Month: January 2021

Management Notes

Securities Trading Corporation of India

indiafreenotesby indiafreenotes0

STCI Finance Ltd (formerly Securities Trading Corporation of India Limited), is a Systemically Important Non-Deposit taking NBFC registered with Reserve Bank of India (RBI). Presently STCI Finance Ltd is classified as a loan NBFC.

In May 1994, STCI Finance Limited was promoted by RBI with the main objective of fostering an active secondary market in Government of India Securities and Public Sector bonds. RBI owned a majority stake of 50.18% in the paid-up share capital of the company. In 1996, the Company was accredited as the first Primary Dealer in the India. As one of the leading Primary Dealers in the country, the Company was a market maker in government securities, corporate bonds and money market instruments. Its other lines of activities included trading in interest rate swaps and trading in equity – cash & derivatives segment. The Company enjoyed a successful track record of achieving profits during consecutive years spanning nearly a decade. RBI divested its entire shareholding in STCI in two stages- first in 1997 to bring it down from 50.18% to 14.41% and the balance in 2002 to the existing shareholders. Bank of India became the largest shareholder in the company with 29.96% stake.

In order to diversify into new activities, the Company hived off its Primary Dealership business to its separate 100% subsidiary, STCI Primary Dealer Limited (STCI-PD) in June 2007. Since year 2007, the Company has been undertaking lending and investment activities with its main focus on lending/ financing activities. With growth in the size of the Look Book, the lending activity became the core business of the Company and STCI Finance Limited was classified as a Loan NBFC . With a view to reflecting the lending/ financing business of the Company, the name of the Company was changed from Securities Trading Corporation of India to ‘STCI Finance Limited’ with effect from October 24, 2011.

STCI Finance Limited is a diversified mid-market B2B NBFC offering its product and services across multiple locations in the areas of Capital Markets, Real Estate, Corporate Finance and Structured Finance.

Subsidiaries:

STCI Primary Dealer Limited (STCI PD)

This company is a wholly owned subsidiary of STCI Finance Limited established consequent to the hiving off of the Company’s primary dealership business in line with the Reserve Bank of India guidelines on diversification of business activities by primary dealers. The Company undertakes trading in government securities, corporate bonds, money market instruments, interest rate swaps and trading in equity.

STCI Commodities Limited

This company is a wholly owned subsidiary of STCI Finance Limited. The Company has discontinued its commodity broking operations with effect from September 20, 2011 and has also surrendered its membership with Multi Commodity Exchange (MCX) and National Commodity and Derivative Exchange (NCDEX).

Management Notes

Functions of Money Market

indiafreenotesby indiafreenotes0

Money market is the market for short-term loanable funds, as distinct from the capital mar­ket which deals in long-term funds.

Money mar­ket is also defined as a mechanism through which short-term funds are loaned and borrowed and through which a large part of the financial transac­tions of a particular country are cleared.

The money market is divided into direct, negotiated, or customers’ money market and the open or impersonal money market. In the former, banks and financial firms supply funds to local customers and also to larger centres such as London for direct lending. In the open money market, idle funds drawn from all-over the country are transferred through intermediaries to the New York City market or the London market.

These intermediaries comprise the Federal Reserve Banks in the USA or the Bank of England in England, commercial banks, insurance companies, business corporations, brokerage houses, finance companies, state and local government securities’ dealers. The money market is a dynamic market in which new money market instruments are evolved and traded and more participants are permitted to deal in the money market.

Use of Surplus Funds:

It provides and opportunity to banks and other institutions to use their surplus funds profitably for a short period. These institutions include not only commercial banks and other financial institutions but also large non-financial business corporations, states and local governments.

Provides Funds:

It provides short-term funds to the public and private institutions needing such financing for their working capital requirements. It is done by discounting trade bills through commercial banks, discount houses, brokers and acceptance houses. Thus the money market helps the development of commerce, industry and trade within and outside the country.

Helps Government:

The money market helps the government in borrowing short-term funds at low interest rates on the basis of treasury bills. On the other hand, if the government were to issue paper money or borrow from the central bank. It would lead to inflationary pressures in the economy.

No Need to Borrow from Banks:

The existence of a developed money market removes the necessity of borrowing by the commercial banks from the central bank. If the former find their reserves short of cash requirements they can call in some of their loans from the money market. The commercial banks prefer to recall their loans rather than borrow from the central banks at a higher rate of interests.

Helps in Financial Mobility:

By facilitating the transfer for funds from one sector to another, the money market helps in financial mobility. Mobility in the flow of funds is essential for the development of commerce and industry in an economy.

Helps in Monetary Policy:

A well-developed money market helps in the successful implementation of the monetary policies of the central bank. It is through the money market that the central banks is in a position to control the banking system and thereby influence commerce and industry.

Equilibrium between Demand and Supply of Funds:

The money market brings equilibrium between the demand and supply of loanable funds. This it does by allocating saving into investment channels. In this way, it also helps in rational allocation of resources.

Promotes Liquidity and Safety:

One of the important functions of the money market is that it promotes liquidity and safety of financial assets. It thus encourages savings and investments.

Economy in Use of Cash:

As the money market deals in near-money assets and not money proper, it helps in economising the use of cash. It thus provides a convenient and safe way of transferring funds from one place to another, thereby immensely helping commerce and industry.

The monetary policy takes care of promotional aspects such as:

(i) Monetary integration of the country,

(ii) Directing credit flow according to policy priorities,

(iii) Assisting in mobilisation of the savings of the community,

(iv) Promotion of capital formation and

(v) Maintain an appropriate structure of relative prices and demand containment.

Management Notes

LAF (Liquidity Adjustment Facility), Repo and Reverse Repo

indiafreenotesby indiafreenotes0

A liquidity adjustment facility (LAF) is a tool used in monetary policy, mainly by the Reserve Bank of India (RBI), which enables banks to borrow money through repurchase agreements (reposals) or banks to lend to the RBI using reverse repo contracts.

This arrangement manages liquidity pressures and ensures basic financial-market stability. The Reserve Bank of India transacts repositories and reverse repos within its open market operations in India.

The Liquidity Adjustment Facility or LAF is the principal operating monetary policy tool that allows banks to borrow money through repurchase agreements. This means, in order to meet short-term cash needs, bank, borrow money against government approved securities with an agreement to repurchase the same at a predetermined rate and date.

The liquidity adjustment facility is used to aide banks in the emergency arising out of severe cash shortage or acute liquidity crisis. It is used for modulating the short-term liquidity and transmitting the interest rate into the market.

Basic of a Liquidity Adjustment Facility

Facilities for liquidity adjustment are used to help banks overcome any short-term cash shortages during periods of economic uncertainty or any other stress caused by circumstances beyond their control. Different banks use eligible securities as collateral through a repo agreement and utilize the funds to ease their short-term requirements, thus remaining constant.

The facilities are introduced on a daily basis as banks and other financial institutions make sure they have sufficient capital on the overnight market.

The transaction of liquidity adjustment facilities takes place at a set time of the day, through an auction. A company that wants to raise capital to accomplish a shortfall is engaged in repo agreements, while one with excess capital is doing the opposite executing a reverse repo agreement.

Liquidity Adjustment Facility and the Economy

The RBI may use the facility for adjusting liquidity to manage high levels of inflation. It does this by raising the repo rate, which increases the cost of debt servicing. This, in turn, reduces the supply of investment and money within the economy of India.

Alternatively, if the RBI tries to boost the economy after a period of slow economic growth, the repo rate can be lowered to encourage businesses to borrow, thus increasing the supply of money.

For instance, analysts predict RBI to cut the repo rate in April 2019 by 25 basis points due to weak economic activity, low inflation, and slower global growth. However, as growth accelerates and inflation picks up, analysts expect repo rates to resume rising by 2020.

Repo Rate

Repo or repurchase option allows the scheduled commercial banks to borrow funds from the Reserve Bank of India against any government approved securities with an agreement to repurchase them in the near future at a predefined rate of interest. The rate at which RBI charges from the banks against such lending is called the Repo rate. Through these operations, the liquidity is injected into the economy or the financial system.

Banking is the first sector to get affected by any change in monetary policies. A cut in repo rate can allow banks to borrow from the Reserve Bank of India at a cheaper rate and infuse higher liquidity in the banking system. This can lead banks to reduce their lending rates for customer leading to cheaper loans in the long term. As bank loans get cheaper, consumers can borrow and spend more which boosts consumption and can eventually lead to economic growth. However, this is depending on the decision by the bank whether to pass on the RBI repo rate cut benefits to their customers through cheaper loan offers.

Components

Preventing Economy “squeezes”: The Central bank increases or decreases the Repo rate depending on the inflation. Thus, it aims at controlling the economy by keeping inflation in the limit.

Hedging & Leveraging: RBI aims to hedge and leverage by buying securities and bonds from the banks and provide cash to them in return for the collateral deposited.

Short-Term Borrowing: RBI lends money for a short period of time, maximum being an overnight post which the banks buy back their securities deposited at a predetermined price.

Collaterals & Securities: RBI accepts collateral in the form of gold, bonds etc.

Cash Reserve (or) Liquidity: Banks borrow money from RBI to maintain liquidity or cash reserve as a precautionary measure.

Repo Rate Affect on Economy

Repo rate is a powerful arm of the Indian monetary policy that can regulate the country’s money supply, inflation levels, and liquidity. Additionally, the levels of repo have a direct impact on the cost of borrowing for banks. Higher the repo rate, higher will be the cost of borrowing for banks and vice-versa.

  • Rise in inflation

During high levels of inflation, RBI makes strong attempts to bring down the flow of money in the economy. One way to do this is by increasing the repo rate. This makes borrowing a costly affair for businesses and industries, which in turn slows down investment and money supply in the market. As a result, it negatively impacts the growth of the economy, which helps in controlling inflation.

  • Increasing Liquidity in the Market

On the other hand, when the RBI needs to pump funds into the system, it lowers the repo rate. Consequently, businesses and industries find it cheaper to borrow money for different investment purposes. It also increases the overall supply of money in the economy. This ultimately boosts the growth rate of the economy.

Reverse Repo Rate

This is just opposite to the Repo rate, here the RBI borrows money from the commercial banks against government approved securities. The rate at which RBI pays interest to the commercial bank is called a reverse repo rate. Through reverse repo operations, the liquidity is absorbed from the economy or the financial system.

Whenever RBI decides to reduce the reverse repo rate, banks earn less on their excess money deposited with the Reserve Bank of India. This leads the banks to invest more money in more lucrative avenues such as money markets which increases the overall liquidity available in the economy. While this can also lead to lower interest rate on loans for the bank’s customers, the decision will depend on multiple factors including the bank’s internal liquidity situation and the availability of other potentially less risky and equally lucrative investment opportunities.

Repo Rate Reverse Repo Rate
It is the rate at which RBI lends money to banks It is the rate at which RBI borrows money from banks
It is higher than the reverse repo rate It is lower than the repo rate
It is used to control inflation and deficiency of funds It is used to manage cash-flow
It involves the sale of securities which would be repurchased in future. It involves the transfer of money from one account to another.

Management Notes

MSF (Marginal Standing Facility)

indiafreenotesby indiafreenotes0

The Marginal Standing Facility (MSF) is the rate at which the scheduled commercial banks borrow funds fortnight from the Reserve Bank of India against the government approved securities.

Marginal standing facility (MSF) is a window for banks to borrow from the Reserve Bank of India in an emergency when inter-bank liquidity dries up completely. The Marginal standing facility is a scheme launched by RBI while reforming the monetary policy in 2011-12.

Marginal Standing Facility (MSF) is a provision made by the RBI through which scheduled commercial banks can obtain liquidity overnight, in the event that inter-bank liquidity completely dries up. This is a facility for emergencies, through which banks obtain liquidity support at the MSF rate, which is a rate higher than the repo rate.

Banks can avail immediate cash of up to a percentage, now 3%, of their NDTL under MSF, meaning that they can dip into their SLR to obtain liquidity support from the RBI at the MSF rate. It is a penal rate of interest at which the RBI offers banks funds under the Marginal standing facility. If a bank’s liquidity dries up due to, say, a loan-deposit mismatch, it could avail funds from the RBI at the marginal standing facility rate even if it does not have eligible securities beyond the SLR.

MSF is a short-term arrangement as banks generally do not run out of liquidity for a long time, but at a given point they may face a dire shortage of funds.

  • Banks borrow from the RBI by pledging government securities at a rate greater than the repo rate under LAF (liquidity adjustment facility).
  • The MSF rate is pegged 100 basis points or a percentage point above the repo rate.
  • Under MSF, banks can borrow funds up to one percent of their net demand and time liabilities (NDTL).
  • The minimum amount for which RBI receives application is Rs.1 Crore, and afterward in multiples of Rs.1 Crore.

Normally, banks pledge eligible securities above the SLR requirement to the RBI to obtain liquidity through loans at the repo rate. Now, if a bank exhausts this means, it can resort to the MSF provision to get quick money for a 1-day period by pledging, within the limits of SLR, government securities.

Objectives of MSF rate

The Marginal Standing Facility was introduced by the RBI in the 2011-2012 monetary policy and it helps both banks and the RBI in a handful of ways.

  • There is less volatility in overnight lending rates thanks to MSF
  • Banks have a way to plug short-term liquidity shortfalls with MSF
  • With MSF, RBI has more control over the money supply in the economy

RBI uses Marginal standing facility to control and manage the money supply in the financial system. With the increase in the rate, the borrowing becomes expensive for the commercial banks and in return the loans become dearer for the individual or corporate borrowers, which will result in less flow of money in the market. Also, the MSF rate is often increased by RBI to curb the excessive availability of rupee and to avoid further rupee depreciation against a dollar.

Rate of Interest

The rate of interest on MSF is above 100 bps above the Repo Rate.  The banks can borrow up to 1 percent of their net demand and time liabilities (NDTL) from this facility. This means that Difference between Repo Rate and MSF is 200 Basis Points.  So, Repo rate will be in the middle, the Reverse Repo Rate will be 100 basis points below it, and the MSF rate 100 bps above it. Thus, if Repo Rate is X%, reverse repo rate is X-1% and MSF is X+1%.

Borrowing under MSF

  • Banks can borrow through MSF on all working days except Saturdays, between 3:30pm and 4:30pm in Mumbai where RBI has its headquarters.
  • The minimum amount which can be accessed through MSF is Rs. 1 crore and in multiples of Rs. 1 crore.
  • The application for the facility can be submitted electronically also by the eligible scheduled commercial banks.
Management Notes

Organization of Money Market, Defects, Dealers

indiafreenotesby indiafreenotes0

Money market is a financial market that facilitates the trading of short-term financial instruments with high liquidity and maturities of one year or less. It serves as a platform for borrowers to meet short-term funding needs and for lenders to invest excess funds securely. Key participants include central banks, commercial banks, non-banking financial institutions, and primary dealers. Common instruments traded in the money market include treasury bills, commercial papers, certificates of deposit, and repurchase agreements. The money market plays a crucial role in ensuring liquidity and stability in the financial system.

Organization of Money Market:

Money market is a component of the financial system where short-term borrowing, lending, buying, and selling of financial instruments with maturities of one year or less take place. It plays a crucial role in ensuring liquidity in the economy by facilitating the transfer of short-term funds among financial institutions, businesses, and governments. The organization of the money market includes various institutions, instruments, and participants that interact to fulfill short-term funding needs.

1. Structure of the Money Market

The money market in India is well-organized and comprises two broad segments:

(a) Organized Sector

The organized sector is regulated by the Reserve Bank of India (RBI) and includes formal institutions and instruments:

  • Reserve Bank of India (RBI):

The RBI is the central authority that regulates and monitors the money market, ensuring liquidity and stability. It conducts monetary policy operations, such as open market operations (OMO) and repo rate adjustments, to control the money supply.

  • Commercial Banks:

Commercial banks play a key role by lending and borrowing short-term funds. They participate actively in call money markets and interbank lending.

  • Development and Cooperative Banks:

These banks cater to specific sectors and also participate in the money market to manage their liquidity requirements.

  • Non-Banking Financial Companies (NBFCs):

NBFCs participate in money market transactions to meet short-term financing needs.

  • Primary Dealers:

Authorized primary dealers help in the development of government securities and participate in short-term borrowing through treasury bills.

(b) Unorganized Sector

The unorganized sector includes informal financial entities such as moneylenders, indigenous bankers, and traders. Though this sector is not regulated by the RBI, it plays a significant role in providing short-term funds, especially in rural areas.

2. Instruments of the Money Market

Several financial instruments are used in the money market, including:

  • Treasury Bills (T-Bills):

Short-term government securities issued by the RBI on behalf of the government, typically with maturities of 91, 182, and 364 days.

  • Commercial Paper (CP):

Unsecured promissory notes issued by corporations to raise short-term funds.

  • Certificates of Deposit (CD):

Negotiable instruments issued by banks to raise short-term deposits from investors.

  • Call Money and Notice Money:

Call money refers to funds borrowed or lent for a very short period, usually one day. Notice money involves borrowing for 2 to 14 days.

  • Repo and Reverse Repo Agreements:

These are short-term borrowing agreements in which securities are sold and repurchased at a future date.

3. Participants in the Money Market

  • Commercial banks
  • Non-banking financial institutions
  • Primary dealers
  • Mutual funds
  • Insurance companies
  • Corporations

Defects of Money Market:

  • Lack of Integration

The money market in many developing countries lacks proper integration between its various components, such as the central bank, commercial banks, and non-banking financial institutions. This fragmentation reduces the market’s overall efficiency in meeting liquidity demands uniformly.

  • Limited Instruments

In well-developed money markets, a variety of financial instruments, such as treasury bills, commercial papers, and certificates of deposit, are actively traded. However, in underdeveloped markets, there is often a limited range of instruments, leading to reduced options for investors and borrowers.

  • Seasonal Fluctuations

A major defect in certain money markets is the occurrence of seasonal fluctuations in demand for funds. For instance, in agriculture-driven economies, the demand for short-term funds increases sharply during sowing and harvesting seasons, leading to interest rate volatility.

  • Ineffective Central Bank Control

The central bank is responsible for regulating and stabilizing the money market. In some economies, the central bank’s control mechanisms may not be well-developed or effectively enforced, resulting in unstable interest rates and liquidity imbalances.

  • Limited Participation by Institutions

A healthy money market requires active participation from a wide range of financial institutions, including commercial banks, non-banking financial companies (NBFCs), and mutual funds. In certain markets, institutional participation is low, which limits the depth and breadth of the market.

  • Underdeveloped Banking System

A weak or underdeveloped banking system can significantly hamper the functioning of the money market. In many countries, commercial banks may lack sufficient resources or the necessary infrastructure to actively participate in money market operations, leading to reduced liquidity.

  • High Transaction Costs

In some money markets, high transaction costs can deter participation by smaller institutions and investors. These costs can include regulatory fees, brokerage charges, and administrative expenses, making short-term borrowing and lending less attractive.

  • Lack of Transparency

Transparency is essential for the efficient functioning of the money market. In some economies, a lack of clear information about interest rates, market demand, and supply of funds can result in inefficient allocation of resources and increased risks for participants.

Dealers of Money Market:

  • Central Bank

The central bank, such as the Reserve Bank of India (RBI) or the Federal Reserve, plays a pivotal role in regulating and controlling money market operations. It acts as a lender of last resort, ensuring liquidity and stability in the market. The central bank also influences short-term interest rates through its monetary policy and open market operations.

  • Commercial Banks

Commercial banks are the most prominent dealers in the money market. They borrow and lend short-term funds to manage their liquidity requirements and meet the reserve requirements set by the central bank. They also trade in money market instruments such as treasury bills, certificates of deposit, and interbank loans.

  • Non-Banking Financial Institutions (NBFIs)

NBFIs, such as insurance companies, mutual funds, and pension funds, participate actively in the money market. Although they do not have a banking license, they provide short-term financing and liquidity to the market. Their participation enhances market depth and stability by diversifying the sources of funds.

  • Primary Dealers (PDs)

Primary dealers are specialized financial institutions appointed by the central bank to participate in the issuance and trading of government securities. Their primary role is to ensure the smooth functioning of the government securities market by underwriting and distributing new issues. PDs also provide liquidity to the secondary market by actively buying and selling government securities.

  • Cooperative Banks

Cooperative banks operate at regional and local levels, providing short-term credit to agricultural and rural sectors. They participate in the money market by borrowing funds to meet seasonal credit requirements and lending to small businesses and farmers.

  • Discount and Finance Houses

Discount and finance houses act as intermediaries in the money market by discounting short-term financial instruments, such as treasury bills, commercial papers, and bills of exchange. They enhance liquidity in the market by facilitating the conversion of securities into cash.

  • Corporations and Large Businesses

Large corporations participate in the money market to manage their short-term financing needs. They often issue commercial papers to raise funds at lower interest rates than bank loans. Corporations also invest surplus cash in money market instruments to earn interest on idle funds.

  • Brokers and Dealers

Brokers and dealers facilitate transactions between buyers and sellers in the money market. They act as intermediaries, matching parties for short-term lending and borrowing. Dealers, in particular, may also trade money market instruments on their own account to earn profits.

Management Notes

MPC (Monetary Policy Committee) Structure and Functions

indiafreenotesby indiafreenotes1

The term ‘Monetary Policy’ is the Reserve Bank of India’s policy pertaining to the deployment of monetary resources under its control for the purpose of achieving GDP growth and lowering the inflation rate. The Reserve Bank of India Act 1934 empowers the RBI to make the monetary policy. We can say that the monetary policy stands for the control measures adopted by the Central Bank of a nation.

The Monetary Policy Committee is responsible for fixing the benchmark interest rate in India. The meetings of the Monetary Policy Committee are held at least 4 times a year (specifically, at least once every quarter) and it publishes its decisions after each such meeting.

Monetary Policy Committee (MPC) has been instituted by the Central Government of India under Section 45ZB of the RBI Act that was amended in 1934. MPC had its first meeting for two days on October 3 and October 4, 2016. The MPC is entrusted with the responsibility of deciding the different policy rates including MSF, Repo Rate, Reverse Repo Rate, and Liquidity Adjustment Facility. Monetary Policy Committee (MPC) has six members and the main objective of this body is to maintain the price stability and boosting up the growth rate of the country’s economy.

The committee comprises six members, three officials of the Reserve Bank of India and three external members nominated by the Government of India. They need to observe a “silent period” seven days before and after the rate decision for “utmost confidentiality”. The Governor of Reserve Bank of India is the chairperson ex officio of the committee. Decisions are taken by majority with the Governor having the casting vote in case of a tie. The current mandate of the committee is to maintain 4% annual inflation until 31 March 2021 with an upper tolerance of 6% and a lower tolerance of 2%.

The Reserve Bank of India Act, 1934 was amended by Finance Act (India), 2016 to constitute MPC which will bring more transparency and accountability in fixing India’s Monetary Policy. The monetary policy are published after every meeting with each member explaining his opinions. The committee is answerable to the Government of India if the inflation exceeds the range prescribed for three consecutive quarters.

Functions:

The MPC is entrusted with the responsibility of deciding the different policy rates including MSF, Repo Rate, Reverse Repo Rate, and Liquidity Adjustment Facility.

Composition of MPC:

The committee will have six members. Of the six members, the government will nominate three. No government official will be nominated to the MPC.

The other three members would be from the RBI with the governor being the ex-officio chairperson. Deputy governor of RBI in charge of the monetary policy will be a member, as also an executive director of the central bank.

Objectives of the Monetary Policy:

The Chakravarty committee has emphasized that price stability, economic growth, equity, social justice, promoting and nurturing the new monetary and financial institutions have been important objectives of the monetary policy in India.

RBI tries always tries to reduce rate of inflation or keep it within a sustainable limit while on the other hand government of India focus to accelerate the GDP growth of the country.

Monetary Policy Objectives

As per the suggestions made by Chakravarty Committee, aspects such as price stability, economic growth, equity, social justice, and encouraging the growth of new financial enterprises are some crucial roles connected to the monetary policy of India.

  • While the Government of India tries to accelerate the GDP growth rate of India, the RBI keeps trying to bring down the rate of inflation within a sustainable limit.
  • In order to achieve its main objectives, the Monetary Policy Committee determines the ideal policy interest rate that will help achieve the inflation target in front of the country.
University of Mumbai BMS Notes

Flow of Funds Matrix

indiafreenotesby indiafreenotes1

The national income accounts do not tell anything about monetary or financial transactions whereby one sector places its savings at the disposal of the other sectors of the economy by means of loans, capital transfers, etc.

In fact, the national income accounts do not take into consideration the financial dimensions of economic activity and they describe product accounts as if they are operated through barter. The flow of funds accounts is meant to supplement national income and product accounts. The flow of funds accounts was developed by Prof. Morris Copeland’ in 1952 to overcome the weaknesses of national income accounting.

The flow of funds accounts lists the sources of all funds received and the uses to which they are put within the economy. They show the financial transactions among different sectors of the economy and the link between saving and investment aggregates with lending and borrowing by them.

The account for each sector reveals all the sources of funds whether from income or borrowing and all the uses to which they are put whether for spending or lending. This way of looking at financial transactions in their entirety has come to be known as the flow of funds approach or of sources and uses of funds.

In the flow of funds accounts, all changes in assets are recorded as uses and all changes in liabilities are recorded as sources. Uses of funds are increases in assets if positive or decreases in assets if negative. They refer to capital expenditures or real investment spending which involve the purchase of real assets.

Sources of funds are increases in liabilities or net worth or saving if positive, and repayment of debt or dissaving if negative. Net worth is equal to a sector’s total assets minus its total liabilities. Therefore, a change in net worth equals any change in total assets less any change in total liabilities.

Flow of Funds Matrix:

The flow of funds accounting system is presented in the form of a matrix by placing sources and uses of funds statements of different sectors side by side. It is an interlocking self-contained system that reveals financial relationships among all sectors of the economy.

For the economy as a whole, total liabilities must equal total financial assets, although for any one sector its liabilities may not equal its financial assets. The consolidated net worth of an economy is consequently identical to the value of its real assets. This implies that saving must equal investment in an economy. Any single sector may save more than it invests or invest more than it saves. But the economy-wise total of saving must equal investment.

Limitations:

  1. The flow of funds accounts are more complicated than the national income accounts because they involve the aggregation of a large number of sectors with their very detailed financial transactions.
  2. There is the problem of valuation of assets. Many assets, claims and obligations have no fixed value. It, therefore, becomes difficult to have their correct valuation.
  3. The problem of inclusion of non-reproducible real assets arises in the flow of funds accounts. Economists have not been able to decide as to the type of reproducible assets which may be included in flow of funds accounts.
  4. Similarly, economists have failed to decide about the inclusion of human wealth in flow of funds accounts.

Despite these problems, the flow of funds accounts supplements the national income accounts and help in understanding social accounts of an economy.

Importance:

The flow of funds accounts presents a comprehensive and systematic analysis of the financial transactions of the economy.

As such, they are useful in a number of ways:

  1. The flow of funds accounts is superior to the national income accounts. Even though the latter are fairly comprehensive, yet they do not reveal the financial transactions of the economy which the flow of funds accounts do.
  2. They provide a useful framework for studying the behaviour of individual financial institutions of the economy.
  3. According of Prof. Goldsmith, they bring “the various financial activities of an economy into explicit statistical relationships with one another and with data on the nonfinancial activities that generate income and production.”
  4. They trace the financial flows that interact with and influence the real saving-investment process. They record the various financial transactions underlying saving and investment.
  5. They are essential raw materials for any comprehensive analysis of capital market behaviour. They help to identify the role of financial institutions in the generation of income, saving and expenditure, and the influence of economic activity on financial markets.
  6. The flow of funds accounts show how the government finances its deficit and surplus budget and acquires financial assets.
  7. They also show the results of transactions in government and corporate securities, net increase in deposits and foreign assets in the economy.
  8. The flow of funds accounts help in analysing the impact of monetary policies on the economy as to whether they bring stability or instability or economic fluctuations.
Management Notes

Financial System and Economic Development

indiafreenotesby indiafreenotes2

The financial system is crucial to the economic development of a country as it facilitates the efficient allocation of resources, mobilizes savings, enables investments, and supports the creation of wealth. It consists of financial institutions, markets, instruments, and regulatory frameworks that together create an environment conducive to economic growth.

Role of Financial Institutions

Financial institutions, which include banks, insurance companies, pension funds, and other non-banking financial companies, play a pivotal role in economic development. They act as intermediaries between savers and borrowers, channeling funds from those with surplus capital to those in need of capital for productive use. Banks, for instance, accept deposits and extend credit to businesses and consumers, facilitating investment in new ventures and supporting existing businesses in expansion efforts. These activities are fundamental to job creation, wealth generation, and the overall growth of the economy.

Financial Markets and Their Impact

Financial markets, encompassing the stock market, bond market, and derivative market, provide a platform for buying and selling financial assets efficiently. These markets ensure that capital is allocated to its most productive uses by enabling price discovery through the mechanisms of demand and supply. Efficient financial markets stimulate economic growth by providing individuals and corporations with access to capital. For example, the equity market enables companies to raise capital by issuing stocks, while government and corporate bonds in the bond market fund various activities without directly taxing citizens and businesses.

The liquidity provided by financial markets also helps in risk management. Derivatives markets allow businesses to hedge against risks associated with currency fluctuations, interest rates, and other economic variables. This risk mitigation is crucial for stable business planning and investment.

Mobilization of Savings

One of the fundamental aspects of a financial system is its ability to mobilize savings. Financial institutions offer various savings instruments that attract idle funds from individuals and institutions. These savings are then directed towards investment opportunities. Mobilization not only pools financial resources but also facilitates their distribution across the economy, ensuring that these resources are available for productive investment rather than remaining idle.

Investment Facilitation

The efficient facilitation of investment is a direct function of a robust financial system. By providing information, managing risks, and allocating resources efficiently, financial systems lower the cost of capital and reduce the barriers to investment. This environment encourages both domestic and foreign investments, driving economic growth. Moreover, by offering a variety of investment products, financial systems enable diversification, which reduces the risk of investment portfolios and stabilizes the economy.

Technological Advancements and Financial Innovation

Technological advancements have significantly influenced the effectiveness of financial systems. Financial technology (fintech) innovations such as digital banking, mobile money, and blockchain technology have revolutionized traditional financial services, making them more accessible, faster, and cheaper. For instance, mobile money services have dramatically increased financial inclusion in developing countries by providing financial services to people without access to traditional banking facilities.

Additionally, fintech innovations contribute to better financial data management and fraud prevention systems, enhancing the overall health of the financial system. The increased efficiency and security provided by these technological tools support economic growth by building trust and encouraging wider participation in the financial system.

Regulatory Framework and Stability

A sound regulatory framework is essential for maintaining the stability and integrity of the financial system. Regulatory bodies ensure that financial institutions operate in a safe and sound manner, adhering to policies that mitigate risks such as excessive leverage, liquidity crises, and insolvencies. For example, central banks monitor monetary policy and interest rates to control inflation and stabilize the currency, which are vital for economic growth.

Effective regulation also fosters consumer confidence in the financial system, encouraging more active participation in financial activities. It protects investors and consumers from potential losses due to fraudulent activities or unfair practices, further enhancing the system’s stability.

Financial Inclusion

Financial inclusion is a critical aspect that underscores the link between financial systems and economic development. An inclusive financial system ensures that financial services are accessible to all segments of society, including the underprivileged and those living in remote areas. This inclusion supports poverty reduction and wealth equality by providing everyone with opportunities for economic participation and risk mitigation.

Challenges and Recommendations

Despite the significant role of the financial system in economic development, there are challenges that must be addressed to harness its full potential. These include financial crises, which can lead to severe economic downturns, and disparities in financial inclusion. Regulatory challenges also persist, as too stringent regulations might stifle innovation, whereas lax regulations could lead to instability.

To optimize the financial system’s role in economic development, continuous regulatory improvements are necessary to balance stability with innovation. There should also be a concerted effort to enhance financial literacy, which will enable more people to participate effectively in the financial system. Furthermore, leveraging technology to extend financial services, especially in underserved regions, will promote greater financial inclusion and, by extension, economic development.

Management Notes

Indian Financial System Functions

indiafreenotesby indiafreenotes2

Encourage Savings:

Financial system promotes savings by providing a wide array of financial assets as stores of value aided by the services of financial markets and intermediaries of various kinds. For wealth holders, all this offers ample choice of portfolios with attractive combinations of income, safety and yield.

With financial progress and innovations in financial technology, the scope of portfolio choice has also improved. Therefore, it is widely held that the savings-income ratio is directly related to both financial assets and financial institutions. That is, financial progress generally insures larger savings out of the same level of real income.

As stores of value, financial assets command certain advantages over tangible assets (physical capital, inventories of goods, etc.) they are convenient to hold, or easily storable, more liquid, that is more easily encashable, more easily divisible, and less risky.

A very important property of financial assets is that they do not require regular management of the kind most tangible assets do. The financial assets have made possible the separation of ultimate ownership and management of tangible assets. The separation of savings from management has encouraged savings greatly.

Savings are done by households, businesses, and government. Following the official classification adopted by the Central Statistical Organization (CSO), Government of India, we reclassify savers into, household sector, domestic private corporate sector, and the public sector.

The household sector is defined to comprise individuals, non-Government, non-corporate entities in agriculture, trade and industry, and non-profit making organisations like trusts and charitable and religious institutions.

The public sector comprises Central and state governments, departmental and non departmental undertakings, the RBI, etc. The domestic private corporate sector comprises non-government public and private limited companies (whether financial or non-financial) and corrective institutions.

Of these three sectors, the dominant saver is the household sector, followed by the domestic private corporate sector. The contribution of the public sector to total net domestic savings is relatively small.

Risk Function

The financial markets provide protection against life, health, and income risks. These guarantees are accomplished through the sale of life, health insurance, and property insurance policies.

Mobilisation of Savings:

Financial system is a highly efficient mechanism for mobilising savings. In a fully-monetised economy this is done automatically when, in the first instance, the public holds its savings in the form of money. However, this is not the only way of instantaneous mobilisation of savings.

Other financial methods used are deductions at source of the contributions to provident fund and other savings schemes. More generally, mobilisation of savings taken place when savers move into financial assets, whether currency, bank deposits, post office savings deposits, life insurance policies, bill, bonds, equity shares, etc.

Transfer Function

A financial system provides a mechanism for the transfer of resources across geographic boundaries.

Allocation of Funds:

Another important function of a financial system is to arrange smooth, efficient, and socially equitable allocation of credit. With modem financial development and new financial assets, institutions and markets have come to be organised, which are replaying an increasingly important role in the provision of credit.

In the allocative functions of financial institutions lies their main source of power. By granting easy and cheap credit to particular firms, they can shift outward the resource constraint of these firms and make them grow faster.

On the other hand, by denying adequate credit on reasonable terms to other firms, financial institutions can restrict the growth or even normal working of these other firms substantially. Thus, the power of credit can be used highly discriminately to favour some and to hinder others.

Reformatory Functions

A financial system undertaking the functions of developing, introducing innovative financial assets/instruments services and practices and restructuring the existing assets, services, etc, to cater to the emerging needs of borrowers and investors.

Key Points

  • Issuing and gathering of deposits.
  • Supply of loans from the collected pool of money.
  • The undertaking of financial transactions.
  • Boosting the growth of stock markets and other financial markets.
  • Setting up the legal commercial substructure.
  • Provision of monetary and consultative services.
  • Permits portfolio adaptation for existing assets.
  • Allotment of chance and risk.
  • It forges a connection between depositors and investors.
  • Boosts depth and breadth of finances by increasing its horizon.
  • It is responsible for capital creation.
  • Adds time value to assets and money.
  • To set up an entire payment structure and system.
  • Allocate and dissipate the economic resources.
  • To maintain the economic stability in the country and the markets.
  • To create markets that can judge the investment performance.
Management Notes

Weaknesses of Indian Financial System

indiafreenotesby indiafreenotes0

In order to meet the growing requirements of the Government and the industries, many innovative financial instruments have been introduced. Besides, there has been a mushroom growth of financial intermediaries to meet the ever-growing financial requirements of different types of customers. Hence, the Indian financial system is more developed and integrated today than what it was 50 years ago. Yet, it suffers from some weaknesses as listed below:

Dominance of development banks in industrial finance:

The industrial financing in India today is largely through the financial institutions set up by the government. They get most of their funds from their sponsors. They act as distributive agencies only. Hence, they fail to mobilise the savings of the public. This stands in the way of growth of an efficient financial system in the country.

Lack of co-ordination among financial institutions:

There are a large number of financial intermediaries. Most of the financial institutions are owned by the government. At the same time, the government is also the controlling authority of these institutions. As there is multiplicity of institutions in the Indian financial system, there is lack of co-ordination in the working of these institutions.

Unhealthy financial practices:

The dominance of development banks has developed unhealthy financial practices among corporate customers. The development banks provide most of the funds in the form of term loans. So there is a predominance of debt in the financial structure of corporate enterprises. This predominance of debt capital has made the capital structure of the borrowing enterprises uneven and lopsided. When these enterprises face financial crisis, the financial institutions permit a greater use of debt than is warranted. This will make matters worse.

Inactive and erratic capital market:

In India, the corporate customers are able to raise finance through development banks. So, they need not go to capital market. Moreover, they do not resort to capital market because it is erratic and inactive. Investors too prefer investments in physical assets to investments in financial assets.

Monopolistic market structures:

In India some financial institutions are so large that they have created a monopolistic market structures in the financial system. For instance, the entire life insurance business is in the hands of LIC. The weakness of this large structure is that it could lead to inefficiency in their working or mismanagement. Ultimately, it would retard the development of the financial system of the country itself.

High Rate of Interest:

There is a possibility of the high-interest rate charged by several financial institutions in the financial system of our country. Various institutions due to their monopolistic structure in the market may charge high or unfair interest rates.

Other factors:

Apart from the above, there are some other factors which put obstacles to the growth of Indian financial system. Examples are:

a. Banks and Financial Institutions have high level of NPA.

b. Government burdened with high level of domestic debt.

c. Cooperative banks are labelled with scams.

d. Investors confidence reduced in the public sector undertaking etc., e. Financial illiteracy.

error: Content is protected !!