Financial System Long Answer Type Questions

Question 1.
Explain the defects of money market. [Nov. 2012] OR Explain the features of Indian Money Market.
Answer:
(i) Dichotomy:
Dichotomy i.e. existence of two markets (organized money market and unorganized money market is a major defect of the Indian money market. The unorganized money market comprises of indigenous bankers, money lenders, chit funds, nidhis, loan companies and finance brokers that do not come under the control and supervision of the RBI.

This unorganized sector is mainly concentrated in the rural areas and it does not differentiate between short term and long term finance and between the purposes of finance. This puts a limit on the RBI’s control over the money market.

(ii) Lack of Integration:
The RBI finds it difficult to integrate the organized and the unorganized money market. While the RBI can control and supervise the working of the organized sector effectively, the heterogeneous unorganized sector is out of RBI’s control. There is no uniformity in the practices and operations of the unorganized money market. Moreover, the interest rates in both the markets are also different. Thus there is lack of integration in the Indian money market.

(iii) Multiplicity in Interest Rates:
There is diversity in rates of interest in the Indian money market. This multiplicity in the interest rates is due to lack of mobility of funds from one section of the money market to another.The rates differ from institution to institution even for funds of the same duration. Although the wide differences are being narrowed down ,the existing differences do hamper the efficiency of the money market.

(iv) Absence of Organised Bill Market:
The existence of a well organized bill market is essential for effective linking up various credit agencies. It refers to a mechanism where bills of exchange are purchased and discounted by commercial banks/ financial institutions.
The bill market is not yet developed in India due to the following reasons:

  • Banks keeping large amount of cash.
  • Preference for borrowing rather than discounting bills.
  • Over dependence on cash / cheque transactions.
  • High stamp duty on usance bill, etc.

(v) Shortage of Funds:
The Indian money market is characterized by shortage of funds. Various factors like inadequate banking facilities, low savings, lack of banking habits, existence of parallel economy, etc lead to shortage of funds. Thus demand for short term funds far exceeds the supply. This results in high interest rate.
are flush, with, funds especially in urban area as people prefer to invest their money with banks rather than keeping them as deposits in the unorganized sector.

(vi) Seasonal Stringency of Money:
Since agriculture continues to play a major role in the Indian economy, farm operations do influence the demand for supply and money. Thus seasonal stringency of money and high interest rate during the busy season (November to June ) is a striking feature of the Indian money market. Also there is a wide fluctuations in the interest rates from one reason to another. However, the RBI makes attempt to reduce the fluctuations by adding money into the money market during the busy season and withdrawing the funds during the slack season.

(vii) Inadequate Credit Instruments:
The Indian money market lacked adequate short-term paper instruments till 1985-86. Only call money market and bill market existed. Also there were no specialized dealers / brokers in the money market. After 1985-86 the RBI introduced new credit instruments in the market like CDs, CPs, MMMF, etc, but they are not yet fully developed in India.

(viii) Absence of a Well-Organised Banking Sector in Rural Area:
There is a poor banking system in the rural area due to the problems of overheads and maintenance of branches.The commercial bank branches in rural area are only 40% of the total bank branches. This also hampers the development of money market in India.

(ix) Inefficient and Corrupt Management:
Faulty selection, lack of training, poor performance appraisal and faulty promotions result in inefficiency and corruption in the banking sector. This adversely affects the success and performance of money market.

Question 2.
Explain the various money market instruments.
OR
Explain various components of money market.
Answer:
The various money market instruments includes the following:

  • Call/Notice Money
  • Treasury Bills
  • Term Money
  • Certificate of Deposit
  • Commercial Papers
  • Capital Market Instruments
  • Hybrid Instruments

(a) Call /Notice-Money Market:
Call/Notice money is the money borrowed or lent on demand for a very short period. When money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on the next working day, (irrespective of the number of intervening holidays) is “Call Money”. When money is borrowed or lent for more than a day and up to 14 days, it is “Notice Money”. No collateral security is required to cover these transactions.

(b) Inter-Bank Term Money:
Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money market. The entry restrictions are the same as those for Call/ Notice Money except that, as per existing regulations, the specified entities are not allowed to lend beyond 14 days.

(c) Treasury Bills:
Treasury Bills are short term (up to one year) borrowing instruments of the union government. It is an IOU of the Government. It is a promise by the Government to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e. less than one year). They are issued at a discount to the face value, and on maturity the face value is paid to the holder. The rate of discount and the corresponding issue price are determined at each auction.

(d) Certificate of Deposits:
Certificates of Deposit (CDs) is a negotiable money market instrument issued in dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time. CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI. Banks have the freedom to issue CDs depending on their requirements. An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments viz., term money, term deposits, commercial papers and intercorporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet.

(e) Commercial Paper:
CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper the debt obligation is transformed into an instrument. CP is thus an unsecured promissory note privately placed with investors at a discount rate to face value determined by market forces. CP is freely negotiable by endorsement and delivery. A company shall be eligible to issue CP provided – (a) the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; (b) the working capital (fund-based) limit of the company from the banking system is not less than Rs.4 crore and (c) the borrowal account of the company is classified as a Standard Asset by the financing bank/s. The minimum maturity period of CP is 7 days. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies, (for more details visit www.indianmba.com faculty column)

(f) Capital Market Instruments:
The capital market generally consists of the following long term period i.e., more than one year period, financial instruments; In the equity segment Equity shares, preference shares, convertible preference shares, non-convertible preference shares etc and in the debt segment debentures, zero coupon bonds, deep discount bonds etc. .

(g) Hybrid Instruments:
Hybrid instruments have both the features of equity and debenture. This kind of instruments is called as hybrid instruments. Examples are convertible debentures, warrants etc.

Question 3.
Explain the role of important players in the Indian money market.
Answer:
The role of important players in the money market is discussed below:
Reserve Bank of India:

  • The Reserve bank of India is the most important player in the Indian money market.
  • The organized money market is to ensure that the levels of liquidity and short term interest rates are maintained at an optimum level so as to facilitate economic growth and price stability.
  • RBI also plays the role of a merchant banker to the government. It issues Treasury Bills and other
  • Government securities to raise funds for the government.
  • The RBI thus plays the role of an intermediary and regulator of the money market.

Government:

  • The government is the most active player and the largest borrower in the money market.
  • It raises funds to make up the budget deficit.
  • The funds may be raised through the issue of Treasury Bills (with a maturity period Of 91 day/182 day/364 days) and government securities.

Banks:

  • Commercial Banks play an important role in the money market.
  • They undertake lending and borrowing of short term funds.
  • The collective operations of the banks on a day to day basis are very predominant and hence have a
  • major impact and influence on the interest rate structure and the liquidity position.

Flinancial Institutions:

  • Financial institutions also deal in the money market.
  • They undertake lending and borrowing of short-term funds.
  • They also lend money to banks by rediscounting Bills of Exchange.
  • Since they transact in large volumes, they have a significant impact on the money market.

Corporate Firms:

  • Corporate firms operate in the money market to raise short term funds to meet. their working capital requirements.
  • They issue commercial papers with a maturity period of 7 days to 1 year. These papers are issued at a discount and redeemed at face value o maturity.
  • These corporate firms use both organized and*unorganized sectors of money market.

Institutional Players:

  • They consist of mutual funds, Foreign institutional players, insurance Firms, etc.
  • Their level of participation depends on the regulations.
  • For instance the level of participation of the Flls in the Indian money market is restricted to investment in Government securities.

Discount Houses and Primary Dealers:

  • They are the intermediaries in the money market.
  • Discount houses discount and rediscount commercial bill and Treasury Bills.
  • Primary Dealers were introduced by RBI for developing an active secondary market for Government securities.
  • They also underwrite Government securities.

Question 4.
Explain different types of Classification of financial market?
Answer:
Classification of financial market
Financial System Long Answer Type Questions 1
(1) Unorganised Markets:
Unorganised Markets are those where there are number of money lenders, Indigenous bankers, traders etc., who lend money to the public. Indegenous bankers also collect deposits from the public. There are also private finance companies, chit funds etc., whose activities are not controlled by the RBI.

(2) Organised Markets:
Organised markets are those where there are standardised rules and regulations governing their financial dealings. There is also a high degree of institutionalisation and instrumentalisation. These markets are subject to strict supervision and control by the RBI or other regulatory bodies.

These organised markets can be further classified into two they are:

  • Capital Market
  • Money Market.

(I) Capital Market: It is a market for financial assets which have a long or indefinite maturity. Generally, it deals with long term securities which have a maturity period of above one year.
Capital markets are diveded into:

  • Industrial securities market
  • Government securities market
  • Long term loans market.

(a) Industrial securities market:
It is a market for Industrial Securities namely, equity shares or ordinary shares, preference shares, debentures or bonds. It is a market where Industrial concerns raise their capital or debit by issuing appropriate instruments. It is diveded into.

(i) Primary markets or New issue Markets:
It is a market for new issues or new financial claims. Hence, it is also called new issue market. The primary market deals with those securities which are issued to the public for the first time. In the primary market, borrowers exchange new financial securities for long term funds. Thus, primary market facilitates capital formation. There are three ways by which a company may raise capital in a primary market.
They are:

  • Public issue
  • Rights issue
  • Private placement.

(ii) Secondary Market:
It is a market for secondary sale of securities. In other words, securities which have already passed through the new issue market are traded in this market. Generally, such continuous and regular market for buying and selling of securities. This market consists of all stock exchange recognised by the govt, of India.

(b) Government securities market:
It is otherwise called gilt – edged securities market. It is a market where Govt, securities – are traded. In India there are many kinds of govt, securities – short term and long term. Long term securities are traded in this market.

While short term securities are traded in the money market. Securities issued by the central govt, state govt, semi-government authorities like electricity corporations, Port trusts etc., Improvements trusts, state electricity boards. All India and state level financial institutions and public sector enterprices are dealt in this market. Government securities are in many forms.
These are generally –

  • Stock certificates or inscribed stock.
  • Promissory notes
  • Bearer Bonds which can be discounted.

(c) Long – term loans market:
Development banks and commercial banks play a significant role in this market by supplying long term loans to corporate customers. Long term loans market may further be classified into

(i) Term loans market:
In India many Industrial financing institutions have been created by govt. both at the National and regional levels to supply long term and medium term loans to corporate customer directly as well as indirectly. These development banks dominate the industrial finance in India. Institutions like IDBI, IFCI, ICICI, and other state financial corporations come under this category. These institutions meet the growing and varied long – term financial requirements of industries by supplying long term loans.

(ii) Mortgage market:
It refers to those centres which supply mortgage loan mainly to individual customers. A mortgage loan is a loan against the security of immovable property like real estate. The transfer of interest in a specific immovable property to secure a loan is called mortgage. This mortgage may be equitable mortgage or legal. Again it may be a first charge or second charge. Equitgable mortgage is created by a mere deposit of title deeds to properties as security where as in the case of a legal mortgage the title in the property is legally transfered to the lender by the borrower. Legal mortgage is less risky.

In first charge, the mortgager transfers his interest in the specific property to the mortgage as security. When the property in question is already mortgaged once to another creditor, it becomes a second charge when it is subsequently mortgaged to somebody else. The mortgage can also further transfer his interest in the Mortgaged property to another. In such a case, It is called a sub-mortgage.

(iii) Financial Guarantee Markets:
Guarantee market is a centre where finance is provided against the guarantee of a reputed person in the financial circle. Guarantee is a contract to discharge the liability of a third party in case of his default. Guarantee acts as a security from the creditor’s point of view.
Though there are many types of guarantees, the common forms are,

  • Performance Guarantee ; It covers the payment of earnest money, retention money, advance payments, non-completion of contracts etc.
  • Financial Guarantee : It covers only financial contracts.

(II) Money market:
It is a market for dealing with financial assets and securities which have a maturity period of upto one year. In other words, it is a market for purely short term funds. The money market may be subdivided into:

  • Call money market
  • Commercial bill market
  • Treasury bills market
  • Short-term loan market.

(a) Call money market:
It is a market for extremely short period loans say one day to fourteen days. So it is highly liquid. The loans are repayable on demand at the option of either the lender or the borrower. In India Call money markets are assosiciated with the presence of stock exchanges and hence, they are located in major industrial towns like Mumbai, Calcutta, etc. The special feature of this market is that the interest rate varies from day to day and even from hour to hour and centre to centre, it is very sensitive to changes in demand and supply of call money.

(b) Commercial bills market:
It is a market for Bills of exchange arising out of genuine trade transactions. In the case of credit sale, the seller may draw a bill of exchange op the buyer, the buyer accepts such a bill promising to pay at a later date specified in the bill. The seller need not wait untill the due date of the bill. Instead, he can get immediate payment by discounting the bill. In India the bill market is underdeveloped.

(c) Treasury bills Market:
It is a market for treasury bills which have ‘short-term’ maturity. A treasury bill is a promissory note or a financial bill issued by the govt, it is highly liquid because its repayment is guaranteed by the govt, it is an important instrument for short term borrowing of the govt. There are two types of treasury bills namely.

  • Ordinary or regular
  • Adhoc treasury bills properly known as ‘ad hoes’

Ordinary treasury bills are issued to the public, banks and other financial institution with a view to raising resources for the central govt, to meet its , short term financial needs. Adhoc treasury bills are issued in favour of the RBI only. They are not sold through tender or auction.

(d) Short-term loan Market:
It is a market where short – term loans are given to corporate customers for meeting their working capital requirements. Commercial banks play a significant role in this market. Commercial banks provide short – term loans . in the form of cash credit and overdraft.

Foriegn exchange Market:
It refers to tlte process of converting horhe currencies into foreign currencies and vice versa. The market where foreign exchange transactions take place is called a foreign exchange market.

Question 5.
Name and explain the financial institutions in India.
Answer:
Following are the financial institutions works in India to cater the diverse financial requirements of the enterprises.
(a) All India development banks (AIDBs): It includes those development Banks which provide institutional credit to large, medium and small scale industries.

(b) Industrial development bank of India (IDBI): It is the main financial institution for industrial development in the country. It caters diversified needs of medium and large scale industries in the form of financial assistance both in direct and indirect ways

(c) Industrial finance corporation of India Ltd(IFCIL): It is oldest and first financial institutions established to provide financial assistance to industries for long term purpose.

(d) Small Industries Development Bank of India (SIDBI): It is established to give financial assistance for promotion, financing and development of small scale industries in the economy.

(e) Industrial Investment Bank of Indiaf IIBI): The main aim of this financial institution is to give credit for sick industrial units. It gives short term loans to companies to meet their fund requirements.

(f) Special finance Institutions (SFIs): SFI s are the financial institutions which have been set up to serve the increasing financial needs of commerce and trade in the area of venture capital, credit rating and leasing etc.

(g) IFCI Venture capital funds Ltd (IVCF): It is subsidiary of IFCI Ltd. It provides financial assistance by way of soft loans to promotes under its risk capital scheme. .

(h) ICICI venture funds Ltd : It is a technology venture finance company It is started to sanction project finance for new technology venture. The industrial units assisted by it are in the fields of computer, chemical drugs biotechnology, environmental engineering etc..

(i) Tourism Finance Corporation of India Ltd(TFCI): it is setup by government of India to promote the tourism industry in the country. It provides financial assistance for non- convential tourism projects.

(j) Investment institutions: It is a financial intermediaries catering the needs of small investors.

(k) Life Insurance Corporation of India (LIC): It gives financial assistance for development of infrastructure facilities like housing rural electrification water supply sewerage etc.

(l) Unit Trust of India(UTI): It mobilizes the savings of small investors and channelizes them into corporate jnvestments mainly by way of secondary capital market operations.

(m) General Insurance Corporation of India(GIC): It was formed for the purpose of superintending, controlling and carrying on the business of general insurance.

Question 6.
State the functions of secondary market?
Answer:
Secondary market plays an important role in Indian financial system it performs following functions:
(a) Continuous and ready market for securities : Secondary market provides a ready and continuous market for purchase and sale of securities. Stock exchange market is a market for these listed security.

(b) Facilitates evaluation of securities : Secondary market is useful for the evaluation of industrial securities. This enables investors to know the true value of their holdings at any time

(c) Encourages capital formation : Secondary market creates the habit of saving. Investing and risk taking among the investing class. And converts their savings into profitable investment.

(d) Provides safety and security in dealings; It provides safety and security in dealings as transactions are conducted as per rule’s and regulations

(e) Regulates company management: Secondary market deals with listed securities and listed companies have to comply with rules and regulations of concerned stock exchange and work under the supervision of stock exchange authorities

(f) Facilitates public borrowings : Secondary market serves as a plat form for marketing government securities. It enables government to raise public debt easily and quickly.

(g) Provides cleaning house facility : Secondary market also provides a cleaning house facility to members. It settles the transactions among the members quickly and with ease

(h) Facilitates healthy speculation : Secondary market provides normal and healthy speculation of investors for more business in stock exchange

(i) Serves as economic barometer : Market indicates the state of health of companies and national economy. It acts as a barometer of the economic conditions

(j) Facilitates bank landing; Secondary market provides information about prices of quoted securities. Banks offer loans to consumers against corporate securities holding them. This gives conveniences to the owners of securities to transact more.