Unit 7: Banking and Financial Institutions mind map

How the Indian financial system is built, the Reserve Bank of India and its functions, and the tools of monetary policy.

The financial system

Parts of the financial system

The formal financial system has four parts. The informal sector sits outside regulation.

• Formal: financial markets, instruments, services and institutions.
• Informal: moneylenders, chit funds and community lending.
• Financial dualism is the coexistence of the formal and informal sectors.
• Financial markets let buyers and sellers trade financial instruments.

The primary function of a financial market is to allow buying and selling of instruments. In doing so it creates liquidity and price discovery. Chit-fund companies belong to the informal side.

Financial intermediation and crises

Intermediaries move savings to borrowers. They take on different risks. Crises take three main forms.

• Default-risk intermediation: lending to risky borrowers using savings of risk-averse savers.
• Maturity intermediation: borrowing short and lending long.
• Crises: currency, banking and foreign debt crises.
• Raising capital requirements can lower the chance of bank failure.

A bank that pools small savings and lends to riskier firms takes the default risk. A currency crisis is a sudden fall in a currency. A banking crisis is when banks fail. A foreign debt crisis is when a country cannot repay foreign borrowing.

Committees and reforms

Many committees shaped Indian banking and finance. Learn the main ones with their purposes.

• Narasimham Committee 1991: first-generation banking reforms.
• Chakravarty 1985, Vaghul 1987: monetary system and money market.
• Shah Working Group 1992 and Malegam 1995: NBFC regulation.
• Rajan Committee 2007: financial sector reform. Urjit Patel: monetary framework.

The Basel Committee supervises banks internationally. Malhotra 1993 dealt with insurance. Chalapathi Rao dealt with regional rural banks. Padmanabhan 1995 and Saraf 1994 studied bank supervision and technology. The Y. V. Reddy Committee studied small savings rates.

Year of establishment of financial institutions

Questions ask to arrange institutions by the year they were set up. Learn them as a timeline.

• Imperial Bank 1921, RBI 1935, SBI 1955, LIC 1956.
• UTI 1963-64, IDBI 1964, RRBs 1975.
• EXIM Bank 1982, NABARD 1982, NHB 1988, SIDBI 1990, SEBI 1992.

RBI began on 1 April 1935. SBI was formed on 1 July 1955 from the Imperial Bank. The first five RRBs started on 2 October 1975. SEBI got statutory status in 1992.

Banking committees by year

Many committees reformed banking in the 1990s. Learn them in order with their subject.

• Narasimham I (1991): banking sector reforms.
• Rashid Jilani: final accounts and audit of banks.
• Saraf (1994): technology in banks.
• Padmanabhan (1995): bank supervision. Verma (1999): weak banks.

The Sodhani Committee (1994) looked at foreign exchange markets. The Shere Committee (1995) studied electronic fund transfers. The Malegam Committee (1995) was the NBFC working group. Y. V. Reddy's committee looked at small savings interest rates.

The RBI

Functions and subsidiaries of the RBI

The RBI is the central bank. It issues currency and controls credit. It does not take public deposits.

• Bank of issue, banker to government, bankers' bank and lender of last resort.
• Controller of credit and custodian of foreign exchange reserves.
• Development role: promotional functions.
• It does not regulate fiscal policy or accept deposits from the public.

The RBI began on 1 April 1935. It acted as the central bank of Burma till April 1947 and of Pakistan till June 1948. It was not the central bank of Bangladesh. Fully owned subsidiaries include DICGC, Bharatiya Reserve Bank Note Mudran and IFTAS. IDFC is not an RBI subsidiary.

Monetary policy

Instruments of monetary control

The RBI controls money and credit through quantitative and qualitative tools. Techniques include CRR, SLR, OMO and the repo rate.

• Quantitative: bank rate, open market operations, variable reserve ratio.
• Qualitative: consumer credit regulation, margin requirements, differential interest rates.
• A cut in CRR raises banks' lendable resources.
• Selling securities in open market lowers banks' cash reserves.

Quantitative tools affect the total volume of credit. Qualitative tools affect where credit goes. To restrict credit, the RBI raises the bank rate or the CRR. Loans and advances to industry are not a tool of control.

Repo, reverse repo, MCLR and stances

These rates and terms appear in match questions. The repo rate is the RBI's lending rate against securities. The reverse repo absorbs liquidity.

• Repo: RBI lends short-term to banks against government securities.
• Reverse repo: RBI borrows from banks and absorbs liquidity.
• MCLR: an internal benchmark lending rate of banks.
• Stances: accommodative, neutral, hawkish. Neutral means rates may move either way.

Quantitative easing is the purchase of assets by the central bank. The Market Stabilisation Scheme absorbs enduring surplus liquidity by selling government securities and the money cannot be used for normal government spending. NPA means loans unpaid for more than 90 days. SLR is a share of liabilities kept in liquid assets.

Objective of monetary policy and interest rate structure

The primary aim of monetary policy is price stability. Central banks raise interest rates to tame inflation.

• Primary purpose: stability of prices.
• Central banks influence savings, investment and spending.
• RBI shapes interest rates through the T-bill rate, bank rate and deposit rate caps.
• Demonetisation is the removal of a currency's legal tender status.

When inflation comes from supply shocks, raising interest rates does little. The passage in a past paper suggested that the RBI could increase access to credit for micro, small and medium enterprises. India demonetised on 8 November 2016.

Types of banks, what banks do, the limits on credit, and the development finance institutions with their years and functions.

Commercial banks

SBI and Regional Rural Banks

SBI was formed from the Imperial Bank in 1955. Regional Rural Banks serve rural areas under their own Act.

• SBI came into existence on 1 July 1955.
• The first RRBs started on 2 October 1975.
• The RRB Act 1976 and the Banking Regulation Act apply.
• RRB share capital: Centre 50, State 15, sponsor bank 35.

The Chalapathi Rao Committee studied the restructuring of RRBs. RRBs sponsored by SBI include Saurashtra Gramin Bank (1978) and Arunachal Pradesh Rural Bank (1983). RRB services are not available in every state, such as Goa.

Small finance, payments, foreign and offshore banks

Newer and special banks have distinct rules. Know the main facts about each.

• Small finance banks: minimum capital Rs 200 crore.
• Payments banks accept deposits but cannot lend.
• Offshore banks have a majority of non-resident depositors.
• Foreign banks can set up wholly owned subsidiaries in India since 2002.

Group banking is when two or more banks are controlled by one or a few individuals through a holding company. Chain banking is similar. A foreign bank branch is not incorporated in India. Banks of international reach are controlled because they can add to inflation and cause bank failures.

Functions of commercial banks

Bank functions are primary or secondary. Business can be fund based or non-fund based.

• Primary: accepting deposits, lending, discounting bills, financing foreign trade.
• Secondary: agency services and general utility services.
• Fund based: deposits, loans, overdrafts, bill discounting.
• Non-fund based: letters of credit, guarantees.

Off-balance sheet items include letters of credit, future contracts and swaps. A loan to a depositor is an asset and appears on the balance sheet. The legal relationship between banker and customer is debtor and creditor.

Reserves, credit creation and credit appraisal

Banks hold reserves and create credit within limits. Loans are appraised before sanction.

• Primary reserves: cash and balances with RBI. They earn no interest.
• Secondary reserves: short-term marketable securities.
• Limits on credit creation: cash held, collateral supply, monetary policy.
• Credit appraisal checks technical feasibility, economic viability and bankability.

Investment in commercial paper is a secondary reserve. Pricing a housing loan: assess credit, apply MCLR, add the spread, compete and quote. Spread is related to net interest income and the asset ratio.

Banking history, reforms and customer relief

Banking changed in phases. Reforms and relief schemes appear in questions.

• Second phase of modern banking: liberalisation of the economy.
• Reforms include digitisation and consolidation.
• Banking Ombudsman Scheme started in 1995.
• COVID relief: moratorium and 2 per cent interest subvention on Shishu loans.

The first phase was nationalisation. The third brought NBFCs and fintechs. In the pandemic the government gave collateral-free loans of Rs 3 lakh crore to small firms and guarantee cover. Agricultural and SME credit rose as the RBI relaxed some controls.

Development finance institutions

IFCI, IDBI, ICICI and SIDBI

The older development banks financed industry. Each has a role and a year.

• IFCI 1948: India's first, medium and long-term finance for industry.
• ICICI 1955. IDBI 1964: apex institution that coordinates others.
• SIDBI 1990: set up as an IDBI subsidiary to take over small business financing.
• ICICI and IDBI each merged with their own subsidiary banks.

IDBI began as an RBI subsidiary and later became independent. SIDBI promotes micro, small and medium enterprises. IIBI was set up in 1971.

NABARD, NHB and EXIM Bank

These specialised banks serve agriculture, housing and foreign trade.

• NABARD 1982: apex for rural credit, refinance and inspection of cooperatives.
• NHB 1988: wholly owned by the RBI, promotes housing finance institutions.
• EXIM Bank 1982: financing exports and imports.
• ECGC 1957 and UTI 1964 came earlier.

NABARD schemes include Kisan Credit Card, Capital Investment Subsidy, Rural Innovation Fund and Tribal Development Fund. EXIM Bank's value-added services include workshops and export marketing, not lines of credit or pre-shipment credit.

The capital rules for banks, bad loans and how they are recovered, and non-banking finance companies.

Basel norms

Basel I, II and III

The Basel Committee sets international bank capital rules. Each accord added to the last.

• Basel I (1988): minimum capital of 8 per cent of risk-weighted assets.
• Basel II: three pillars and three risks.
• Basel III: stronger capital, a countercyclical buffer and liquidity ratios.
• Pillars: minimum capital, supervisory review, market discipline.

The Committee began in 1974, set up by central bank governors of the Group of Ten countries after currency and banking disturbances. Capital adequacy ratio is capital divided by risk-weighted assets. The risks counted are credit, market and operational risk. The countercyclical buffer limits bank participation in credit booms.

Capital adequacy in India

The capital adequacy ratio compares a bank's capital with its risk-weighted assets. RBI sets the minimum.

• CAR = (Tier 1 + Tier 2 capital) / risk-weighted assets.
• RBI minimum for scheduled commercial banks: 9 per cent.
• A higher figure of 12 per cent was cited for public sector banks.
• Innovative perpetual debt is Tier 1. The net stable funding ratio is Basel III liquidity.

Capital adequacy means a bank can absorb a reasonable amount of loss. The maturity gap is an asset-liability management tool. Asset liability management addresses risk from mismatches between assets and liabilities.

NPAs and risk

Non-performing assets and their classification

A loan becomes a non-performing asset when it is overdue for more than 90 days. NPAs are classified in three groups.

• NPA test: overdue for more than 90 days.
• Sub-standard: NPA for up to 12 months.
• Doubtful: sub-standard for more than 12 months.
• Loss assets: identified as uncollectable.

Before the 90 days, accounts pass through special mention stages. Credit risk arises when a principal or interest is not repaid. It also arises from guarantees and letters of credit if funds are not forthcoming.

Tackling NPAs: DRTs, SARFAESI and ARCs

The government introduced several steps to tackle bad loans. They came in a time order.

• Debt Recovery Tribunals 1993, Credit Information Bureau 2000.
• Corporate Debt Restructuring 2001, compromise settlement, then SARFAESI Act 2002.
• ARC steps: buy loans at a discount, issue receipts, recover, charge a fee.
• DRT steps: show cause notice, disclose assets, restrain dealing.

An asset reconstruction company buys the bank's bad loans at a discount and pays the bank in security receipts. It then recovers and charges a 2 per cent management fee. The DRT first issues notice to show cause within 30 days.

Asset liability management and credit risk

Asset liability management manages the mismatch between assets and liabilities. Credit risk is the risk of loss from a borrower's failure.

• ALM addresses risk from mismatches of assets and liabilities.
• Maturity gap is a tool of ALM.
• NPAs are not written off in the year they are identified. They are provided for.
• Undisclosed reserves can form part of capital.

Credit risk arises from direct lending, guarantees and letters of credit. A bank must match the timing of what it owes with what it earns.

Passage: forbearance and corporate funding

A passage in a past paper dealt with loan forbearance in the Covid period. It warned against long forbearance.

• Forbearance should be an emergency medicine, not a staple diet.
• Extended forbearance after 2007-08 built up bad loans.
• A moratorium on debt service cushioned companies in Covid.
• The government promised a fund of funds for micro, small and medium enterprises.

Many firms would face liquidity problems when the moratorium ended. Firms need capital that does not need debt service, such as equity. A suitable title is Forbearance and corporate funding in crisis times.

NBFCs

Non-banking finance companies

NBFCs lend and invest like banks, but they are not banks. They are registered with the RBI.

• They cannot accept demand deposits.
• They are not part of the payment and settlement system and cannot issue cheques on themselves.
• Deposit insurance is not available to NBFC depositors.
• Categories: asset finance, investment and loan companies.

Services of NBFCs include leasing, hire purchase and asset management. They do not implement modernisation, they finance it. The Shah Working Group of 1992 suggested the regulatory framework.

Payment systems like RTGS, NEFT, IMPS and UPI, mobile banking and its risks, payment banks and financial inclusion.

Payment systems

RTGS, NEFT and IMPS

These systems move money between banks. They differ in speed and size.

• RTGS: real time gross settlement, minimum Rs 2 lakh, no upper cap.
• NEFT: batch settlement.
• IMPS: instant payment, 24 x 7, started by NPCI in 2010.
• RTGS and NEFT are digital. A demand draft and a cheque are not.

The objectives of IMPS include mobile as a channel to access accounts 24 x 7 and payments with only a mobile number. A claim that RTGS has no minimum is wrong. A fixed Rs 3 lakh daily NEFT cap is also wrong.

NPCI, UPI, RuPay and SWIFT

NPCI runs India's retail payment systems. SWIFT serves international transfers.

• NPCI products: RuPay, UPI, IMPS.
• RuPay is India's own card network.
• SWIFT is used for international money transfers.
• UPI let initial adoption soar partly because the merchant discount rate was waived.

NPCI was set up by the RBI and banks. Paytm and BharatPe are private apps. Mastercard is a foreign card network. UPI cross-border use and the digital rupee are expected to help payments banks grow.

Mobile banking, cyber risks and technology

Mobile banking saves time and cuts fraud, but has risks. Technology items appear in banking exams.

• Advantages: faster processing, time saving, fraud reduction.
• Cyber attacks: backdoor, denial of service and direct access.
• Skimming copies card information.
• Star topology: each node joins a central node by a separate link.

A database management system gives central control, shared data and better integrity. High acquisition cost is a disadvantage. A decision support system generates new evidence in support of a decision. An electronic purse stores value on a card for small payments.

Payments banks, neo banks and digital challenges

Payments banks accept deposits but cannot lend. Neo banks are digital-only. Interoperability is a key challenge.

• Payments banks need to be part of the UPI ecosystem.
• Neo banks cater to the unbanked and underbanked.
• The main challenge is lack of standardisation and interoperability.
• AI helps through advanced analytics.

Lack of standard systems causes confusion and inconvenience for customers. Initial UPI adoption was helped by waiving the merchant discount rate. A non-fungible token is a unique digital asset that cannot be split.

Financial inclusion

Financial inclusion: meaning, schemes and index

Financial inclusion gives all sections of society access to suitable financial services at affordable cost. India has several schemes.

• PM Jan Dhan 2014, PM Mudra 2015, Stand-Up India 2016, Vaya Vandana 2017.
• The RBI Financial Inclusion Index has three dimensions: access, usage and quality.
• Universal access promotes inclusion.
• Quality captures financial literacy, consumer protection and inequality in service.

Poor service, high transaction costs and lack of trust hold inclusion back. Jan Dhan aims to give a bank account to every citizen. Mudra gives microfinance to small enterprises.

How securities are issued and traded, short-term instruments, the market regulator and mutual funds.

Capital market

Capital market and its instruments

The capital market deals in medium and long-term funds. It links savers to investment opportunities.

• Instruments: equity shares, debentures, preference shares.
• Commercial paper is a money market instrument, not a capital market one.
• Primary market: IPO, long-term loans, venture capital.
• Co-promoting state-level venture funds is not a feature.

A GDR is issued by an international depository bank, not only by a US bank. Capital markets mobilise resources and divert them into productive channels. Richard Roll said efficient markets need traders who make a living by beating the market.

Methods of issuing shares

New shares can be issued by public issue, rights issue, book building or private placement. A bonus issue is a free issue.

• Public issue: invites the general public.
• Rights issue: offered to existing shareholders.
• Book building: price discovery by an order book.
• Bonus shares: free to existing members.

Fixed price offer steps: select merchant banker, issue prospectus, receive applications, allot shares, issue share certificates. Book building steps: appoint merchant banker and syndicate, file the red herring prospectus, build the order book, determine price, allot.

Value of a right and issue disclosures

The value of a right is the fall in the share price after the right is detached. Public issues must make standard disclosures.

• Ex-rights price = (old shares x price + new shares x issue price) / total.
• Value of right = market price - ex-rights price.
• Disclosures: EPS, pre-issue P/E, average return on net worth, net asset value.

Take a market price of Rs 150 and an issue price of Rs 120, with one new share for every five held. The ex-rights price is (5 x 150 + 120) / 6 = Rs 145. The right is worth Rs 5.

Stock exchanges, NSE and market institutions

Stock exchanges provide the secondary market. NSE has a timeline of milestones.

• NSE milestones: Nifty 1996, index futures 2000, index options 2001.
• OTCEI was meant for small investors. The grey market deals before listing.
• Insider trading is illegal.
• UPI lets trading money go straight to the clearing corporation.

ASBA works in the primary market and a similar facility is proposed for the secondary market. Copying it is complicated because of the number of parties and the kinds of transactions. SEBI protects investors' cash and securities.

Market efficiency, ASBA and investor protection

Efficient markets need informed trading. SEBI protects investors' cash and securities.

• Roll: efficiency needs traders who profit by beating the market.
• ASBA blocks money in the investor's account in the primary market.
• A similar facility was proposed for the secondary market.
• UPI lets trading money go straight to the clearing corporation.

Money going to a clearing corporation does not sit in a broker's pool account, so misuse risk falls. SEBI offered relief to brokers who lose float income. ASBA copying is complicated by the number of parties and the kinds of transactions.

SEBI

SEBI: objectives, tools and regulations

SEBI protects investors and regulates the securities market. It works under the SEBI Act 1992.

• SEBI regulates through regulations, rules, guidelines, schemes and orders.
• It is not constituted from stock exchange directors.
• Regulations in time order: buy-back 1998, intermediaries 2008, ICDR 2009, REIT, LODR.
• The Investor Protection and Education Fund regulations came in 2009.

Merchant banking, underwriting and issue management are regulated by SEBI. Complaints through SCORES are sorted into types. Non-receipt of dividend is a Type II complaint. The J. R. Verma Committee is linked with investor protection in the key.

Money market

Treasury bills

Treasury bills are short-term government securities. They are issued at a discount and repaid at par.

• Highly liquid and negotiable. Yield is assured.
• Tenors: 91, 182 and 364 days. A 273-day bill has never existed.
• Ordinary T-bills are marketable. Ad hoc T-bills were issued only to the RBI.
• Participants: RBI, banks, foreign banks, provident funds, corporates.

The 14-day intermediate bills began in 1996-97 after the 91-day on-tap bills were stopped. They let state governments and some foreign central banks park surplus funds. T-bills are not issued at par and repaid at a premium.

Commercial paper and call money

Commercial paper is a corporate money market instrument. The call market is for overnight funds.

• CP: unsecured, short-term promissory note, issued at a discount.
• Issued by creditworthy corporates, primary dealers and financial institutions.
• The Vaghul Committee recommended CP.
• Call rates rise when liquidity is tight.

Because CP is unsecured, the credit rating matters a lot. Call rates under normal conditions are not a cap for term money rates. An interbank call market trades overnight funds between banks.

Development and defects of the Indian money market

The Indian money market developed step by step. It still has defects.

• Commercial paper 1990.
• Ways and Means Advances linked to bank rate 1997.
• Liquidity Adjustment Facility 1999-2000, then interest rate swaps.
• Defects: dichotomy in the market and diversity in interest rates.

NBFCs belong mainly to the credit market, not to the organised money market. Government and short-term securities are dominant. A well-developed money market is essential for a modern economy.

Mutual funds

Structure and regulation of mutual funds

A mutual fund is a trust with four parties. SEBI regulates it.

• Sponsor: like the promoter of a company.
• Trustees: hold property and monitor SEBI compliance.
• AMC: invests in various securities.
• Custodian: keeps the securities safe. A depository is not a part of the trust.

A mutual fund is an investment intermediary that pools small savings. An entry load is charged when units are bought. Hedge funds are not mutual funds and cannot be sold to the public. SEBI's skin-in-the-game rule asks fund managers to invest in their own schemes. When the economy weakens, money market funds are preferred to equity funds.

UTI and the Indian mutual fund industry

UTI was India's first mutual fund institution. Its objectives centred on small savers.

• Mobilise savings with safety, liquidity and returns.
• Channel pooled savings into productive uses.
• Let everyone indirectly own shares in many companies.
• Hire purchase and housing finance are not its objectives.

UTI was later split into UTI-I and UTI-II rather than merged. A mutual fund is an investment conduit. Money market mutual funds can be sold to corporates and individuals.

How insurance works and is regulated, and services such as securitisation, factoring, credit rating and pensions.

Insurance

Insurable interest and the nature of insurance contracts

Insurable interest is a genuine financial stake in the thing insured. The time it must exist differs.

• Life: at the time the policy is taken.
• Fire: at the time of contract and at the time of loss.
• Marine: at the time of loss.
• Life insurance is a contingent agreement and an assurance, not an indemnity.

A life cannot be valued, so life insurance is not indemnity. An endowment policy pays the sum assured at maturity or to the nominee on death. A wagering agreement is not valid insurance.

Average clause, subrogation and indemnity

Property insurance follows the principle of indemnity. Related rules prevent profit from loss.

• Indemnity: compensation only for the actual loss.
• Average clause: applies in cases of under-insurance.
• Subrogation: after paying, the insurer takes over the insured's rights to recover.
• Contribution applies where there is double insurance.

If a property is insured for half its value, the average clause reduces the compensation in proportion. Subrogation lets the insurer recover from a third party who caused the loss.

Marine insurance, claims and solvency

Marine insurance covers ships, cargo and freight. Claims follow set steps.

• Hull insurance: the ship. Cargo insurance: the goods. Freight insurance: freight revenue.
• Jettison: throwing cargo overboard to save the ship.
• Claim steps: notice of loss, claim form, scrutiny, investigation, settlement.
• Solvency margin: the safety margin an insurer must keep.

The loss from jettison is shared under general average. IRDAI sets the solvency margin to protect policyholders. A new life insurer needs paid-up capital of Rs 100 crore.

Insurance legislation and history

Indian insurance has a long history. Laws and committees marked its stages.

• Oriental Life Insurance Company 1818 was started by Europeans in Calcutta.
• Life Insurance Companies Act 1912 and the Provident Fund Act 1912.
• Insurance Act 1938 was the predecessor of the IRDA Act 1999.
• Malhotra Committee 1993 recommended reform and private entry.

The Bombay Mutual Life Assurance Society of 1870 was the first Indian insurer to cover Indians at normal rates. Swadeshi Life was later renamed Bombay Life. Early foreign insurers discriminated against Indian lives with extra premiums.

Financial services

Securitisation

Securitisation pools loans and sells them as securities. A bank selling a mortgage portfolio through pass-through securities is doing it.

• Pool the assets, transfer them to a vehicle, issue securities.
• Self-liquidating structure: no new assets, collateral fixed for the life.
• Revolving structure: new assets are added as old ones are paid.
• Reasons: diversify funding, lower cost, accelerate earnings.

Securitisation can also raise capital from non-conventional sources. It lets a lender free capital for new loans. An amortising structure repays the investors out of the pool.

Factoring, credit rating and credit scores

Factoring turns receivables into cash. Credit ratings and scores measure creditworthiness.

• Factoring: a specialist collects receivables and often pays in advance.
• Export factoring: contract, shipment, advance, invoice to the import factor, collection.
• Credit scores in India range from 300 to 900.
• Credit rating agencies include CRISIL, ICRA and CARE.

In agency factoring the customers of the client are asked to pay the factor directly. A higher score means better creditworthiness. Not all agencies named in questions are RBI-accredited domestic agencies.

Venture capital, term finance and pension asset classes

Venture capital finances new and growing firms. The National Pension System divides investments into asset classes.

• Venture capital is risk capital. Not all venture funds are government promoted.
• Term finance: for expansion and modernisation.
• Refinance: replenishment finance to institutions.
• NPS classes: E equity, C corporate bonds, G government securities, A alternative assets.

Share capital issued for the first time is an initial public offer, not venture capital. Venture capitalists also give managerial help. Financial inclusion means banking services at an affordable cost.