Tag: Indian Financial System Osmania University b.com Notes

The Structure of the Federal Reserve System is unique among all the assets within central banks, with both public and private aspects. It is described as “independent within the government” rather than “independent of government”.

The Federal Reserve System (also known as the Federal Reserve or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of financial panics (particularly the panic of 1907) led to the desire for central control of the monetary system in order to alleviate financial crises. Over the years, events such as the Great Depression in the 1930s and the Great Recession during the 2000s have led to the expansion of the roles and responsibilities of the Federal Reserve System

The Federal Reserve does not require public funding, instead it remits its profits to the federal government. It derives its authority and purpose from the Federal Reserve Act, which was passed by Congress in 1913 and is subject to Congressional modification or repeal.

Purpose

The primary declared motivation for creating the Federal Reserve System was to address banking panics. Other purposes are stated in the Federal Reserve Act, such as “to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes”. Before the founding of the Federal Reserve System, the United States underwent several financial crises. A particularly severe crisis in 1907 led Congress to enact the Federal Reserve Act in 1913. Today the Federal Reserve System has responsibilities in addition to stabilizing the financial system.

Current functions of the Federal Reserve System include:

• To address the problem of banking panics
• To serve as the central bank for the United States
• To strike a balance between private interests of banks and the centralized responsibility of government
• To supervise and regulate banking institutions
• To protect the credit rights of consumers
• To manage the nation’s money supply through monetary policy to achieve the sometimes-conflicting goals of
• Maximum employment
• Stable prices, including prevention of either inflation or deflation
• Moderate long-term interest rates
• To maintain the stability of the financial system and contain systemic risk in financial markets
• To provide financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system
• To facilitate the exchange of payments among regions
• To respond to local liquidity needs
• To strengthen U.S. standing in the world economy

Composition

• The presidentially appointed Board of Governors (or Federal Reserve Board), an independent federal government agency located in Washington, D.C.
• The Federal Open Market Committee (FOMC), composed of the seven members of the Federal Reserve Board and five of the twelve Federal Reserve Bank presidents, which oversees open market operations, the principal tool of U.S. monetary policy.
• Twelve regional Federal Reserve Banks located in major cities throughout the nation, which divide the nation into twelve Federal Reserve districts. The Federal Reserve Banks act as fiscal agents for the U.S. Treasury, and each has its own nine-member board of directors.
• Numerous other private U.S. member banks, which own required amounts of non-transferable stock in their regional Federal Reserve Banks.
• Various advisory councils.

Fund Based Services: It refers to services that are used to acquire assets or funds for a customer. It consists of:

• Primary market activities
• Secondary market activities
• Foreign exchange activities
• Specialized financial Services

Important fund based services include:

• Leasing
• Hire purchase
• Factoring
• Forfeiting
• Mutual funds
• Bill discounting
• Credit Financing
• Housing Finance
• Venture capital

Fee based services: When financial institutions operate in specialised fields to earn income in form of fees, commission, brokerage or dividends it is called a Fee based Service.  They include:

• Issue Management
• Portfolio management
• Corporate counseling
• Merchant banking
• Credit rating
• Stock broking
• Capital restructuring
• Bank Guarantee
• Letter of Credit
• Debt Restructuring

Types of Financial Activities

Fund based Activities:

• Underwriting or investment in shares, debentures, bonds, etc. of new issues (Primary Market Activities)
• Dealing in secondary market activities
• Participating in money market instruments eg. Discounting bills, treasury bills, certificate of deposit etc.
• Involving in equipment leasing, hire purchase, venture capitals
• Dealing in foreign exchange activities

Fee based Activities:

• Managing the capital issue in accordance with SEBI guidelines enabling promoters to market their issue
• Making arrangements for placement of capital and debt instruments with investment institutions
• Arrangement of funds from financial institutions for clients project cost or working capital
• Assisting in getting all Government and other clearances

Banking financial institutions

Banks, more precisely retail or commercial banks, fall under the category of banking financial institutions. A bank is a financial intermediary with a purpose to act as a middleman between suppliers of funds or depositors and borrowers. The main task of a bank is to accept deposits and use these funds later on to offer loans to its customers. Another duty of a bank is to act as a payment agent, which is done by offering a host of payment services, such as credit and debit cards, direct deposit facilities, cheques and bank drafts. A bank makes money by investing the deposits in financial securities and assets, but mostly by lending the funds further to its customers. The primary reasons for depositing money in banks are convenience, safety and interest income.

Bank falls under one category of financial institutions known as banking financial institutions. A bank is known as financial intermediaries that act as middlemen between depositors or suppliers of funds and lenders who are the users of funds. The main tasks of a banking financial institution are to accept deposits and then to use those funds to offer loans to its customers, who will in turn utilize them to fund purchases, education, to expand business, to invest in development, etc. A bank also acts as a payment agent by offering a host of payment services including debit cards, credit cards, cheque facility, direct deposit facilities, bank drafts, etc. The primary purposes in depositing funds in banks are convenience, interest income, and safety. A bank’s ability to lend out funds is determined by the amount of excess reserves and the ratio of cash reserves held by the bank. It is relatively easy for a bank to raise funds as certain accounts such as demand deposits pay no interest to the account holder (this means that no cost is incurred by the bank in attracting deposits for demand deposit accounts). A bank makes money investing the money that they receive from deposits, sometimes in assets and financial securities, but mostly in loans.

Investment banks, leasing companies, insurance companies, investment funds, finance firms, etc. A non-banking financial institution offers a range of financial services. Investment banks offer services to corporations which include underwriting of debt and share issues, securities trading, investment, corporate advisory services, derivate transactions, Financial institutions such as insurance companies offer protection against specific losses for which an insurance premium is paid. Pension and mutual funds act as savings institutions in which investors are able to invest their funds in collective investment vehicles, and receive interest income in return. Market makers or financial institutions that act as brokers and dealers facilitate the transactions in financial assets such as derivative, currencies, equity, etc. Other financial service providers such as leasing companies facilitate the purchase of equipment, real estate financing companies make capital available for real estate purchases and financial advisors and consultants offer advice for a fee.

Non-banking financial institutions

The other type of financial institutions includes investment banks, insurance companies, investment funds and other. A range of financial services offered by non-banking financial institutions differ from those of a bank. The main difference between both is that non-banking financial institutions cannot accept deposits into savings and demand deposit accounts, while it is one of the core businesses for banking financial institutions.

Meanwhile, they offer a variety of other services. For example, investment banks offer services to their clients such as underwriting of debt and share issues, corporate advisory, securities trading and derivative transactions and other investment services. Insurance companies offer a protection against specific losses in exchange for an insurance premium. Pension and mutual funds are savings institutions where investors are able to invest their funds in collective investment vehicles. There are financial services that are provided by both banking and non-banking financial institutions, such as granting loans, financial consultancy, leasing of equipment and investment in financial securities.

Bank vs Financial Institution

• A bank is known as financial intermediaries that act as middlemen between depositors or suppliers of funds and lenders who are the users of funds.
• Financial institutions can be divided into two types: banking financial institutions and non-banking financial institutions.
• The main tasks of a banking financial institution are to accept deposits and then to use those funds to offer loans to its customers.
• The main difference between the two types of financial institutions is that banking financial institutions can accept deposit into various savings and demand deposit accounts, which cannot be done by a non-banking financial institution.
• There are also a number of non-banking financial institutions which include investment banks, leasing companies, insurance companies, investment funds, finance firms, etc. A non-banking financial institution offers a range of financial services.
• The primary purposes in depositing funds in banks are convenience, interest income, and safety. Whereas the primary purpose in investing funds in non-banking financial institutions is to gain additional income.

All India Financial Institutions (AIFI) is a group composed of development finance institutions and investment institutions that play a pivotal role in the financial markets. Also known as “financial instruments”, the financial institutions assist in the proper allocation of resources, sourcing from businesses that have a surplus and distributing to others who have deficits – this also assists with ensuring the continued circulation of money in the economy. Possibly of greatest significance, the financial institutions act as an intermediary between borrowers and final lenders, providing safety and liquidity. This process subsequently ensures earnings on the investments and savings involved. In Post-Independence India, people were encouraged to increase savings, a tactic intended to provide funds for investment by the Indian government. However, there was a huge gap between the supply of savings and demand for the investment opportunities in the country.

The health of the financial services sector is integral to the overall level of global economic activity. For this reason, the major macroeconomic indicators are also very important pieces of data for the outlook of this sector. Financial services companies rely on high levels of business activity to generate revenue because they act as the intermediary in many economic transactions.

The financial services sector is made up of firms and institutions that provide financial services to commercial and retail customers. This includes banks, investment companies, insurance companies, and real estate firms.

Economic indicators are released through studies, surveys, sector reports, and the data-gathering efforts of government agencies. These indicators have wide-reaching implications for every economic sector. However, the financial services sector is perhaps the most sensitive to large economic aggregates.

Based on this approach some researchers have used one or more indicator to denote the degree of financial development.

Finance ration

The ratio of total issues of primary and secondary claim to national income

Financial Inter-relation ratio

The ratio of financial assets to physical assets in the economy.

Intermediation ratio

The ratio of secondary issue to primary issue, which indicates the extent of development of financial institution as mobilizers of funds relative to real sectors as direct mobilizers of funds. It indicates institutionalization of financial activity in the economy.

The ratio of money to income

Higher the ratio greater the financial development because it indicates the extent of monetization and size of exchange economy in the nation.

• Developed Financial sector is fully integrated domestically as well as internationally. In such system risk adjusted rate of return doesn’t differ significantly in respect of investor as well as saver.
• The lower the transaction and information cost, the higher the financial development.
• A developed financial structure is characterized by presence of strong, active, large sized non-banking financial sector comprising stock market, debt market, insurance companies, pension fund, mutual fund etc.
• The greater the financial development, the greater the openness of the economy reflected in high level of current account openness/convertibility, minimum restriction on foreign ownership of assets and repatriation of earning and absence of parallel foreign exchange market.
• In a developed financial system, private banking not the public sector banking is predominant.

1. Interest Rates

Interest rates are the most significant indicators for banks and other lenders. Banks profit from the difference between the rates they pay depositors and the rates that they charge to borrowers. Banks find it increasingly difficult to pass on interest rate costs to consumers as rates rise. High borrowing costs correspond with fewer loans and more saving. This limits the volume of total profitable activity for lenders.

It is very clear that banks perform best (at least in the short term) when interest rates are lower.

Lower interest rates also turn savers into speculators. It’s more difficult to beat inflation when the rate on a savings account or certificate of deposit (CD) is paying a low rate. Workers will turn more often to equities to try to find ways to counter inflation and grow their nest eggs for retirement. This creates demand for asset management services, brokers, and other money intermediaries.

2. Government Regulation and Fiscal Policy

Government regulation is not necessarily an indicator in the traditional sense; instead, investors should keep an eye toward how regulations and tariffs might impact activity from the financial services sector. Banks, which comprise more than half of the entire sector in the U.S., are heavily influenced by reserve requirements, usury laws, insurance and lending guidelines as well as the possibility of government assistance.

Fiscal policy doesn’t affect banks as directly. Rather, it impacts the banks’ possible customers and trading partners. Consumer confidence tends to rise during expansionary fiscal policy and fall during contractionary fiscal policy. This could translate into fewer investments, trades, and loans.

3. Gross Domestic Product (GDP)

Countries around the world track levels of economic activity through gross domestic product (GDP) calculations. Increases in the level of spending or investments cause GDP to rise, and the financial service sector typically sees increased demand for its goods and services when spending and investment levels go up.

Since GDP is the most common and broadest measure of a region’s economy and it is often considered a lagging indicator the relationship between any one company’s stock and the GDP is tenuous at best. Nevertheless, it is considered a useful benchmark for the overall health of the financial sector.

4. Existing Home Sales

The Existing-Home Sales report is issued monthly by the National Association of Realtors. It provides banks and mortgage lenders with recent data on sales prices, inventory levels, and the total number of homes sold.

This report often impacts prevailing mortgage rates. Investors in financial services and home construction should see upticks when home sales data is rising.

The money market and capital market are closely interrelated because most corporations and financial institutions are active in both. Firms may borrow funds from the money market for a short period or for a loan period from the capital market.

Differences

1. The money market uses such instruments as promissory notes, bills of exchange, treasury bills, certificates of deposits, commercial papers, etc. On the other hand, the capital market uses long-term securities such as shares, debentures and bonds of industrial concerns, and bonds and securities of the government.
2. The money market deals in short-term funds which are used for financing current business operations and short-term needs of the government. On the other hand, the capital market deals in long-term funds required by industry and government.
3. The institutions operating in the money market and the capital market also differ from each other. The central bank, commercial banks, non bank financial intermediaries and bill brokers deal in money market instruments. On the other hand, stock exchanges, mutual funds, leasing companies, investment banks, investment trusts, insurance companies, etc. dealing capital market instrument.
4. Short-term funds in the money market refer to a period of less than a year, while in the capital market long-term funds refer to a period up to 25 years.

Interrelations between Money and Capital Markets:

The money market and capital market are closely interrelated because most corporations and financial institutions are active in both. Firms may borrow funds from the money market for a short period or for a loan period from the capital market. A number of factors may prompt borrowers and lenders to resort to either the money market or the capital market which reflect the interdependence of the two markets.

1. Some corporations and financial institutions serve both markets by buying and selling short-term and long-term securities.
2. Borrowers may obtain their funds from either or both markets according to their requirements. A firm may borrow short-term funds by selling commercial paper or it may float additional shares or bonds.
3. Funds flow back and forth between the two markets whenever the treasury finances maturing bills with treasury securities or whenever a bank lends the proceeds of a maturing loan to a firm on a short-term basis.
4. All long-term securities become short-term instruments at the time of maturity. So, some capital market instruments also become money market instruments.
5. Yields in the money market are related to those of the capital market. A fall in the short-term interest rates in the money market shows a condition of essay credit which is likely to be followed or accompanied by a more moderate fall in the long-term interest rates in the capital market. However, money market interest rates are more sensitive than are long-term interest rates in the capital market.
6. Lenders may choose to direct their funds to either or both markets depending on the availability of funds, the rates of return, and their investment policies.

Financial regulation is a form of regulation or supervision, which subjects financial institutions to certain requirements, restrictions and guidelines, aiming to maintain the stability and integrity of the financial system. This may be handled by either a government or non-government organization. Financial regulation has also influenced the structure of banking sectors by increasing the variety of financial products available. Financial regulation forms one of three legal categories which constitutes the content of financial law, the other two being market practices and case law.

The functioning of financial markets is regulated by several legislations that include Acts, Rules, Regulations, Guidelines, Circulars, etc. Understanding the legislations governing the financial markets in India will give the reader a fair idea of how the financial markets in India are regulated. The regulators of the financial market lay down specific rules of behaviour for participants in the financial system and provide for the monitoring of the observance of the rules and regulation. Such regulations became more important in the situations of far reaching technological progress, liberalization and greater integration in the financial system.

Aims of regulation

• Market confidence: To maintain confidence in the financial system
• Financial stability: Contributing to the protection and enhancement of stability of the financial system
• Consumer protection: Securing the appropriate degree of protection for consumers.

The Securities Contracts (Regulation) Act, 1956 (SCRA) which was enacted to prevent undesirable transactions in securities and to regulate the business of securities had given certain powers to the Central Government, under the provisions of that Act. The functions of the Central Government under that Act have been granted to SEBI. These Functions are:

(a) Power to call for periodical returns or direct enquires to be made (Section 6): SEBI will receive from every recognized Stock Exchange such periodical returns relating to its affairs as may be prescribed by SCRA rules.

(b) Power to approve the bye-laws of stock exchanges: Section 9 of SCRA provides that any stock exchange may make bye-laws for the regulation ad control of contracts with the previous approval of SEBI.

(c) Power of SEBI to make or amend bye-laws of recognized stock exchanges (Section 10, SCRA): SEBI may either on a request in writing received by it in this behalf from the governing body of a recognized stock exchange or in its own motion make bye-laws on matters specified in Section 9 of SCRA or amend any bye laws made by stock exchange.

(d) Licensing of dealers in securities in certain areas (Section 17 SCRA): SEBI has been empowered to grant a license to any person for the business of dealing in securities in any State or area to which Section 13 of SCRA has not been declared to apply.

(e) Power to delegate: Section 29A of SCRA provides that the Central Government may, by order published in the Official Gazette, direct that the powers exercisable by it under any provision of the SCRA shall, in relation to such matters and subject to such conditions, if any as may be specified in the order, be exercisable also by SEBI or the Reserve Bank of India.

SEBI Regulatory Functions

1. Registration of brokers and sub brokers and other players in the market.
2. Registration of collective investment schemes and Mutual Funds.
3. Regulation of stock brokers, portfolio managers, underwriters and merchant bankers and the business in stock exchanges and any other securities market.
4. Regulation of takeover bids by companies.
5. Calling for information by undertaking inspection, conducting enquiries and audits of stock exchanges and intermediaries.
6. Levying fee or other charges for carrying out the purposes of the Act.
7. Performing and exercising such power under Securities Contracts (Regulation) Act 1956, as may be delegated by the Government of India.

Protective Functions

1. Prohibition of fraudulent and unfair trade practices like making misleading statements, manipulations, price rigging etc.
2. Controlling insider trading and imposing penalties for such practices.
3. Undertaking steps for investor protection.
4. Promotion of fair practices and code of conduct in securities market.