Unit 3 Financial Institutions

A financial institution is an institution that provides financial services for its clients or members. Any institution that
collects money and puts it into assets such as stocks, bonds, bank deposits,or loans is considered a financial institution.
Financial Institutions are business organizations serving as a link between savers and investors and so help in the credit
allocation process.
Features of Financial Institutions:

 It is an institution as well as intermediary.

 It channelizes savings fund into investment fund.
 It creates financial assets such as deposits, loans, securities etc.
 It includes banking and non-banking institutions.
 It includes both organized and unorganized institutions.
 Established with a clear operating function.
 Regulated by the government and regulating authority.
 It accepts deposits.
 It provides commercial loans, real estate loans and mortgage loans.
 Financial institutions keep money flowing through the economy among consumers,
businesses and government.
Types of Financial Institutions –

 Commercial Banks - Commercial banks: These are also called as business banks. The following are the types
of commercial banks.
i. Public sector.
ii. Private sector.
iii.Regional Rural Banks (RRB`s)
iv. Foreign banks
 Non-banking Financial Companies - These are the financial institutions that provide banking services without
meeting the legal definition of a bank. The non-banking financial institutions also mobilize financial resources
directly or indirectly from the people. They lend the financial resources mobilized. The non-banking institutions
are classified into organized and unorganized financial institutions. Non-banking financial institutions can also
be categorized as investment companies housing
companies, leasing companies, hire purchase companies, specialized financial institutions (EXIM Bank),
Investment Institutions, State level institutions etc
 Cooperative Banks: These are established to safeguard the interest of its members. These are organized on a co-
operative basis, accept deposits and lend money to the required members.

Role of Financial Institutions:

The importance of FI is as follows:

 Provide funds: financial institutions provide funds for the investment and industrial
activities.
 Infrastructural facilities: financial institutions also offer basic infrastructural facilities
needed for the development and promotion of lucrative ventures. Infrastructural facilities involve development
of industrial estates tech parks, road and water etc.
 Promotional activities: promotional activities are undertaken by the financial institutions to mobilize the funds,
reduce the risk of selling financial securities, arrangement of working and long term capital of the business.
 Development of backward areas: apart from the financial activities, financial
institutions also take some social responsibilities of developing the backward areas at free of cost by offering
credit facilities, free education, employment creation etc.
 Planned development: financial institutions initiate all planned developments in the
view of economic growth of the state. All planned developments are coordinated with the government plan and
social welfare.
  Accelerating industrialization: since the financial institutions are established to earn the profit and safeguard
interest of its members, they accelerate the industrialization to
contribute industrial growth. They support industries by granting finance, project
development and consultancy.
 Employment generation: channelizing the funds for investment, building of
infrastructural facilities, and acceleration of industries generates employment to the
educated and qualified people of the state.

Commercial Banks
The commercial banking structure in India consists of: Scheduled Commercial Banks and Unscheduled Banks.
Scheduled commercial banks constitute those banks, which have been
included in the Second Schedule of Reserve Bank of India (RBI) Act, 1934. RBI includes only those banks in this
schedule, which satisfy the criteria laid down vide section 42 (6) (a) of the Act.
Indian banks can be broadly classified into nationalized banks/public sector banks, private banks and foreign banks.
According to Banking Regulation Act of 1949, “Banking means the accepting for the
purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise, and
withdrawal by cheque, draft, order or otherwise”. From the above definitions
we can analyze that the primary functions of banks are accepting of deposits, lending of these deposits, allowing deposits
to withdraw through cheque whenever they demand.
Activities of Commercial Banks

 Receiving deposits from the public. The primary function of commercial banks is receiving of deposits in the
form of savings bank account, current account and term deposits
from the savers usually from the public. People usually prefer to deposit their savings with the commercial
banks because of safety, security and liquidity.
 Giving loans and advances. The second major function of the commercial banks is giving loans and advances
to the all types of persons, particularly to businessmen and investors, against personal security, gold and silver
and other movable and immovable assets. The bank advances loans in the form of cash credit, call loans,
overdraft and discounting bills of exchange to businessmen.
 Use of cheque system and credit cards. The commercial banks will allow the depositors of the bank to withdraw
and make payment of their amount in their bank account through cheques. Now the banks are allowed to use
debit and credit cards for making their payments.
 Credit creation. Credit creation is one of the most important functions of the commercial banks. Like other
financial institutions, they aim at earning profits. For this purpose, they accept deposits and advance loans by
keeping small cash in reserve for day-to-day transactions.
 Financing foreign trade. The commercial banks finance foreign trade of its customers by accepting foreign
bills of exchange and collecting them from foreign banks. It also transacts other foreign exchange business and
buys and sells foreign currency.
 Transfer of funds. Commercial banks will help the
customers to transfer their money from one account to another account, from one place to another place through
cheques. Now the transfer of funds from one place to another place, or from one party account to another party
account or one bank to another bank is done through Electronic Fund Transfer (EFT). The technology like
MICR helps the banks to have innovative banking like anywhere banking, anytime banking, and virtual banking
and so on.
 Agency functions. The commercial banks act as agents for customers to buy and sell shares, securities on their
behalf. It pays subscriptions to insurance premiums, mutual funds, rent, water taxes, electricity bills etc on
behalf of its clients. It also acts as a trustee and executor of the property and will of its customers.

Role of Commercial Banks in Project finance –

  Project finance allows project assets to be separated from the sponsor and to be financed on the basis of the cash
flow from the project assets. It allows a sponsor to undertake a project with more risk than the sponsor is willing
to underwrite independently. Commercial banks can provide project financing because they are able to evaluate
complex project financing transactions and to assess and assume the construction and performance risks usually
involved in such financings. However, largely because of the short-term nature of a commercial bank's liabilities
(its deposits), commercial bank participation is usually limited in amount, although banks closely monitor and
control their project finance assets much as they do their other long-term assets. Project sponsors frequently
seek financing through a "request for proposal" or "RFP" process, and several commercial banks are likely to
form separate syndicates or "clubs" to respond to an RFP. The division of work within a syndicate is often
functional, and has become quite efficient, with individual banks designated as technical agent, documentation
agent, syndication agent, and variations thereof. A project's sponsor normally requests commitments from its
commercial banks for both construction financing and then the permanent long-term financing of its project. A
typical commitment for construction financing is for two years and permanent financing is usually from ten to
fifteen years, although in rare cases commercial banks have provided permanent financing commitments of
twenty years or more. Most permanent financing commitments by commercial banks include specified increases
in the applicable interest rate ("step-ups" in the applicable margin or spread over the bank's cost of funds) to
provide incentives for the commercial bank financing to be refinanced before its scheduled maturity.

Source: Trade Finance Global conference

Investment Banks
SOURCE: KALYAN CITY
CATEGORIES OF MERCHANT BANKS:

DEVELOPMENTAL FINANCIAL INSTITUTIONS IN INDIA:

Development banks can be known as special industrial financial institutions. Development banks are nothing but
financial institutions providing long-term funds for capital-intensive investments for a long period of time. Their
lending yields low rates of returns, such as irrigation systems, urban infrastructure, mining, and heavy industries, etc.
They are also known as development finance institutions (DFI) or long-term lending institutions. These banks lend at
low and stable interest rates so as to promote long-term investments along with social benefits. Unlike other
commercial banks, the development banks do not mobilize savings. Instead, they invest the resources in a productive
and efficient manner. These banks are expert financial bodies that perform the dual functions of granting medium and
long-term finances to private entrepreneurs and performing promotional roles for the economic development of the
country. The development banks are responsible to provide medium and long-term finances to the industrial as well as
agricultural sectors. As well, they finance both private and public sectors.
Objectives of Development Financial Institutions:

 Promotion of industrial growth.

 Creation of employment opportunities.
 Promotion of self-employment projects.
 Reviving sick units.
 Improving the capital market in the country.
 To generate more exports and promote import substitution.
 To promote science and technology in new areas by extending risk capital.
 Improving the management of large industries by providing them adequate training.
 Encouraging modernization and improvement of the technology sector.

Types of DFIs in India:

 SIDBI (Small Industries Development Bank of India)

 EXIM (Export-Import Bank of India)
 NABARD (National Bank for Agriculture & Rural Development)
 NHB (National Housing Bank)
 IFCI (Industrial Finance Corporation of India)
 IDBI (Industrial Development Bank of India)
(For details of each DFI, refer to: http://www.differencebetween.net/business/difference-between-commercial-bank-
and-development-bank/)

SOURCE: DIFFERENCE BETWEEN

REGIONAL RURAL BANKS:

Regional Rural Banks (RRBs) in India are the scheduled commercial banks that conduct banking activities for the
rural areas at the state level. As the name suggests, the Regional Rural Banks cater to the needs of the rural and
underprivileged people at the regional level across different states in the country. The Regional Rural Banks or the
RRB government-based banks operate at the regional level in various states across the country. The RRBs are
entrusted to cater to the needs of the rural people in the backward regions and bring financial inclusion at the primary
level. The main objective of the RRBs is to provide credit and other banking facilities to the small, marginal farmers,
agricultural laborers, small artisans, etc. in the rural areas for boosting the rural economy.

MUTUAL FUNDS:
Mutual fund is a unique investment pooling entity which enables investors to invest in a wide range of securities
through a single platform. Mutual Funds are excellent for long-term wealth creation.
STRUCTURE:

Source: RF Group
The Fund Sponsor is the first layer in the three-tier structure of Mutual Funds in India. SEBI regulations say that a
fund sponsor is any person or any entity that can set up a Mutual Fund to earn money by fund management. This fund
management is done through an associate company which manages the investment of the fund. A sponsor can be seen
as the promoter of the associate company. A sponsor has to approach SEBI to seek permission for a setting up a
Mutual Fund. However, a sponsor is not allowed to work alone. Once SEBI agrees to the inception, a Public Trust is
formed under the Indian Trust Act, 1882 and is registered with SEBI. After the successful creation of the trust, trustees
are registered with SEBI and appointed to manage the trust, protect the unit holder’s interest and to comply by the
mutual fund regulations of SEBI. Subsequently, an asset management company is created by the sponsor that should
be complying with the Companies Act, 1956 to regulate the management of funds. Considering that sponsor is the
primary entity that promotes the mutual fund company and that the mutual funds are going to regulate public money,
there are eligibility criteria given by SEBI for the fund sponsor: The sponsor must have experience in financial
services for a minimum of five years with a positive Net worth for all the previous five years. The net worth of the
sponsor in the immediate last year has to be greater than the Capital contribution of the AMC. The sponsor must show
profits in at least three out of five years which includes the last year as well. The sponsor must have at least 40% share
in the net worth of the asset management company. As clear as it could be, the role of a sponsor is quite vital and must
carry highest amount of credibility. The strict and rigorous norms define that the sponsor must have adequate liquidity
as well as faithfulness to return the money of investors in case there is any financial crisis or meltdown. Thus, any
entity that fulfills the above criteria can be termed as a sponsor of the Mutual Fund.
Trust and Trustees Trust and trustees form the second layer of the structure of Mutual Funds in India. Also known as
the protectors of the fund, trustees are generally employed by the fund sponsor. Just as can be comprehended with the
name, they have a critical role to play as far as maintaining the investors’ trust and tracking the fund’s growth are
concerned. A trust is created by the fund sponsor in favour of the trustees, through a document called a trust Deed.
The trust is managed by the trustees and they are answerable to investors. They can be seen as primary guardians of
fund and assets. Trustees can be formed by two ways – a Trustee Company or a Board of Trustees. The trustees work
to monitor the activities of the Mutual Fund and check its compliance with SEBI (Mutual Fund) regulations. They also
monitor the systems, procedures, and overall working of the asset management company. Without the trustees’
approval, AMC cannot Float any scheme in the Market. The trustees have to report to SEBI every six months about
the activities of the AMC. Also, SEBI has established tightened transparency rules to avert any type of conflict of
interest between the AMC and the sponsor. Therefore, it is critical for trustees to behave independently and take
satisfactory measures to keep the hard-earned money of investors protected. Even trustees have to get registered under
SEBI. And furthermore, SEBI regulates their registration by revoking or suspending the registry if any condition is
found to be breached.

Mutual funds pool the money collected from investors and reinvest it on their behalf in the securities market. NAV is
the per-unit market value of all the securities held by a mutual fund scheme. A mutual fund investor is assigned the
number of units based on the amount they invest.
The mathematical formula for NAV is:
Assets – Debits / Number of outstanding units = Net asset value (NAV)
Suppose the market value of the securities of a mutual fund scheme is Rs 500 lakh. The mutual fund issues 10 lakh
units of Rs 10 each to its investors. So, the NAV per unit of the fund is Rs 50.

TYPES OF MUTUAL FUNDS:

SOURCE: http://www.karvyvalue.com/website/what-is-mutual-fund.aspx

NBFCs:

NBFCs or Non-Bank Financial Companies are financial institutions that are registered under the Companies Act, 1956
of India. They are engaged in providing a range of financial services. NBFCs carry out functions similar to banks, but
they are not banks. The differences are provided below:
NBFCs offer a range of product and services, which includes the following:

 loans and advances

 saving and investment plans
 credit facilities
 stocks
 acquisition of shares
 insurance business
 bonds hire-purchase
 money-transfer service

Types of NBFCs:

 Investment Company (IC): ICs primarily deal in securities and their acquisition.
 Asset Finance Company (AFC): AFCs majorly finance assets such as automobiles, machines, material
equipment, generators, industrial machines, etc.
 Loan Companies (LC): Loan Companies provide finance to the public, whether by making loans or
advances. It does not include an equipment leasing company or a hire-purchase, Asset Finance company.
 Systemically Important Core Investment Company (CIC-ND-SI): Such types of NBFCs have assets worth
₹ 100 Crore and above and deploy at least 90% of its assets to invest in debt instruments, shares or loans in
group companies.
 Infrastructure Finance Company (IFC): IFCs have net owned funds of, at least, ₹ 300 Crore and have
deployed 75% of its total assets in infrastructure loans. LCs need to have a CRAR of 15% and a credit rating
of A or above.
 Non-Banking Financial Company Micro Finance Institution (NBFC-MFI): NBFC-MFI needs to deploy
at least 85% of its assets in the form of micro-finance to be given as loans to those with an annual income of ₹
120,000 (in urban areas) and ₹ 60,000 (in rural areas). These loans need to be sanctioned without collateral;
should not exceed ₹ 50,000 and should not have a loan tenure of less than 24 months. The borrower has the
repay the loan in weekly, monthly or fortnightly installments or as agreed.
 Non-Banking Financial Company Factors (NBFC-Factors): NBFC-factoring companies need to have a
minimum net owned funds (NOFs) of ₹ 5 Crore. The financial assets in the factoring business should
constitute at least 75% of its NOF. These companies receive invoices by selling companies at discount prices.
Depositories in India:
In India, there are two depositories: National Securities Depositories Ltd (NSDL) and Central Securities Depositories
Ltd (CDSL). Both the depositories hold all financial securities, like shares and bonds, in dematerialised form and
facilitate trading in stock exchanges. Both NSDL and CDSL are depositories that maintain ownership records of
financial securities. They are linked with investors through Depository Participants (DPs), also called stockbrokers. A
DP is a depository agent acting as an intermediary between the depository and its clients. DPs are registered with the
depository via the relevant provisions of the SEBI Act. DPs are stock brokerage firms that provide investors with the
service of opening Demat and trading accounts along with providing a trade platform, market reports and other value-
added services. Depositories provide information to listed companies about shareholders while facilitating trading
transactions. Furthermore, the listed companies approach the depositories to get information about the shareholders to
send notifications such as dividend rights, stock splits etc.
NSDL: NSDL is the oldest and largest depository in India. It commenced operations in 1996 in Mumbai. It was the
first depository to provide trading services in electronic format. NSDL offers a wide range of services, like:

 Rematerialisation services
 Dematerialisation services
 Transfers between depositories
 Off-market transfers
 Lending of securities
 Collateral and mortgage of securities

CDSL:  CDSL started operations in Mumbai in 1999 and is the second-largest depository in the country after
NSDL. Like NSDL, it provides all services, like holding financial securities in the electronic format and facilitating
trade and settlement of orders. All forms of stocks and securities - just like NSDL - are held at this central depository.

Trading through depositories in India:

Source: Edelweiss
In the stock market, a large number of trades occur simultaneously. The stock exchanges use an electronic order
matching system to match ‘buy’ and ‘sell’ orders from different traders. This way, each trade is executed. The costliest
buy prices are matched against the cheapest available sell prices, and whenever the buy price is less than or equal to
the best available sell price a match is done. The market depth is created by brokerages who collect orders from
different investors and pass it on to the stock exchanges, most likely to be the two most popular exchanges in India —
the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). In this process, brokerages act as the
intermediary between the investor and the stock exchange.
Once two orders match and a trade is executed, the clearing process takes place. Clearing is the identification of what
security is owed to the buyer and how much money is owed to the seller. The entire process is managed by ‘clearing
houses’. These are independent entities.
The next step is to fulfil the financial obligations identified in the clearing step. This involves the transaction
settlement for the buyers and sellers. So once the buyer receives the security and the seller receives the payment, the
transaction is settled.

The stock exchanges in India follow a T+2 rolling settlement cycle. A rolling settlement is one in which the trade is
settled in the days following the trade. Trades are settled in T+2 days with this sort of settlement, which indicates that
deals are closed after the second working day. Sunday, Saturday, Bank holidays, and exchange holidays are not
included in this time frame. So, if a trade is made on a Tuesday, it will be closed on a Thursday.

Clearing and Settlement Process:

 The stock exchange transfers the details of every trade to the clearing corporation on the T day when trade is
executed

 The clearing corporation confirms with the clearing members before they close the trade. Once they receive
confirmation, they determine the obligations of the clearing member

 After the details are confirmed the clearing banks must have sufficient funds, and depositories should make
the shares available

 The clearing corporations get funds and securities from clearing banks and depositories for purchase and sale
transactions respectively.

 In the case of the purchase transaction, the clearing member receives securities and in the case of sale
transaction, the clearing member receives money in the clearing account.
Participants in trade settlement process:
Clearing corporation is one of the major participants involved in clearing and settlement process in stock market.
The responsibility for clearing and settlement of trade executed at the stock exchange lies on the National Securities
Clearing Corporation Limited (NSCCL). It is also in charge of risk management and is obligated for meeting all
settlement regardless of the member defaults.
The clearing member is in charge of determining the position of share to suit the trade. They are another participant
in the clearing and settlement process in Indian stock market. When trading members place deals in the stock
exchange, the same is moved to NSCCL, which transfers them to the clearing members.
Clearing banks are responsible for the settlement of funds. There are 13 clearing banks, and each clearing member
needs to open a clearing account with either one of them. In case of a pay-out, clearing members receive funds in the
clearing account and in case of pay-in they need to make funds available.
There are two depositories in India – National Securities Depository Limited (NSDL) and Central Depository
Services Limited (CDSL). These two depositories hold investor Demat account, and clearing members also need to
maintain a clearing pool account with them.

Credit Rating Agencies

Credit Rating Agencies (CRA) assess creditworthiness of organisation and different entities. In simple words, these
agencies analyse a debtor’s ability to repay the debt and also rate their credit risk. All the credit rating agencies in
India are regulated by SEBI (Credit Rating Agencies) Regulations, 1999 of the Securities and Exchange Board of
India Act, 1992. There are a total of seven credit agencies in India viz, CRISIL, CARE, ICRA, SMREA, Brickwork
Rating, India Rating and Research Pvt. Ltd and Infomerics Valuation and Rating Private Limited.
Credit rating agencies take into consideration several factors like the financial statements, level and type of debt,
lending and borrowing history, ability to repay the debt, and the past debts of the entity before rating their credit. Once
a credit rating agency rates the entities, it provides additional inputs to the investor following which the investor
analyses and takes a sound investment decision. Poor credit rating indicates that the entity is at a high risk of
defaulting. The credit ratings that are given to the entities serve as a benchmark for financial market regulations.
Credit ratings are published by agencies like Moody’s Investors Service and Standard and Poor’s (S&P) based on
detailed analysis.