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.

Financial “products” or “instruments” are contracts that can be negotiated on capital markets. There are several ways to classify such products. The approach taken in this website is to focus on the technical characteristics of such instruments. However, we also present an alternative classification based on market segment which more closely reflects economic realities.

Technical viewpoint: Securities / balance sheet transactions / derivatives

Securities

Securities cover all direct financing instruments of companies, banks, states or public entities. A security represents a share of a medium or short-term (Medium term note, commercial paper) claim or long term claim (bonds), or a share in the capital of a company (equities or shares). For the issuer of the security, it is a financing instrument and for the buyer an investment instrument. Securities can be traded over the counter or through organised markets (such as the NYSE or Euronext) in variable amounts, either whole numbers (shares), decimals (certain shares in UCITS) or nominal amounts for bonds. Securities are negotiable instruments, in other words they can change hand after they have been issued on what is called the secondary market, provided of course that a counterparty exists for the exchange. In this section we will deal with related subjects such as securitisation and corporate actions.

Balance sheet transactions

Balance sheet transactions include all transactions involving an immediate or deferred recognition in the balance sheet of operators (purchase/sale transactions or issuance of securities, but we have chosen to isolate the “securities” section given the extent of the subject…). Loans/cash borrowings, uncovered or guaranteed by collateral (repos) represent the simplest element as basically simply cash loans or borrowings. Currency transactions concern currency markets and cover purchase/sale transactions in currencies, either spot or futures. These products are only traded over the counter.

Derivatives

Derivative products include all transactions generally referred to as “off-balance sheet” as not recorded in the balance sheet of the financial institution. They are referred to as “derivative” because they have been developed from or in some way “out of” basic financial instruments. As the imagination of markets is limitless, the number and variety of such products is practically infinite and it is therefore difficult to make an exhaustive presentation. In addition, derivative products usually mix various types of basic asset: equities and bonds, currencies and interest rates. Derivative products are traded on organised markets (options markets and futures markets) or over the counter: interest rate swaps, credit derivatives, FRAs.

Risk approach: classification by economic characteristic

A presentation that is closer to economic reality consists in classifying products by market or by the type of risk traded.

Interest-rate products

Interest-rate products include all those whose income and valuation depends on an interest-rate and which therefore fluctuate according to market rates. The associated risk is an interest-rate risk. In this category can be found securities representative of claims such as bonds and MTNs, cash loans and borrowings, repos and derivative products whose underlying asset is interest-rate sensitive: interest-rate swaps, FRAs, interest-rate futures, interest-rate options and caps and floors etc.

Equities

The equity and equity derivatives markets are based on securities (shares, investment securities and hybrid securities) which represent a share in the capital of a company or which provide access in the case of hybrids (convertible bonds, bonds with equity warrants). Equities can change hand through purchase and sale transactions but also temporarily through the lending/borrowing of securities. Equity derivatives (futures, options and warrants) facilitate hedging transactions or enable investors to take a position on market fluctuations or associated equity risk.

Foreign exchange

The forex market (or foreign exchange market) is the place where spot or term trading of currencies occurs. In this market, prices, i.e. the currency exchange rate, can fluctuate very rapidly. FX options and futures enable operators to hedge against currency fluctuations, in other words to hedge FX risk. Traders specialised in currency transactions are called forex brokers.

Credit derivatives

Credit derivatives enable operators to take a position (speculation or hedging) vis-a-vis the credit risk of a company, country or market sector.

Commodities

Commodities are raw materials traded spot or more frequently derivative products (futures) traded on international markets.

Structured products

Shares in funds, asset-backed securities (ABS) and other structured products are composite products that are difficult to classify in a particular category. In the case of an ABS or CDO, for example, the main risk is related to securitised assets and can take many forms. Furthermore, if the structure includes a CDS or a guarantee provided by a monoline insurance company, the quality of the security also depends on the CDS underlying risk or the guarantor. Such instruments, by their nature composite, cannot like the others be assimilated to a specific economic risk.

A financial intermediary is an entity that facilitates a financial transaction between two parties. Such an intermediary or a middleman could be a firm or an institution. Some examples of financial intermediaries are banks, insurance companies, pension funds, investment banks and more.

One can also say that the primary objective of the financial intermediaries is to channel savings into investments. These intermediaries charge a fee for their services.

Examples of Financial Intermediaries

Bank: These intermediaries are licensed to accept deposits, give loans and offer many other financial services to the public. They play a major role in the economic stability of a country, and thus, face heavy regulations.

Mutual Funds: They help pool savings of individual investors into financial markets. A fund manager oversees a mutual fund and allocates the funds to different investment products.

Financial advisors: Such intermediaries may or not offer a financial product, but advises investors to help them achieve their financial objectives. These advisors usually undergo special training.

Credit Union: It is also a type of bank, but works to serve its members and not public. They may or may not operate for profit purposes.

Other financial intermediaries are pension funds, insurance companies, investment banks and more.

Functions of Financial Intermediaries

A financial intermediary performs the following functions:

• As said before, the biggest function of these intermediaries is to convert savings into investments.
• Intermediaries like commercial banks provide storage facilities for cash and other liquid assets, like precious metals.
• Giving short and long-term loans is a primary function of the financial intermediaries. These intermediaries accept deposits from the entities with surplus cash and then loan them to entities in need of funds. Intermediaries give the loan at interest, part of which is given to the depositors, while the balance is retained as profits.
• Another major function of these intermediaries is to assist clients to grow their money via investment. Intermediaries like mutual funds and investment banks use their experience to offer investment products to help their clients maximize returns and reduce risks.

Advantages of Financial Intermediaries

• They help in lowering the risk of an individual with surplus cash by spreading the risk via lending to several people. Also, they thoroughly screen the borrower, thus, lowering the default risk.
• They help in saving time and cost. Since these intermediaries deal with a large number of customers, they enjoy economies of scale.
• Since they offer a large number of services, it helps them customize services for their client. For instance, banks can customize the loans for small and long term borrowers or as per their specific needs. Similarly, insurance companies customize plans for all age groups.
• They accumulate and process information, thus lowering the problem of asymmetric information.

When most people hear about Social Security benefits, they think of retirement benefits. In fact there are many types of Social Security benefits that a wide variety of people are eligible for.

Retirement Benefits

About 71% of people receiving Social Security benefits do so as retirees. Retirement benefits are available for people who are at least age 62 and have worked enough in their lifetime to become eligible. To be eligible, you must have earned at least 40 work credits. 4 credits are available each year that you work (in 2015, 1 credit is available for every $1220 in earnings). Although you can begin collecting partial benefits at 62, maximum benefits are not available until age 70, so it is important to understand the benefit amounts and make an educated decision. The amount of your benefit is based on an average of your earnings in the 35 years in which you worked the most, but there is a cap on how much you can receive.

Social Security benefits eligibility for the spouse of a living retired worker occurs if the spouse is at least 62 years old, has a child who is under age 16, or a child who is disabled. Divorced spouses are entitled to collect retirement benefits through their former spouses if the marriage lasted at least 10 years, they’ve been divorced at least 2 years, and have not remarried. Spouse can receive up to half of the amount the worker receives or their own SSI benefit, whichever is higher. Note that the spouse’s benefit does not come out of the worker’s benefit. It is a separate amount.

Survivor Benefits

The Social Security death benefit is a one-time payment of $255 that may be available to the spouse and children of a deceased worker. Ongoing survivor benefits are payable to the family of a worker who is deceased in the following situations. The spouse can collect SSI if he or she is at least 60 years old, if he or she is disabled and at least age 50, or if he or she is the parent of a child younger than 16 or a disabled child. Spouses receive either their widow/er payment (which may be 100% of the spouse’s amount if the survivor waits to claim it at full retirement age) or their own SSI payment, whichever is higher. The parent of a deceased worker is also eligible for a Social Security benefit if the parent is at least age 62 and was dependent on the worker for at least 50% of his or her support.

There are also Social Security benefits for children (including adopted children or dependent stepchildren) of a deceased worker. Children are eligible for benefits if they are under 18, under 19 and still in high school, or an adult who was disabled before reaching the age of 22.

Disability Benefits

Social Security is not just for retired people. Social Security disability benefits are available for people who have been working but become disabled and unable to work. If you are under 24 when you become disabled, you must have worked one and a half years during the three years before your disability began. For people over age 24, there must be a medical condition that is severe. The disability must be on is on the Social Security impairment list, the person must be unable to do any of their previous jobs, or be unable to any other job they qualify for. The disability must last, or expect to last, at least one year.

There are also benefits available for the spouse and child of a disabled worked. A spouse is eligible if he or she is at least 62, has a child under age 16 or a disabled child, or is divorced but was married to the worker for 10 years. Children (including adopted children or dependent stepchildren) of disabled workers are also eligible if they are under 18, under 19 and still in high school, or are adults who were disabled before age 22.

Supplemental Security Income Benefits

Another special category of benefits is provided for people who are aged (age 65 or older), blind, or disabled and who have limited income and resources. To find out if you or a family member is eligible use the online screening tool.

Social Security in India

In India, the modern social security measures were planned and implemented after independence. They were too meagre and limited to the organized sector workers only, which constituted about 8 per cent of the total workforce, despite a majority of the workforce (about 93% in 2004-05) comes in the unorganized sector (self-employed or casual workers).

Importantly, the need to ensure social security for all, especially those in the unorganized sector, is an overarching concern recognized in the Eleventh Five-Year Plan (2007-12). The Constitution of India provides strength and spirit to the social security for organized and unorganized workers through its Directive Principles of the State Policy.

Social security legislations came into existence as a part of indus­trial policy after large-scale industrialization. Some social security benefits in the form of Acts for the organized workers working in the big industrial units (factories, mills, etc.) were also enacted during the British period. But major social legislations were passed only after independence.

The important social legislations and social security measures relating to industrial workers may be cited as under:

1. The Workmen’s Compensation Act, 1923
2. Provident Funds and Miscellaneous Provisions Act, 1952
3. The Employees State Insurance (ESI) Act, 1948
4. The Maturity Benefit Act, 1961 (amended in 1976)
5. The Payment of Gratuity Act, 1972
6. Universal Contributory Health Insurance Act, 2004
7. The Aam Admi Bima Yojana, 2008
8. The National Health Insurance Scheme, 2007
9. The Indira Gandhi National Old Age Pension Scheme

To mention a few, followings are the ameliorative programmes and schemes for the tribals, rural and urban poor:

1. Five-Year Plans and Community Development Projects (CDPs)
2. Food for Work and Antyodaya Yojana, 1977
3. Integrated Rural Development Programme (IRDP), 1976
4. National Rural Employment Programme (NREP), 1977
5. Jawahar Rojgar Yojana (JRY), 1980
6. Mahatma Gandhi National Rural Employment Guarantee Scheme (MNREGS), 2006
7. Integrated Tribal Development Plan
8. Swarna Jayanti Gram Swrozgar Yojana, 1999
9. Swarna Jayanti Shahri Swarozgar Yojana
10. Sarva Shiksha Abhiyan, 2001
11. Indira Awas Yojana
12. Rajiv Awas Yojana, 2009
13. Pradhan Mantri Gram Sadak Yojana
14. Bharat Nirman, 2005
15. Jnanani Suraksha Yojana, 2011
16. Pradhan Mantri Swastha Surksha Yojana
17. Total Sanitation Programme or Nirmal Bharat Abhiyan, 2012

Thus, while a large proportion of the organized sector workers have been be benefiting from legally mandated and budget-provided social security benefits since independence, but most of the workers in the unorganized sector have been left out (only less than 10% of the total unorganized were benefited).

According to the World Labour Report, 2000, the public sector expenditure on social security in India was as meagre as 1.8 per cent of the GDP, whereas it was 4.7 per cent in Sri Lanka and 3.6 per cent in China. The eligibility criterion is also too tight as the exclude many a vulnerable persons.

The below poverty line (BPL) criterion is a minimalist and inappropriate approach to extend social security to the unorganized workers. About 55 per cent of the population though not comes in the category of the poor in India but is vulnerable. Not only this, most of the unorganized workers suffer from the lack of awareness about social security and social welfare measures.

It has been argued that globalization has adversely affected social welfare programmes of the state. The state often promotes rather than accepts global­ization. This is why it is bound to impact on the policy regime and welfare character of the state.

Social welfare and social security are intimately linked up but they are pursuing different ends. Social security refers to a state of mind as well as an objective fact. It is mainly directed towards providing income security as a preliminary to a state of social and psychological well-being.

Social welfare, on the other hand, is broadly understood as ‘the end product of possession of goods, positions in life and supply of services to help him to live in wholesome contentment and communication with others in the group’.

Narrowly speaking, social welfare refers to a set of institutional or personal services provided either by the state or voluntary organizations to prevent the incidence or to reform or rehabilitate the victims of disabilities, or disorgani­zation or delinquencies or destitution and so on.

Bureaucracy in business is a hierarchical organization or a company that operates by a set of pre-determined rules. In a large business, there are typically several diverse functions that need to be performed by specialized sub-institutions that report up the management chain.

A small business can operate under rules that managers create as they go along and do not necessarily need a written set of policies. A small number of employees can manage all of the necessary tasks without much diversification. However, once a small business grows to a certain size, its functioning will rely increasingly on assigning responsibilities on a formal basis to various employees. Additionally, a larger company will need to write rules that apply to every function the business takes on, from internal rules for compensation to external policies for deciding how to manage customer returns.

A bureaucracy allows such a large business to create a set of rules. Bureaucratic organizations have an organizational chart for each department that delineates responsibilities and functions. Bureaucracies also establish a protocol for decision-making.

Business bureaucracies are typically made up of several layers of management. The chief executive officer or president is typically at the top of the organization. Vice presidents report to the CEO or president, and directors report to the vice presidents. Below the directors, employees report to supervisors, who report to managers. Managers, in turn, report to the directors.

Whether you are just starting out in an entry-level role or are moving up to become a manager, understanding business bureaucracy can help you better understand your workplace and advance your career. You can use the benefits of bureaucracy to create a fair working environment, institutionalize your company’s rules, improve processes and facilitate transparency. In this article, we explain the key characteristics of business bureaucracy and the pros and cons of bureaucracy in business.

Business bureaucracy

Bureaucracy in business is a hierarchical organization or a company that operates by a set of pre-determined rules. In a large business, there are typically several diverse functions that need to be performed by specialized sub-institutions that report up the management chain.

A small business can operate under rules that managers create as they go along and do not necessarily need a written set of policies. A small number of employees can manage all of the necessary tasks without much diversification. However, once a small business grows to a certain size, its functioning will rely increasingly on assigning responsibilities on a formal basis to various employees. Additionally, a larger company will need to write rules that apply to every function the business takes on, from internal rules for compensation to external policies for deciding how to manage customer returns.

A bureaucracy allows such a large business to create a set of rules. Bureaucratic organizations have an organizational chart for each department that delineates responsibilities and functions. Bureaucracies also establish a protocol for decision-making.

Business bureaucracies are typically made up of several layers of management. The chief executive officer or president is typically at the top of the organization. Vice presidents report to the CEO or president, and directors report to the vice presidents. Below the directors, employees report to supervisors, who report to managers. Managers, in turn, report to the directors.

Four key characteristics of a bureaucracy

You can recognize a business bureaucracy by four key characteristics:

1. A clear hierarchy

Business bureaucracies have a clearly laid out chain of command that is understood by every employee. Decision-making power flows from the top of the organization. Not unlike a beehive, where each worker bee has its place below the queen bee, each employee has a particular place in a business bureaucracy.

2. Specialization

Each member of a bureaucracy has a specific role, from finance or accounting to sales or marketing. Each employee is aware of their role and develops expertise that is specific to their job.

3. A division of labor

Each task is divided into its component parts in a bureaucracy. The specialization of roles reflects this division of labor. Different departments and individual employees contribute to various parts of the business’s overall task, whether that is producing and selling a product or providing a service.

4. A set of formal rules

Business bureaucracies have standard operating procedures that provide written guidance for each role within the hierarchy. Written instructions provide job descriptions for each employee as well as other rules within the business, such as the conditions of employment. The written regulations should be unambiguous to ensure that each employee understands their role.

Pros and cons of bureaucracy in business

In many forms, business bureaucracy can be a helpful tool that can be refined over time. Some common advantages of bureaucracy include:

1. Bureaucracy centralizes power

This allows each employee to have defined rules for their work. There is a measure of equality among employees at each level, which minimizes confusion about who is in charge of any given decision or outcome. Additionally, this form of organization encourages specialization by clearly defining each employee’s role. This allows employees to develop expertise and knowledge in their area while helping the business to become more efficient as well. Bureaucracies inevitably become more complex as the scale and complexity of an organization get larger to manage this increasing complexity effectively.

2. Bureaucracies promote impartiality and fairness

They provide mechanisms for resolving workplace disputes and apportioning tasks and help avoid the duplication of labor by promoting specialization. The rules established by a bureaucracy discourage favoritism and can protect employees from a supervisor who might otherwise exercise their discretion unfairly.

3. Bureaucracy protects employees

Its rules can help protect employees from workplace health and safety hazards and poor employment practices. When each employee is covered by the same, clearly defined employment practices and rules, the system feels fairer to all employees. By doing so, bureaucracies encourage a positive company culture, which can in turn increase employee satisfaction, productivity and retention rates. Put simply, bureaucracies help make a business a better place to work.

4. Bureaucracies help to create best practices

By promoting such best practices in written rules and creating a corporate structure, bureaucracies create predictable outcomes and can save time and resources when they are appropriately followed. In addition to these benefits, the bureaucratization of business can also present significant cons that can hinder employee output and create other problems:

5. Bureaucratic rules and structures can be backward-looking

Bureaucracies identify SOPs that worked well in the past, but not necessarily ones that will work well in the future or identify areas where processes might be improved. They can therefore inadvertently hinder innovation by making businesses less agile and reducing operational efficiency. For example, an overly-rigid bureaucracy can make it difficult to fire a poor performer due to an arduous termination process.

6. Bureaucracies can hinder transparency

Unless you are at the top of the organizational structure, in a large business, you likely will not have access to senior decision-making processes—even if you are in a supervisory role. This could mean that you are unaware of major decisions, such as an upcoming merger or restructuring.

7. Bureaucracies tend to have extensive rules or policies

These can sometimes seem useless, overly onerous or misguided. If you work at a large company, your company handbook likely includes any useful policies, from office dress code to expected behavior and responsibilities. However, there are also likely a few policies that appear unnecessary or unfair, such as a seemingly challenging process for requesting paid time off.

8. Bureaucracies can minimize freedom

Bureaucratic processes can restrict the ability that any individual employee has to act independently or make decisions without approval from above. Even if it seems like the right thing to do, an employee may not be able to decide because they could face bureaucratic consequences, such as a reprimand or even termination, or because the process of getting approval is too time-consuming.

9. Bureaucracies can be sources of inefficiency

For example, employees at a certain level might receive fixed salaries and benefits and work to complete the same tasks. While this makes the compensation scale more fair for everyone, it can make positions without a near-term prospect for promotion feel like a dead end. Additionally, these inefficiencies can be difficult to alter. Even as the market evolves and business conditions change, a bureaucracy may struggle to stay updated. This can mean that inefficiencies are further institutionalized over time.

How to minimize unnecessary bureaucracy in business?

Some forms of bureaucracy are helpful, if not vital, to organizing a business, while others can impede the work of an organization. Once you have identified which elements of bureaucracy are useful and which are not, you can implement the following steps to minimize unnecessary bureaucracy in your team or organization:

1. Keep your goals in mind

Business bureaucracy can be inefficient when employees become overly-focused on processes rather than results. Instead of focusing on completing procedures at the expense of being productive, try to find the shortest or most efficient route to achieving your goals.

2. Make your priorities clear

This can help you navigate bureaucracy at work. While having meetings and completing paperwork may be part of your everyday tasks in the office, your actual job priority is probably something else, whether that is writing code, making sales or crunching numbers. Prioritize these tasks so you can avoid doing bureaucratic functions at the expense of your actual job.

3. Eliminate unnecessary paperwork

Creative solutions can help you avoid tedious bureaucratic work. For example, instead of filling out the same information on different forms, you might create an automated way to store this information and insert it automatically into a document. Thinking creatively can help you cut down on time doing tasks that are not particularly productive. Additionally, look for other routine processes that could be streamlined or eliminated.

4. Empower your employees

Management roles can help cut out unnecessary bureaucracy by empowering their employees. Teams can slow down their productivity if they have to wait for permission from their supervisor for every task. Instead, give your employees clear instructions, room to work and the authority to make less critical decisions independently. You can further facilitate your team’s independence by looking for action-oriented people to hire.

5. Reward your team

Praising team members for taking action is another way to keep them working productively and avoid becoming mired in bureaucracy. Rewards from simple praise to promotions and bonuses can be distributed to employees who take the initiative and proactively work to streamline processes. These rewards are a signal to your team and the company that you value action more than bureaucratic processes at the expense of productivity.