks. They composed mainly of customers’ overdrafts whereby in return for interest being paid on the amount actually drawn, banks agree to customers over-drawing their accounts, i.e., running into debt, up to stated amounts. These facilities are usually limited to relatively short periods of time, e.g., 6 to 12 months, but they are renewable by agreement.

• Special Deposits

These may be called for the central bank when it wishes to restrict the banks’ ability to extend credit to their customers. Conversely, a release of existing special deposits will encourage bank lending. As any release of these deposits depends entirely on the central bank they are illiquid and, as they carry only a low rate of interest, they are not profitable assets.

Along with profitability and safety, banks also give importance to Solvency. Solvency refers to the situation where assets are equal to or more than liabilities. A bank should select its assets in such a way that the shareholders and depositors’ interest are protected.

1. Prudential Norms

The norms which are to be followed while investing funds are called “Prudential Norms.” They are formulated to protect the interests of the shareholders and depositors. Prudential Norms are generally prescribed and implemented by the central bank of the country. Commercial Banks have to follow these norms to protect the interests of the customers.

For international banks, prudential norms were prescribed by the Bank for International Settlements popularly known as BIS. The BIS appointed a Basle Committee on Banking Supervision in 1988.

2. Basel Committee

Basel committee appointed by BIS formulated rules and regulation for effective supervision of the central banks. For this it, also prescribed international norms to be followed by the central banks. This committee prescribed Capital Adequacy Norms in order to protect the interests of the customers.

3. Definition of Capital Adequacy Ratio

Capital Adequacy Ratio (CAR) is defined as the ratio of bank’s capital to its risk assets. Capital Adequacy Ratio (CAR) is also known as Capital to Risk (Weighted) Assets Ratio (CRAR).

The Government of India (GOI) appointed the Narasimham Committee in 1991 to suggest reforms in the financial sector. In the year 1992-93 the Narasimhan Committee submitted its first report and recommended that all the banks are required to have a minimum capital of 8% to the risk weighted assets of the banks. The ratio is known as Capital to Risk Assets Ratio (CRAR). All the 27 Public Sector Banks in India (except UCO and Indian Bank) had achieved the Capital Adequacy Norm of 8% by March 1997.

The Second Report of Narasimham Committee was submitted in the year 1998-99. It recommended that the CRAR to be raised to 10% in a phased manner. It recommended an intermediate minimum target of 9% to be achieved by the year 2000 and 10% by 2002.

Concepts of Capital Adequacy Norms

Concepts of Capital Adequacy Norms
Tier-I Capital	Tier-II Capital	Risk Weighted Assets	Subordinated Debt

Capital Adequacy Norms included different Concepts, explained as follows:

1. Tier-I Capital

Capital which is first readily available to protect the unexpected losses is called as Tier-I Capital. It is also termed as Core Capital.

Tier-I Capital consists of:

• Paid-Up Capital.
• Statutory Reserves.
• Other Disclosed Free Reserves: Reserves which are not kept side for meeting any specific liability.
• Capital Reserves: Surplus generated from sale of Capital Assets.

2. Tier-II Capital

Capital which is second readily available to protect the unexpected losses is called as Tier-II Capital.

Tier-II Capital consists of:

• Undisclosed Reserves and Paid-Up Capital Perpetual Preference Shares.
• Revaluation Reserves (at discount of 55%).
• Hybrid (Debt / Equity) Capital.
• Subordinated Debt.
• General Provisions and Loss Reserves.

There is an important condition that Tier II Capital cannot exceed 50% of Tier-I Capital for arriving at the prescribed Capital Adequacy Ratio.

3. Risk Weighted Assets

Capital Adequacy Ratio is calculated based on the assets of the bank. The values of bank’s assets are not taken according to the book value but according to the risk factor involved. The value of each asset is assigned with a risk factor in percentage terms.

Suppose CRAR at 10% on Rs. 150 crores is to be maintained. This means the bank is expected to have a minimum capital of Rs. 15 crores which consists of Tier I and Tier II Capital items subject to a condition that Tier II value does not exceed 50% of Tier I Capital. Suppose the total value of items under Tier I Capital is Rs. 5 crores and total value of items under Tier II capital is Rs. 10 crores, the bank will not have requisite CRAR of Rs. 15 Crores. This is because a maximum of only Rs. 2.5 Crores under Tier II will be eligible for computation.

4. Subordinated Debt

These are bonds issued by banks for raising Tier II Capital.

They are as follows:

• They should be fully paid up instruments.
• They should be unsecured debt.
• They should be subordinated to the claims of other creditors. This means that the bank’s holder’s claims for their money will be paid at last in order of preference as compared with the claims of other creditors of the bank.
• The bonds should not be redeemable at the option of the holders. This means the repayment of bond value will be decided only by the issuing bank.

A bank makes investments for the purpose of earning profits. First it keeps primary and secondary reserves to meet its liquidity requirements.

This is essential to satisfy the credit needs of the society by granting short-term loans to its customers. Whatever is left with the bank after making advances is invested for long period to improve its earning capacity.

Before discussing the investment policy of a commercial bank, it is instructive to distinguish between a loan and an investment because the usual practice is to regard the two as synonymous. The bank gives a loan to a customer for a short period on condition of repayment.

It is the customer who asks for the loan. By advancing a loan, the bank creates credit which is a temporary source of fund for the bank. An investment by the bank, on the other hand, is the outlay of its funds for a long period without creating any credit. A bank makes investments in government securities and in the stocks of large reputed industrial concerns, while in the case of a loan the bank advances money against recognised securities and bills. However, the goal of both is to increase its earnings.

The investment policy of a bank consists of earning high returns on its unloaned resources. But it has to keep in view the safety and liquidity of its resources so as to meet the potential demand of its customers.

Since the objective of profitability conflicts with those of safety and liquidity, the wise investment policy is to strike a judicious balance among them. Therefore, a bank should lay down its investment policy in such a manner so as to ensure the safety and liquidity of its funds and at the same time maximise its profits. This requires adherence to certain principles.

Principles of Commercial Banking

Principles of Liquidity

A commercial bank offers two types of deposits

• Demand depositswhich the bank has to repay on demand like a Savings Account and
• Time deposits which the bankhas to repay after the expiry of a certain period

Further, on a daily basis, customers withdraw as well as deposit cash. therefore, all commercial banks have to keep a certain amount of cash in their custody to meet the cash demands of customers.

Principles of Profitability

Any commercial enterprise primarily tries to generate profit. A commercial bank is a commercial enterprise as well. Hence, it tries to generate profits.

Principles of Solvency

Commercial banks must be financially sound. Further, they need to maintain a certain required capital for running the business.

Principles of Safety

A commercial bank accepts deposits from its customers and then invests it. However, since it is investing the investor’s money it keeps the safety of the money first.

Principles of Collection of Savings

This is one of the most important principles in the current banking scenario. Commercial banks seek huge amounts of idle money from their clients. In fact, bank employees are given targets to collect more savings from people.

Principles of Loans and Investment Policy

A commercial bank primarily earns money through its lending and investing activities. It also ensures that the investor’s money is invested in viable projects. Therefore, banks need strong loans and investment policies to earn a good profit.

Principles of Economy

Commercial banks always try to avoid any unnecessary expenditure. Therefore, they try to manage their functions within a set budget and increase their profits.

Principles of providing services

Commercial banks are usually service-focused banks. After all, good service ensures a better reputation and therefore, profits.

Principles of Secrecy

Commercial banks ensure that they keep the accounts of their clients secret. Also, access to the accounts is given only to legitimized persons.

Principles of Modernization

We live in an era of technology as well as modernization. Therefore, to cope with the advancements in the world, commercial banks adopt modern technical services like online banking, mobile banking, etc.

Principles of Specialization

Apart from modernization, we also live in the age of specialization as well as super-specialization. Therefore, commercial banks segment their entire functions into smaller units and place their employees according to their efficiencies.

Principles of Location

Usually, commercial banks choose a location where they think they can find many customers.

Principles of Relation

All commercial banks try to maintain good relations with their existing clients as well as potential customers.

Principles of Publicity

Any successful business needs good publicity. Therefore, most successful businesses advertise to get the attention of more customers. Hence, commercial banks follow the principles of publicity.

Liquidity in banking refers to the ability of a bank to meet its financial obligations as they come due. It can come from direct cash holdings in currency or on account at the Federal Reserve or other central bank. More frequently, it comes from acquiring securities that can be sold quickly with minimal loss. This basically states highly creditworthy securities, comprising of government bills, which have short term maturities.

If their maturity is short enough the bank may simply wait for them to return the principle at maturity. For short term, very safe securities favor to trade in liquid markets, stating that large volumes can be sold without moving prices too much and with low transaction costs.

Nevertheless, a bank’s liquidity condition, particularly in a crisis, will be affected by much more than just this reserve of cash and highly liquid securities. The maturity of its less liquid assets will also matter. As some of them may mature before the cash crunch passes, thereby providing an additional source of funds.

Need for Liquidity

We are concerned about bank liquidity levels as banks are important to the financial system. They are inherently sensitive if they do not have enough safety margins. We have witnessed in the past the extreme form of damage that an economy can undergo when credit dries up in a crisis. Capital is arguably the most essential safety buffer. This is because it supports the resources to reclaim from substantial losses of any nature.

The closest cause of a bank’s demise is mostly a liquidity issue that makes it impossible to survive a classic “bank run” or, nowadays, a modern equivalent, like an inability to approach the debt markets for new funding. It is completely possible for the economic value of a bank’s assets to be more than enough to wrap up all of its demands and yet for that bank to go bust as its assets are illiquid and its liabilities have short-term maturities.

Banks have always been reclining to runs as one of their principle social intentions are to perform maturity transformation, also known as time intermediation. In simple words, they yield demand deposits and other short term funds and lend them back out at longer maturities.

Maturity conversion is useful as households and enterprises often have a strong choice for a substantial degree of liquidity, yet much of the useful activity in the economy needs confirmed funding for multiple years. Banks square this cycle by depending on the fact that households and enterprises seldom take advantage of the liquidity they have acquired.

Deposits are considered sticky. Theoretically, it is possible to withdraw all demand deposits in a single day, yet their average balances show remarkable stability in normal times. Thus, banks can accommodate the funds for longer durations with a fair degree of assurance that the deposits will be readily available or that equivalent deposits can be acquired from others as per requirement, with a raise in deposit rates.

How Can a Bank Achieve Liquidity

Large banking groups engage themselves in substantial capital markets businesses and they have considerable added complexity in their liquidity requirements. This is done to support repo businesses, derivatives transactions, prime brokerage, and other activities.

Banks can achieve liquidity in multiple ways. Each of these methods ordinarily has a cost, comprising of −

• Shorten asset maturities
• Improve the average liquidity of assets
• Lengthen
• Liability maturities
• Issue more equity
• Reduce contingent commitments
• Obtain liquidity protection

Shorten asset maturities

This can assist in two fundamental ways. The first way states that, if the maturity of some assets is shortened to an extent that they mature during the duration of a cash crunch, then there is a direct benefit. The second way states that, shorter maturity assets are basically more liquid.

Improve the average liquidity of assets

Assets that will mature over the time horizon of an actual or possible cash crunch can still be crucial providers of liquidity, if they can be sold in a timely manner without any redundant loss. Banks can raise asset liquidity in many ways.

Typically, securities are more liquid than loans and other assets, even though some large loans are now framed to be comparatively easy to sell on the wholesale markets. Thus, it is an element of degree and not an absolute statement. Mostly shorter maturity assets are more liquid than longer ones. Securities issued in large volume and by large enterprises have greater liquidity, because they do more creditworthy securities.

Lengthen liability maturities

The longer duration of a liability, the less it is expected that it will mature while a bank is still in a cash crunch.

Issue more equity

Common stocks are barely equivalent to an agreement with a perpetual maturity, with the combined benefit that no interest or similar periodic payments have to be made.

Reduce contingent commitments

Cutting back the amount of lines of credit and other contingent commitments to pay out cash in the future. It limits the potential outflow thus reconstructing the balance of sources and uses of cash.

Obtain liquidity protection

A bank can scale another bank or an insurer, or in some cases a central bank, to guarantee the connection of cash in the future, if required. For example, a bank may pay for a line of credit from another bank. In some countries, banks have assets prepositioned with their central bank that can further be passed down as collateral to hire cash in a crisis.

All the above mentioned techniques used to achieve liquidity have a net cost in normal times. Basically, financial markets have an upward sloping yield curve, stating that interest rates are higher for long-term securities than they are for short-term ones.

This is so mostly the case that such a curve is referred as normal yield curve and the exceptional periods are known as inverse yield curves. When the yield curve has a top oriented slope, contracting asset maturities decreases investment income while extending liability maturities raises interest expense. In the same way, more liquid instruments have lower yields, else equal, minimizing investment income.

Liquidity Management Theory

There are probable contradictions between the objectives of liquidity, safety and profitability when linked to a commercial bank. Efforts have been made by economists to resolve these contradictions by laying down some theories from time to time.

In fact, these theories monitor the distribution of assets considering these objectives. These theories are referred to as the theories of liquidity management which will be discussed further in this chapter.

Commercial Loan Theory

The commercial loan or the real bills doctrine theory states that a commercial bank should forward only short-term self-liquidating productive loans to business organizations. Loans meant to finance the production, and evolution of goods through the successive phases of production, storage, transportation, and distribution are considered as self-liquidating loans.

This theory also states that whenever commercial banks make short term self-liquidating productive loans, the central bank should lend to the banks on the security of such short-term loans. This principle assures that the appropriate degree of liquidity for each bank and appropriate money supply for the whole economy.

The central bank was expected to increase or erase bank reserves by rediscounting approved loans. When business started growing and the requirements of trade increased, banks were able to capture additional reserves by rediscounting bills with the central banks. When business went down and the requirements of trade declined, the volume of rediscounting of bills would fall, the supply of bank reserves and the amount of bank credit and money would also contract.

Advantages

These short-term self-liquidating productive loans acquire three advantages. First, they acquire liquidity so they automatically liquidate themselves. Second, as they mature in the short run and are for productive ambitions, there is no risk of their running to bad debts. Third, such loans are high on productivity and earn income for the banks.

Disadvantages

Despite the advantages, the commercial loan theory has certain defects. First, if a bank declines to grant loan until the old loan is repaid, the disheartened borrower will have to minimize production which will ultimately affect business activity. If all the banks pursue the same rule, this may result in reduction in the money supply and cost in the community. As a result, it makes it impossible for existing debtors to repay their loans in time.

Second, this theory believes that loans are self-liquidating under normal economic circumstances. If there is depression, production and trade deteriorate and the debtor fails to repay the debt at maturity.

Third, this theory disregards the fact that the liquidity of a bank relies on the salability of its liquid assets and not on real trade bills. It assures safety, liquidity and profitability. The bank need not depend on maturities in time of trouble.

Fourth, the general demerit of this theory is that no loan is self-liquidating. A loan given to a retailer is not self-liquidating if the items purchased are not sold to consumers and stay with the retailer. In simple words a loan to be successful engages a third party. In this case the consumers are the third party, besides the lender and the borrower.

Shiftability Theory

This theory was proposed by H.G. Moulton who insisted that if the commercial banks continue a substantial amount of assets that can be moved to other banks for cash without any loss of material. In case of requirement, there is no need to depend on maturities.

This theory states that, for an asset to be perfectly shiftable, it must be directly transferable without any loss of capital loss when there is a need for liquidity. This is specifically used for short term market investments, like treasury bills and bills of exchange which can be directly sold whenever there is a need to raise funds by banks.

But in general circumstances when all banks require liquidity, the shiftability theory need all banks to acquire such assets which can be shifted on to the central bank which is the lender of the last resort.

Advantage

The shiftability theory has positive elements of truth. Now banks obtain sound assets which can be shifted on to other banks. Shares and debentures of large enterprises are welcomed as liquid assets accompanied by treasury bills and bills of exchange. This has motivated term lending by banks.

Disadvantage

Shiftability theory has its own demerits. Firstly, only shiftability of assets does not provide liquidity to the banking system. It completely relies on the economic conditions. Secondly, this theory neglects acute depression, the shares and debentures cannot be shifted to others by the banks. In such a situation, there are no buyers and all who possess them want to sell them. Third, a single bank may have shiftable assets in sufficient quantities but if it tries to sell them when there is a run on the bank, it may adversely affect the entire banking system. Fourth, if all the banks simultaneously start shifting their assets, it would have disastrous effects on both the lenders and the borrowers.

Anticipated Income Theory

This theory was proposed by H.V. Prochanow in 1944 on the basis of the practice of extending term loans by the US commercial banks. This theory states that irrespective of the nature and feature of a borrower’s business, the bank plans the liquidation of the term-loan from the expected income of the borrower. A term-loan is for a period exceeding one year and extending to a period less than five years.

It is admitted against the hypothecation (pledge as security) of machinery, stock and even immovable property. The bank puts limitations on the financial activities of the borrower while lending this loan. While lending a loan, the bank considers security along with the anticipated earnings of the borrower. So a loan by the bank gets repaid by the future earnings of the borrower in installments, rather giving a lump sum at the maturity of the loan.

Advantages

This theory dominates the commercial loan theory and the shiftability theory as it satisfies the three major objectives of liquidity, safety and profitability. Liquidity is settled to the bank when the borrower saves and repays the loan regularly after certain period of time in installments. It fulfills the safety principle as the bank permits a relying on good security as well as the ability of the borrower to repay the loan. The bank can use its excess reserves in lending term-loan and is convinced of a regular income. Lastly, the term-loan is highly profitable for the business community which collects funds for medium-terms.

Disadvantages

The theory of anticipated income is not free from demerits. This theory is a method to examine a borrower’s creditworthiness. It gives the bank conditions for examining the potential of a borrower to favorably repay a loan on time. It also fails to meet emergency cash requirements.

This theory was developed further in the 1960s. This theory states that, there is no need for banks to lend self-liquidating loans and maintain liquid assets as they can borrow reserve money in the money market whenever necessary. A bank can hold reserves by building additional liabilities against itself via different sources.

These sources comprise of issuing time certificates of deposit, borrowing from other commercial banks, borrowing from the central banks, raising of capital funds through issuing shares, and by ploughing back of profits. We will look into these sources of bank funds in this chapter.

Time Certificates of Deposits

These deposits have different maturities ranging from 90 days to less than 12 months. They are transferable in the money market. Thus, a bank can have connection to liquidity by selling them in the money market. But this source has two demerits.

First, if during a crisis, the interest rate layout in the money market is higher than the ceiling rate set by the central bank, time deposit certificates cannot be sold in the market. Second, they are not reliable source of funds for the commercial banks. Bigger commercial banks have a benefit in selling these certificates as they have large certificates which they can afford to sell at even low interest rates. So the smaller banks face trouble in this respect.

Borrowing from other Commercial Banks

A bank may build additional liabilities by borrowing from those banks that have excess reserves. But these borrows are only for a very short time, that is for a day or at the most for a week.

The interest rate of these types of borrowings relies on the controlling price in the money market. But borrowings from other banks are only possible when the economic conditions are normal economic. In abnormal times, no bank can afford to grant to others.

Borrowing from the Central Bank

Banks also build liabilities on themselves by borrowing from the central bank of the country. They borrow to satisfy their liquidity requirements for short-term and by discounting bills from the central bank. But these types of borrowings are comparatively costlier than borrowings from other sources.

Raising Capital Funds

Commercial banks hold funds by distributing fresh shares or debentures. But the availability of funds through these sources relies on the volume of dividend or interest rate which the bank is prepared to pay. Basically banks are not prepared to pay rates more than paid by manufacturing and trading enterprises. Thus they fail to get enough funds from these sources.

Ploughing Back Profits

The ploughing back of its profits is considered as an alternative source of liquid funds for a commercial bank. But how much it can obtain from this source relies on its rate of profit and its dividend policy. Larger banks can depend on these sources rather than the smaller banks.

Functions of Capital Funds

Generally, bank capital comprises of own sources of asset finances. The volume of capital is equivalent to the net assets worth, marking the margin by which assets outweigh liabilities.

Capital is expected to secure a bank from all sorts of uninsured and unsecured risks suitable to transform into losses. Here, we obtain two principle functions of capital. The first function is to capture losses and the second is to establish and maintain confidence in a bank.

The different functions of capital funds are briefly described in this chapter.

The Loss Absorbing Function

Capital is required to permit a bank to cover any losses with its own funds. A bank can keep its liabilities completely enclosed by assets as long as its sum losses do not deplete its capital.

Any losses sustained minimize a bank’s capital, set off across its equity products like share capital, capital funds, profit-generated funds, retained earnings, relying on how its general assembly decides.

Banks take good care to fix their interest margins and other spreads between the income derived from and the price of borrowed funds to enclose their ordinary expenses. That is why operating losses are unlikely to subside capital on a long-term basis. We can also say that banks with a long and sound track record owing to their past efficiency, have managed to produce enough amount of own funds to easily cope with any operating losses.

For a new bank without much of a success history, operating losses may conclude driving capital below the minimum level fixed by law. Banks run a probable and greater risk of losses coming from borrower defaults, rendering some of their assets partly or completely irrecoverable.

The Confidence Function

A bank may have sufficient assets to back its liabilities, and also adequate capital power which balances deposits and other liabilities by assets. This generates a financial flow in the ordinary course of banking business. Here, it is an important necessity that a bank’s capital covers its fixed investments like fixed assets, involving interests in subsidiaries. These are used in its business operation, which basically generate no financial flow.

If the cash flow generated by assets falls short of meeting deposit calls or other due liabilities, it is not difficult for a bank with sufficient capital backing and credibility to get its missing liquidity on the interbank market. Other banks will not feel uncomfortable lending to it, as they are aware of the capacity to conclude its liabilities with its assets.

This type of bank can withstand a major deposit flight and refinance it with interbank market borrowings. In banks with a sufficient capital base, anyhow, there is no reason to fear a mass-scale depositor exodus. The logic is that the issues which may trigger a bank capture in the first place do not come in the limelight. An alternating pattern of liquidity with lows and highs is expected, with the latter occurring at times of asset financial inflow outstripping outflow, where the bank is likely to lend its excess liquidity.

Banks are restricted not to count on the interbank market to clarify all their issues. In their own interest and as expected by bank regulators, they expect to match their assets and liability maturities, something that permits them to sail through stressful market situations.

Market rates could be affected due to the intervention of Central Bank. There can be many factors contributing to it like the change in monetary policy or other factors. This could lead to an increase in market rates or the market may collapse. Depending upon the market problem the banks may have to cut down the client lines.

The Financing Function

As deposits are unfit for the purpose, it is up to capital to provide funds to finance fixed investments (fixed assets and interests in subsidiaries). This particular function is apparent when a bank starts up, when money raised from subscribing shareholders is used to buy buildings, land and equipment. It is desirable to have permanent capital coverage for fixed assets. That means any additional investments in fixed assets should coincide with a capital rise.

During a bank’s life, it generates new capital from its profits. Profits not distributed to shareholders are allocated to other components of shareholders’ equity, resulting in a permanent increase. Capital growth is a source of additional funds used to finance new assets. It can buy new fixed assets, loans or other transactions. It is good for a bank to place some of its capital in productive assets, as any income earned on self-financed assets is free from the cost of borrowed funds. If a bank happens to need more new capital than it can produce itself, it can either issue new shares or take a subordinated debt, both an outside source of capital.

The Restrictive Function

Capital is a widely used reference for limits on various types of assets and banking transactions. The objective is to prevent banks from taking too many chances. The capital adequacy ratio, as the main limit, measures capital against risk-weighted assets.

Depending on their respective relative risks, the value of assets is multiplied by weights ranging from 0 to 20, 50 and 100%. We use the net book value here, reflecting any adjustments, reserves and provisions. As a result, the total of assets is adjusted for any devaluation caused by loan defaults, fixed asset depreciation and market price declines, as the amount of capital has already fallen due to expenses incurred in providing for identified risks. That exposes capital to potential risks, which can lead to future losses if a bank fails to recover its assets.

The minimum required ratio of capital to risk-weighted assets is 8 percent. Under the applicable capital adequacy decree, capital is adjusted for uncovered losses and excess reserves, less specific deductible items. To a limited extent, subordinated debt is also included in capital. The decree also reflects the risks contained in off-balance sheet liabilities.

In the restrictive function context, it is the key importance of capital and the precise determination of its amount in capital adequacy calculations that make it a good base for limitations on credit exposure and unsecured foreign exchange positions in banks. The most important credit exposure limits restrict a bank’s net credit exposure (adjusted for recognizable types of security) against a single customer or a group of related customers at 25% of the reporting bank’s capital, or at 125% if against a bank based in Slovakia or an OECD country. This should ensure an appropriate loan portfolio diversification.

The decree on unsecured foreign exchange positions seeks to limit the risks caused by exchange rate fluctuations in transactions involving foreign currencies, capping unsecured foreign exchange positions (the absolute difference between foreign exchange assets and liabilities) in EUR at 15% of a bank’s capital, or 10% if in any other currency. The total unsecured foreign exchange position (the sum of unsecured foreign exchange positions in individual currencies) must not exceed 25% of a bank’s capital.

The decree dealing with liquidity rules incorporates the already discussed principle that assets, which are usually not paid in banking activities, need to be covered by capital. It requires that the ratio of the sum of fixed investments (fixed assets, interests in subsidiaries and other equity securities held over a long period) and illiquid assets (less readily marketable equity securities and nonperforming assets) to a bank’s own funds and reserves not exceed 1.

Owing to its importance, capital has become a central point in the world of banking. In leading world banks, its share in total assets/liabilities moves between 2.5 and 8 %. This seemingly low level is generally considered sufficient for a sound banking operation. Able to operate at the lower end of the range are large banks with a quality and well-diversified asset portfolio.

Capital adequacy deserves constant attention. Asset growth needs to respect the amount of capital. Eventually, any problems a bank may be facing will show on its capital. In commercial banking, capital is the king.

RBI is managed by the Central Board of Directors.

Presently, there are 21 members:

Governor for a period of 5 years

Four Deputy Governors for a period of 5 years

Four Directors (Each nominated by four Local Boards)

Ten Directors (Nominated by Government of India)

Two government officers (Nominated by Government of India)

GOVERNORS OF RBI

First Governor of RBI – Sir Osborne Smith

First Indian Governor of RBI – Sir CD Deshmukh
Current Govenor – 25th Shaktikanta Das (who took charge from Dr D Subbarao )

SUBSIDIARIES

RBI’s fully owned subsidiaries are:

• National Housing Bank (NHB)
• Deposit Insurance and Credit Guarantee Corporation (DICGC)
• Bhartiya Reserve Bank Note Mudran Private Limited (BRBNMPL)
• Majority stake in National Bank of Agriculture and Rural Development (NABARD)

DEPARTMENTS OF RBI

Departments	Functions
Currency Management	Responsible for administration of currency issuance. (Core function of RBI, RBI Act, 1934)
Banking Operations and Development	Responsible for regulations of Commercial Bank under provisions of Banking Regulation Act,1934 and RBI Act, 1934
Rural Planning and Credit	Formulates policies related to rural population (Rural credit and employment programmes)
Foreign Exchange	Facilitate external trade and payment and promote the development and maintain the foreign exchange market in India. (FEMA, 1999)
Inspection	Assign duties on behalf of top management and provide feedback to top management for efficient and effective working of organisation.

Departments of RBI

The various departments of the Reserve Bank of India are listed below:

1. Information Technology.
2. Economic Analysis and Policy.
3. Statistical Analysis and Computer Services.
4. Monetary Policy.
5. Premises Department.
6. Secretary’s Department.
7. Press Relations.
8. Exchange Control.
9. Rural Planning and Credit.
10. Financial Institutions Division.
11. Banking Supervision.
12. Banking Operations and Development.
13. Financial Companies.
14. Non-banking Supervision.
15. Administration and Personnel Management.
16. Human Resources Development.
17. Deposit Insurance and Credit Guarantee Corporation.
18. Inspection.
19. Urban Banks.
20. Currency Management.
21. External Investments and Operations.
22. Expenditure and Budgetary Control.
23. Government and Bank Accounts.
24. Internal Debt Management Cell.
25. Industrial and Export Credit.
26. Legal.

Capital Formation:

The significance of Development Finance Institutions or DFIs lies in their making available the means to utilize savings generated in the economy, thus helping in capital formation. Capital formation implies the diversion of the productive capacity of the economy to the making of capital goods which increases future productive capacity. The process of Capital Formation involves three distinct but interdependent activities, viz., saving financial intermediation and investment.

However, poor country/economy may be, there will be a need for institutions which allow such savings, as are currently forthcoming, to be invested conveniently and safely and which ensure that they are channeled into the most useful purposes. A well-developed financial structure will therefore aid in the collections and disbursements of investible funds and thereby contribute to the capital formation of the economy. Indian capital market although still considered to be underdeveloped has been recording impressive progress during the post-interdependence period.

Support to the Capital Market

The basic purpose of DFIs particularly in the context of a developing economy, is to accelerate the pace of economic development by increasing capital formation, inducing investors and entrepreneurs, sealing the leakages of material and human resources by careful allocation thereof, undertaking development activities, including promotion of industrial units to fill the gaps in the industrial structure and by ensuring that no healthy projects suffer for want of finance and/or technical services.

Hence, the DFIs have to perform financial and development functions on finance functions, there is a provision of adequate term finance and in development functions there include providing of foreign currency loans, underwriting of shares and debentures of industrial concerns, direct subscription to equity and preference share capital, guaranteeing of deferred payments, conducting techno-economic surveys, market and investment research and rendering of technical and administrative guidance to the entrepreneurs.

Rupee Loans

Rupee loans constitute more than 90 per cent of the total assistance sanctioned and disbursed. This speaks eloquently on DFI’s obsession with term loans to the neglect of other forms of assistance which are equally important. Term loans unsupplemented by other forms of assistance had naturally put the borrowers, most of whom are small entrepreneurs, on to a heavy burden of debt-servicing. Since term finance is just one of the inputs but not everything for the entrepreneurs, they had to search for other sources and their abortive efforts to secure other forms of assistance led to sickness in industrial units in many cases.

Foreign Currency Loans

Foreign currency loans are meant for setting up of new industrial projects as also for expansion, diversification, modernization or renovation of existing units in cases where a portion of the loan was for financing import of equipment from abroad and/or technical know-how, in special cases.

Subscription to Debentures and Guarantees

Regarding guarantees, it is well-known that when an entrepreneur purchases some machinery or fixed assets or capital goods on credit, the supplier usually asks him to furnish some guarantee to ensure payment of installments by the purchaser at regular intervals. In such a case, DFIs can act as guarantors for prompt of installments to the supplier of such machinery or capital under a scheme called ‘Deferred Payments Guarantee’.

Assistance to Backward Areas

Operations of DFI’s in India have been primarily guided by priorities as spelt out in the Five-Year Plans. This is reflected in the lending portfolio and pattern of financial assistance of development financial institutions under different schemes of financing. Institutional finance to projects in backward areas is extended on concessional terms such as lower interest rate, longer moratorium period, extended repayment schedule and relaxed norms in respect of promoters’ contribution and debt-equity ratio.

Such concessions are extended on a graded scale to units in industrially backward districts, classified into the three categories of A, B and c depending upon the degree of their backwardness. Besides, institutions have introduced schemes for extending term loans for project/area-specific infrastructure development.

Moreover, in recent years, development banks in India have launched special programmes for intensive development of industrially least developed areas, commonly referred to as the No-industry Districts (NID’s) which do not have any large-scale or medium-scale industrial project. Institutions have initiated industrial potential surveys in these areas.

Promotion of New Entrepreneurs

Development banks in India have also achieved a remarkable success in creating a new class of entrepreneurs and spreading the industrial culture to newer areas and weaker sections of the society.

Special capital and seed Capital schemes have been introduced to provide equity type of assistance to new and technically skilled entrepreneurs who lack financial resources of their own even to provide promoter’s contribution in view of long-term benefits to the society from the emergence of a new class of entrepreneurs. Development banks have been actively involved in the entrepreneurship development programmes and in establishing a set of institutions which identify and train potential entrepreneurs.

Again, to make available a package of services encompassing preparation of feasibility of reports, project reports, technical and management consultancy etc. at a reasonable cost, institutions have sponsored a chain of 16 Technical Consultancy organizations covering practically the entire country.

Promotional and development functions are as important to institutions as the financing role. The promotional activities like carrying out industrial potential surveys, identification of potential entrepreneurs, conducting entrepreneurship development programmes and providing technical consultancy services have contributed in a significant manner to the process of industrialization and effective utilization of industrial finance by industry.

IDBI has created a special technical assistance fund to support its various promotional activities. Over the years, the scope of promotional activities has expanded to include programmes for up gradation of skill of State level development banks and other industrial promotion agencies, conducting special studies on important issues concerning industrial development, encouraging voluntary agencies in implementing their programmes for the uplift of rural areas, village an cottage industries, artisans and other weaker sections of the society.

Impact on Corporate Culture

The project appraisal and follow-up of assisted projects by institutions through various instruments, such as project monitoring and report of nominee directors on the Boards of directors of assisted units, have been mutually rewarding.

Through monitoring of assisted projects, the institutions have been able to better appreciate the problems faced by industrial units. It also has been possible for the corporate managements to recognize the fact that interests of the assisted units and those of institutions do not conflict but coincide.

Over the years, institutions have succeeded in infusing a sense of constructive partnership with the corporate sector. Institutions have been going through a continuous process of learning by doing and are effecting improvements in their systems and procedures on the basis of their cumulative experience.

The promoters of industrial projects now develop ideas into specific projects more carefully and prepare project reports more systematically. Institutions insist on more critical evaluation of technical feasibility demand factors, marketing strategies and project location and on application of modern techniques of discounted cash flow, internal rate of return, economic rate of return etc., in assessing the prospects of a project.

This has produced a favorable impact on the process of decision-making in the corporate seeking financial assistance from institutions. In fact, such impact is not continued to projects assisted by them but also spreads over to projects financed by the corporate sector on its own.

The association of institutions in the management of corporate bodies has considerably facilitated the process of progressive professionalism of the corporate management. Institutions have been able to convince the corporate managements to appropriately re-orient their organizational structure, personal policies and planning and control systems. In many cases, institutions have successfully inducted experts on the Boards of assisted companies.

As part of their project follow-up work and through their nominee directors, institutions have also been able to bring about progressive adoption of modern management techniques, such as corporate planning and performance budgeting in the assisted units. The progressive professionalism of industrial management in India reflects one of the major qualitative changes brought about by the institutions.

The financial system of an economy provides the way to collect money from the people who have it and distribute it to those who can use it best. So, the efficient allocation of economic resources is achieved by a financial system that distributes money to those people and for those purposes that will yield the best returns.

The financial system is composed of the products and services provided by financial institutions, which includes banks, insurance companies, pension funds, organized exchanges, and the many other companies that serve to facilitate economic transactions. Virtually all economic transactions are effected by one or more of these financial institutions. They create financial instruments, such as stocks and bonds, pay interest on deposits, lend money to creditworthy borrowers, and create and maintain the payment systems of modern economies.

These financial products and services are based on the following fundamental objectives of any modern financial system:

1. To provide a payment system
2. To give time value to money
3. To offer products and services to reduce financial risk or to compensate risk-taking for desirable objectives
4. To collect and disperse information that allows the most efficient allocation of economic resources
5. To create and maintain financial markets that provide prices, which indicates how well investments are performing, determines the subsequent allocation of resources, and to maintain economic stability in the markets

Components of Financial System

A financial system refers to a system which enables the transfer of money between investors and borrowers. A financial system could be defined at an international, regional or organizational level. The term “system” in “Financial System” indicates a group of complex and closely linked institutions, agents, procedures, markets, transactions, claims and liabilities within an economy. There are five components of Financial System which is discussed below:

1. Financial Institutions: It ensures smooth working of the financial system by making investors and borrowers meet. They mobilize the savings of investors either directly or indirectly via financial markets by making use of different financial instruments as well as in the process using the services of numerous financial services providers. They could be categorized into Regulatory, Intermediaries, Non-intermediaries and Others. They offer services to organizations looking for advises on different problems including restructuring to diversification strategies. They offer complete series of services to the organizations who want to raise funds from the markets and take care of financial assets, for example deposits, securities, loans, etc.
2. Financial Markets: 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 represent 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. There are four components of financial market are given below:

• Money Market: The money market is 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 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.
• Foreign Exchange Market: The Foreign Exchange market deals with the multicurrency requirements which are met by the exchange of currencies.  Depending on the exchange rate that is applicable, the transfer of funds takes place in this market.  This is one of the most developed and integrated markets across the globe.
• Credit Market: Credit market is a place where banks, Financial Institutions (FIs) and Non-Bank Financial Institutions (NBFCs) purvey short, medium and long-term loans to corporate and individuals.

3. Financial Instruments: This is an important component of financial system. The products which are traded in a financial market are financial assets, securities or other types of financial instruments. There are a wide range of securities in the markets since the needs of investors and credit seekers are different. They indicate a claim on the settlement of principal down the road or payment of a regular amount by means of interest or dividend. Equity shares, debentures, bonds, etc. are some examples.

4. Financial Services: It consists of services provided by Asset Management and Liability Management Companies. They help to get the required funds and also make sure that they are efficiently invested. They assist to determine the financing combination and extend their professional services up to the stage of servicing of lenders. They help with borrowing, selling and purchasing securities, lending and investing, making and allowing payments and settlements and taking care of risk exposures in financial markets. These range from the leasing companies, mutual fund houses, merchant bankers, portfolio managers, bill discounting and acceptance houses. The financial services sector offers a number of professional services like credit rating, venture capital financing, mutual funds, merchant banking, depository services, book building, etc. Financial institutions and financial markets help in the working of the financial system by means of financial instruments. To be able to carry out the jobs given, they need several services of financial nature. Therefore, financial services are considered as the 4th major component of the financial system.

5. Money: It is understood to be anything that is accepted for payment of products and services or for the repayment of debt. It is a medium of exchange and acts as a store of value. It eases the exchange of different goods and services for money.

Hence it can be said that a financial provides a platform to the lenders and borrowers to interact with each other for their mutual benefits. The ultimate profits of this interaction come in the form of capital accumulation (which is very crucial for the developing countries like India, who faces the problem of capital crunch) and economic development of the country.