Tag: Financial Institutions and Markets BMS Notes

The Financial Sector Legislative Reforms Committee (FSLRC) set up two years ago to rewrite and review financial sector laws that have become outdated submitted its final report to the finance ministry in March 2013. The Committee has recommended various proposals to protect consumers against mis-selling and fraud. It also suggested proposals for development of the financial sector in India.

The Financial Sector Legislative Reforms Commission (FSLRC) is a body set up by the Government of India, Ministry of Finance, on 24 March 2011, to review and rewrite the legal-institutional architecture of the Indian financial sector. This Commission is chaired by a former Judge of the Supreme Court of India, Justice B. N. Srikrishna and has an eclectic mix of expert members drawn from the fields of finance, economics, public administration, law etc.

Based on substantive research, extensive deliberations in the Commission and in its Working Groups, interaction with policy makers, regulators, experts and stakeholders; the Commission has evolved a tentative framework on the legal–institutional structure required for the Indian financial sector in the medium to the long run. The broad contour of that framework is outlined in the released by the Commission on 4 October 2012.

Based on further feedback on the proposals from stakeholders and deliberations thereon, the FSLRC proposes to complete its Report by March 2013.

Purpose of formation

FSLRC was formed as most legal and institutional structures of the financial sector in India had been created over a century. Many financial sector laws date back several decades, when the financial landscape was very different from that seen today.

There are over 61 Acts and multiple rules and regulations that govern the financial sector. For example, the SEBI (Securities and Exchange Board of India) Act does not give the regulator powers to arrest anyone but tasks it with penalising all market related crimes stiffly. The Reserve Bank of India (RBI) Act and the Insurance Act are of 1934 and 1938 period, respectively.

 The Commission was formed to review and recast these old laws in tune with the modern requirements of the financial sector. FSLRC plans to eliminate 25 of the current 61 laws that currently govern the financial sector and amend many others.

Objectives

The Terms of Reference of the Commission include the following:

• Examining the architecture of the legislative and regulatory system governing the Financial sector in India
• Examine if legislation should mandate statement of principles of legislative intent behind every piece of subordinate legislation in order to make the purposive intent of the legislation clear and transparent to users of the law and to the Courts.
• Examine if public feedback for draft subordinate legislation should be made mandatory, with exception for emergency measures.
• Examine prescription of parameters for invocation of emergency powers where regulatory action may be taken on ex parte basis.
• Examine the interplay of exchange controls under FEMA and FDI Policy with other regulatory regimes within the financial sector.
• Examine the most appropriate means of oversight over regulators and their autonomy from government.
• Examine the need for re-statement of the law and immediate repeal of any out-dated legislation on the basis of judicial decisions and policy shifts in the last two decades of the financial sector post-liberalisation.
• Examination of issues of data privacy and protection of consumer of financial services in the Indian market.
• Examination of legislation relating to the role of information technology in the delivery of financial services in India, and their effectiveness.
• Examination of all recommendations already made by various expert committees set up by the government and by regulators and to implement measures that can be easily accepted.
• Examine the role of state governments and legislatures in ensuring a smooth interstate financial services infrastructure in India.
• Examination of any other related issues.

Consumer protection

According to FSLRC, all financial laws and regulators are intended to protect the interest of consumers. Hence, a dedicated forum for relief to consumers and detailed provisions for protection of unwary customers against mis-selling and defrauding by smaller print etc has been recommended.

The FSLRC report proposes certain basic rights for all financial consumers. For lay investors, the report proposes additional set of protections. The Commission has recommended some amendments to existing laws and new legislations. These changes will have to be carefully brought about accordingly.

Some basic protections consumers would expect include that financial service providers must act with due diligence. It is essential to protect investors against unfair contract terms, unjust conduct and protection of personal information. The FSLRC report also recommends fair disclosure and redressal of investor complaints by financial service providers.

Financial Regulatory Architecture Act

The proposed regulatory structure will be governed by the Financial Regulatory Architecture Act that will ensure a uniform legal process for the financial regulators. The finance ministry will unify the regulatory structure before tweaking the legislative structure. It may take two years for the report to be implemented in a phased manner.

Banking

The Reserve Bank of India is the nerve centre of the monetary system of the country. It is the Central Bank of the country and it started operating since April 1, 1935 subsequent to the RBI Act in 1934 under private shareholders’ institutions.

The Central Government is now empowered to appoint Directors, Deputy Governors and Governors of the bank. The position of the bank is that it is a State-owned institution. This transfer to public ownership from private shareholders’ institution came with the RBI Act in 1948.

The Reserve Bank of India is empowered to control, regulate, guide and supervise the financial system of the country through its monetary and credit policies. This authority was derived from the various acts. These are RBI in 1934, Banking Regulations Act 1949, Companies Act 1956, Banking Laws Act 1965 (applicable to co-operative societies), and Banking Laws Act 1963.

The Reserve Bank of India has several functions to perform. Traditionally, it is the bankers’ bank, and banker to State and Central Governments. It is also a banker to the commercial banks, State co-operative banks and financial institutions of the country. It is the only bank engaged in the issue of legal tender currency.

It provides long-term credit:

(a) By subscribing to debentures of Land Development Banks,

(b) By operating the National Agricultural Credit Fund,

(c) National Agricultural Credit (Stabilisation) Funds (long-term operation fund),

(d) It has also established the Agricultural Refinance Corporation through which it gives long-term and medium-term funds.

Non-banking

The non-banking financial institutions are the organizations that facilitate bank-related financial services but does not have banking licenses.

Types

Mutual Funds

• Mediators between people and stock exchange
• Money collected from people by selling their units is called the corpus
• Oldest Mutual Fund company in India is UTI (Unit Trust of India)
• Mutual Funds nearly provides all the considerations

Insurance Companies

• Collect money from the public through the sale of insurance policies
• There are two types of Insurance; Life Insurance and General Insurance
• General Insurance includes Loss of property, car, house etc.
• It also includes Health Insurance

Hedge Funds

• These are mutual funds for rich investors
• Funds are raised through the sale of their unit to High net worth Individuals and Institutional Investors
• Units of these are usually sold in chunks/groups
• There is a lock-in period for Hedge funds before which funds cannot be withdrawn
• Corpus is an investment in risky instruments with a long term perspective

Venture Capital Firms/ Companies

• They provide finance and technical assistance to firms which undertake a business project based on innovative ventures
• They provide finance for the commercial application of new technology

Merchant banks ( Investment Banks)

• Merchant banks provide financial consultancy services
• They advise firms on fundraising, manage IPO of firms, underwrite new issues and facilitate demat trading.

Finance Companies (Loan Companies)

• Financial Institutions raise funds from the public for lending purpose

e.g. – Muthoot Finance, Cholamandalam

Micro Finance Institutions (MFI)

• Raise funds from the public for lending to weaker sections
• In India, they mainly raise funds from banks

e.g. – Basix, Bandhan, SKS Micro Finance.

Vulture Funds

• These funds buy stocks of companies which are nearing bankruptcy at a very low price.
• After purchasing such stocks they initiate the recovery process to increase the price of shares and sell it at a later point of time

Islamic Banks

• These banks provide loans on the basis of Islamic laws called Sharia.
• In the law of Sharia Interest cannot be charged on the loans

Leasing Companies

• They purchase equipment and machinery and provide the same to companies on a lease.
• These companies charge rent on these machineries which is similar to EMI

Microfinance is the provision of financial services to low-income clients or solidarity lending groups including consumers and the self-employed, who traditionally lack access to banking and related services. It is not just about giving micro credit to the poor rather it is an economic development tool whose objective is to assist poor to work their way out of poverty. It covers a wide range of services like credit, savings, insurance, remittance and also non-financial services like training, counseling etc.

Microfinance is a category of financial services targeting individuals and small businesses who lack access to conventional banking and related services. Microfinance includes microcredit, the provision of small loans to poor clients; savings and checking accounts; microinsurance; and payment systems, among other services. Microfinance services are designed to reach excluded customers, usually poorer population segments, possibly socially marginalized, or geographically more isolated, and to help them become self-sufficient.

Microfinance initially had a limited definition: the provision of microloans to poor entrepreneurs and small businesses lacking access to credit. The two main mechanisms for the delivery of financial services to such clients were:

(1) Relationship-based banking for individual entrepreneurs and small businesses.

(2) Group-based models, where several entrepreneurs come together to apply for loans and other services as a group. Over time, microfinance has emerged as a larger movement whose object is: “a world in which as everyone, especially the poor and socially marginalized people and households have access to a wide range of affordable, high quality financial products and services, including not just credit but also savings, insurance, payment services, and fund transfers.”

Microfinance Institutions (MFIs) in India exist as NGOs (registered as societies or trusts), Section 25 companies and Non-Banking Financial Companies (NBFCs). Commercial Banks, Regional Rural Banks (RRBs), cooperative societies and other large lenders have played an important role in providing refinance facility to MFIs. Banks have also leveraged the Self-Help Group (SHGs) channel to provide direct credit to group borrowers.

Proponents of microfinance often claim that such access will help poor people out of poverty, including participants in the Microcredit Summit Campaign. For many, microfinance is a way to promote economic development, employment and growth through the support of micro-entrepreneurs and small businesses; for others it is a way for the poor to manage their finances more effectively and take advantage of economic opportunities while managing the risks. Critics often point to some of the ills of micro-credit that can create indebtedness. Due to diverse contexts in which microfinance operates, and the broad range of microfinance services, it is neither possible nor wise to have a generalized view of impacts microfinance may create. Many studies have tried to assess its impacts.

New research in the area of microfinance call for better understanding of the microfinance ecosystem so that the microfinance institutions and other facilitators can formulate sustainable strategies that will help create social benefits through better service delivery to the low-income population.

Microfinance and poverty

In developing economies, and particularly in rural areas, many activities that would be classified in the developed world as financial are not monetized: that is, money is not used to carry them out. This is often the case when people need the services money can provide but do not have dispensable funds required for those services. This forces them to revert to other means of acquiring the funds. In their book, The Poor and Their Money, Stuart Rutherford and Sukhwinder Arora cite several types of needs:

• Lifecycle Needs: Such as weddings, funerals, childbirth, education, home building, holidays, festivals, widowhood and old age
• Personal Emergencies: Such as sickness, injury, unemployment, theft, harassment or death
• Disasters: such as wildfires, floods, cyclones and man-made events like war or bulldozing of dwellings
• Investment Opportunities: Expanding a business, buying land or equipment, improving housing, securing a job, etc.

The obstacles or challenges in building a sound commercial microfinance industry include:

• Inappropriate donor subsidies
• Poor regulation and supervision of deposit-taking microfinance institutions (MFIs)
• Few MFIs that meet the needs for savings, remittances or insurance
• Limited management capacity in MFIs
• Institutional inefficiencies
• Need for more dissemination and adoption of rural, agricultural microfinance methodologies
• Members’ lack of collateral to secure a loan

Small Business Model

This model places a big responsibility on small and medium enterprises. With the struggling informal sector, the SMEs can play a significant role in generating employment for the poor by providing training and options to increase their income. The government to strengthen the SMEs is doing direct and indirect interventions in the form of providing training, technical advice and enabling policy and market environment. Microcredit is the critical component, which is being provided to the SMEs, either directly or as a part of larger enterprise development Programme.

ROSCA Model or Chit Funds

Rotating Savings and Credit Associations are a means to save and borrow simultaneously. These are a group of members who make a regular fixed cyclic contribution into a common fund. At the end of a cycle, the total fund collected goes to any one member. Chit Funds are the equivalents of ROSCA in India. It addresses the need to fill the gap left by traditional banking. Easy accessibility and flexibility are the key features here. There are lakhs of ROSCA functioning in India today.

Village Based Model

Closely related to community banking and Group model, this too is community-based saving and credit model. A group of 25-50 people gets together to enhance their income through self-employment activities. They get their first loan from the implementing agency, which helps them form the community credit enterprise. They choose the members, elect their office bearers, establish their bylaws, distribute loan to the individuals and collect savings and payments. The only collateral they work with is the trust. The group stands behind the individual as collateral. NGO Model

NGOs are one of the key players in the field of micro financing. They help the cause of micro financing by playing the intermediary in multiple dimensions. They are instrumental in starting various microcredit programs and improving the credit ratings of the poor. They conduct training programs and workshops to create the opportunity to learn about micro financing. They act as a supporter for the borrower group as well as the promoters for the lending institution. Various NGOs are helping the cause of micro financing. For example, MYRADA in Karnataka, SHARE in Andhra Pradesh, RDO (Rural Development Organization) in Manipur, RUDSOVAT (Rural Development Society for Vocational Training) in Rajasthan and ADITHI in Bihar.

Individual Banking Model

Individual banking model is a shift from the group-based model. The MFI gives loans to an individual based on his or her creditworthiness. It also assists in skill development and outreach programmes. This model suits product-oriented small businesses. Co-operative banks, Commercial banks and Regional Rural Banks mostly adopt this model to give loans to farming and non-farming unorganised sector.

Intermediary Model

This model positions a third party between the lending institutions and the borrowers. These third parties are a part of a local community with information about the creditworthiness of the borrowers. They can be local moneylenders, NGOs, microcredit programmes or commercial banks for government-sponsored programmes. The credit-giving institutions could be the government agencies, commercial banks or even international donors. The intermediaries are incentivised in monetary and non-monetary forms.

Credit Unions Model

This model is based on credit union which is member driven, self-help financial institution. A union of members is formed. These members are from the common community. They agree to save together and give loans to each other at a nominal rate of interest. Compared to co-operative banks, credit unions are a democratic, non-profit financial co-operative.

Bank Guarantee Model

Bank Guarantee Model involves borrowing from a commercial bank. When an individual or a self-formed group goes to the commercial bank for credit, the bank needs collateral. This collateral comes from a Bank Guarantee, which is provided for the borrower either by external agents (donations or government agency) or internally using its member savings. The guaranteed funds can be used for various purposes such as loan recovery or insurance claims. Several international and UN organisations have been creating the guarantee funds that banks can subscribe to. Bellwether Microfinance Funds (India) is one such example.

Grameen Banking Model

A brainchild of Professor Muhammad Yunus, founder of the Grameen Bank in Bangladesh, this model works on the concept of joint liability. It promotes credit as a human right and is based on the premise that the skills of the poor are underutilized. A center is formed with limited people, and the loan is given to few people in the center.

Co-operative Model

Co-operative model is like Association and Community model except for the fact that their ownership structure doesn’t involve the poor. It’s an autonomous association of the people who voluntarily get together to work towards their common social, economic and cultural needs. The members are the shareholders and have their share in equity capital. They also share the profit. These co-operative institutions utilise the local resources and are instrumental in mobilising the micro-savings and microlending. The peer pressure ensures savings and the creditworthiness depend on the savings. Co-operative Development Forum Hyderabad is a successful example of this model. It has built a network of women thrift groups and men thrift groups. This model creates sustainable local prosperity.

Community Banking Model

This is a more formal version of association model. It treats the whole community as a unit. Microfinance is disbursed through semi-formal or formal institutions depending on the location. Sometimes a semi-formal institution governed by the community is formed with the help of external help such as NGOs who train the community members in various financial activities of community banking. These institutions have saving components as well as income generating projects. Thus, the internal financial capacity of the group is developed. It is further classified into Community Managed Loan Funds (CMLF) and Village Savings and Loan Associations (VSLA). A successful example is Royal Bank of Scotland (RBS) Foundation India, which has various microfinancing programmes to help the poorest communities across India.

Association or Group Model

Over 10-20 members of a target community form a group or association based on gender, religion, political or the cultural orientation of its members. The group makes regular savings of fixed amount in a common fund. After the successful working of the group for some months, this group is linked to a financial institution. The institution then lends credit to the association. The group is then responsible for repayment. This model takes advantage of social ties, peer monitoring and peer pressure for repayment of the loan.

In India, the Self-Help Group-Bank Linkage Program (SHG-BLP) is a prominent credit delivery method. All SHG-BLP come under NABARD (National Bank for Agriculture and Rural Development). According to NABARD, the SHG-BLP is the world’s largest microfinance programme in the world.

Reserve Bank of India is the biggest regulator of the Indian markets. It controls the monetary policy of India. Its control is however limited to the organised part of economy and the unorganised sector which has a significant presence is largely unregulated. RBI frequently introduces many reforms to bolster the Indian economy which is in a state of constant flux and is continuously evolving.

The bill market scheme was one very important step. But the Indian money market is still centred on the call money market although efforts have been made to develop secondary market in post 1991 period.

The major money market reforms came after the recommendations of S. Chakravarty Committee and Narsimham Committee. These were major changes which helped unfold the banking potential of India and shape our financial institutions to world class standards. It was soundness of these reforms which helped our economy to easily tide over the economic crisis which had gripped the world in 2008.

Discount and Finance House of India Ltd:

Has been set up as a part of the package of reforms of the money market. It buys bills and other short term papers from banks and financial institutions. It provides short term investment opportunity to banks.

To develop a secondary market in Government securities, it started buying and selling securities to a limited extent in 1992. To enable Discount and Finance House of India Ltd. (DFHI), to deal in Government securities, the Reserve Bank of India provides necessary refinance.

The institutional infrastructure in government securities has been strengthened with the system of Primary Dealers (PDs) announced in March 1995 and that of Satellite Dealers (SDs) in December 1996.

Similarly, Securities Trading Corporation of India was established in 1994, to provide better market and liquidity for dated securities, and to hold short term money market assets like treasury bills. The National Stock Exchange (NSE), has an exclusive trading floor for transparent and screen based trading in all types of debt instruments

Regulation of Non-Banking Financial Companies

RBI Act was amended in 1997 to bring the NBFCs under its regulatory framework. A NBFC is a company registered under Companies Act, 1956 and is involved in making loans and advances, acquisition of shares, stocks, bonds, securities issued by government etc.  They are similar to banks but are different from the latter as they cannot accept demand deposits and cannot issue cheques. They have to be registered with RBI to operate within India. There are a host of regulations which NBFCs have to follow to smoothly operate within India like accept deposit for a minimum period, cannot accept interest rate beyond the prescribed rate given by RBI.

Money Market Mutual Funds:

In 1992 setting up of Money Market Mutual Funds was announced to bring it within in the reach of individuals. These funds have been introduced by financial institutions and banks.

With these reforms the money market is becoming vibrant. There is further scope of introducing new market players and extending refinance from Reserve Bank of India.

Narasimham Committee has also proposed that well managed non-banking financial intermediates and merchant bank should also be allowed to operate in the money market. As and when implemented this will widen the scope of money market.

Permission to Foreign Institutional Investors (FII):

FII’s are allowed to operate in all dated government securities. The policy for 1998-99 had allowed them to buy treasury Bills’ within approved debt ceiling.

Institutional Development:

The post reforms period saw significant institutional development and procedural reforms aimed at developing a strong secondary market in government securities.

Setting up Discount and Finance House of India

Discount and Finance House of India was set up in 1988 to impart more liquidity and also further develop the secondary market instruments. However, maturities of existing instruments like CDs and CPs were gradually shortened to encourage wider participation. Likewise ad hoc treasury bills were abolished in 1997 to stop automatic monetisation of fiscal deficit.

Reintroduction of 182 days treasury bills:

The 182 days bills, which were discontinued in 1992, have been reintroduced from 1998-99. Now Indian money market has 14 days, 91 days, 182 days and 364 days treasury bills.

Demand for Treasury bill is no longer exclusively linked with statutory liquidity rates considerations. The secondary market transactions aiming at effective management of short term liquidity are on the increase.

Disclosure of All Material Facts is made Compulsory: SEBI has made it compulsory for companies do disclose all the facts and risk factors regarding the projects undertaken by the company. The basis on which the premium amount is calculated should also be disclosed by the company as per SEBI norms. SEBI also advises the code of ethics for advertising in media regarding the public issue.

Vetting of Offer Document: SEBI vets offer documents to make sure that the company listing the shares has made all disclosures in it. All the guidelines and regulatory measures of capital issues are meant to promote healthy and efficient functioning of the issue market (or the primary market).

Reforms as to Mutual Funds: The Government has now permitted the setting up of private mutual funds and a few have already been set up. UTI has now been brought under the regulatory jurisdiction of SEBI. All mutual funds are allowed to apply for firm allotments in public issues. To improve the scope of investments by mutual funds, the latter are permitted to underwrite public issues. Further, SEBI has relaxed the guidelines for investment in money market instruments. Finally, SEBI has issued fresh guidelines for advertising by mutual funds.

Imposition of Compulsory Deposit on Companies making Public Issues: In order to induce companies to exercise greater care and diligence for timely action in matters relating to the public issues of capital, SEBI has advised stock exchanges to collect from companies making public issues, a deposit of one per cent of the issue amount which could be forfeited in case of non-compliance of the provisions of the listing agreement and, non-dispatch of refund orders and share certificates by registered post within the prescribed time.

Regulation of Merchant Banking: SEBI has brought Merchant banking under its regulatory framework. The merchant bankers are now to be authorized by SEBI. Merchant bankers, now have a greater degree of accountability in the offer document and issue process.

Conditions regarding Application Size etc.: SEBI has raised the minimum application size and also the proportion of each issue allowed for firm allotment to institutions such as mutual funds.

Issue of Due Diligence Certificate: The lead managers have to issue due diligence certificate, which has now been made part of the offer document.

Underwriting has made Optional: To reduce the cost of issue in primary market, SEBI has made underwriting of issue optional. However, the condition that if an issue was not underwritten and was not able to collect 90% of the amount offered to the public, the entire amount collected would be refunded to the investor is still in force.

Increase of Popularity to Private Placement Market: In recent years, private placement market has become popular with issuers because of stringent entry and disclosure norms for public issues. Besides low cost of issuance, ease of structuring investments and saving of time lag in issuance are the other causes responsible for the rapid growth of private placement market.

Encouragement to Initial Public 0ffers: In order to encourage Initial Public Offers (IPO) in the primary market, SEBI has permitted companies to determine the par value of shares issued by them. SEBI has allowed issues of IPOs to go for “Book Building” i.e. reserve and allot shares to individual investors. But the issuer will have to disclose the price, the issue size and the number of securities to be offered to the public.

Disclosure of All Material Facts is made Compulsory: SEBI has made it compulsory for companies do disclose all the facts and risk factors regarding the projects undertaken by the company. The basis on which the premium amount is calculated should also be disclosed by the company as per SEBI norms. SEBI also advises the code of ethics for advertising in media regarding the public issue.