Chapter 10: FINANCIAL MARKETS
Businesses can raise funds
through various ways and many sources through the financial
markets. A financial market helps mobilize funds between savers
[households] and investors [business]. The work of allocation is
done by two intermediaries which can be banks or financial
markets. The banks can deposit money of the savers and lend to
the businesses or the alternative is buying of shares or
debentures of companies using the financial markets.
Functions of financial markets:
savings and channeling them into the most productive use:
of a financial asset.
to financial assets
platform for buyer and sellers and reduce cost of transaction.
Classification of financial markets:
traded in them mature in less than a year
traded in them mature in more than a year.
Money market instruments:
bills: instrument of short term borrowing by the
government with maturity of less than a year. They are also
called zero coupon bonds.
are unsecured promissory notes issued by companies to secure
short term loans at rates lower than market rates.
money: short term borrowing by banks from each other to
maintain cash reserve ratio.
deposit: issued by commercial banks to secure money for
short periods when liquidity is low and demand for cash is high.
It refers to institutional
arrangements through which long term funds both debt and equity
are raised and invested.
It is a platform where new securities are
issued for the first time. The securities are for opening a new
venture or expansion of an existing venture. The investors can
be institutional or retail investors.
E.g. IPOs, offer for sale, offer through prospectus.
is stock market or stock exchange where existing securities are
Promissory notes or offshore
investor needs a pan card and KYC for purchasing securities in
India. But if he doesn’t want to follow procedures he can take
the p-note route.
registered FII like HSBC can purchase the securities and then
give a p-note to the offshore investor. The p-note is an
anonymous instrument which doesn’t have the name of the person
to which it’s sold.
its value from the underlying securities. The owner of p-note
can sell it to anyone without any paper trail or paying capital
gains tax to country.
have been flagged as security risk due to misuse by terrorists
or hawala operators.
S.E.B.I has taken precaution and
to prevent misuse it has restricted people who can issue
government of foreign countries, foreign PSUs
mutual funds, pension funds, university endowment funds
not in above e.g. Hedge funds
Only Category -I, II can issue
bonds are issued by the government and are secured by underlying
assets which can be sold to repay the bond holders. Debentures
are issued by private company and are unsecured so holder is at
yield and interest are inversely proportional to bond price.
– Securities and Exchange board of India
Established in 1988 as a body for promoting orderly and
healthy growth of securities market and for investor
protection. It was given a statutory status in 1992.
establishment of SEBI:
investor population and the market capitalization led to
malpractices by the companies, traders, brokers, consultants.
included self styled merchant bankers, price rigging, unofficial
private placements, insider trading, non adherence to provisions
of companies act, violation of rules and regulations of stock
exchange, delay in delivery of shares.
confidence was eroded and investor grievance was multiplied. To
counter this government set up a regulatory body.
exchange and securities industry to promote their orderly
and interests of investors
and promote balance between self regulation by the industry and
the intermediaries more professional and competitive by making a
code of conduct and fair practices.
brokers, sub brokers
investment schemes and mutual funds
and prohibitory practices.
act and penalizing defaulters.
and fees for enforcing the act
as delegated to it by the central government under the
securities contracts act.
training of intermediaries, conducting research and promoting
code of conduct.
Nationalization of Banking in India
Once the RBI was nationalised in 1949, the government considered nationalizing private banks for the following reasons:
- Private banks had a narrow reach and the masses had no access to banking
The government needed to direct resources in such a way that greater public benefit could take place.
- Planned development of the country meant that government would need a greater control over the capital of the economy and this could be done only by bank nationalisation.
SBI and its associates were first to be nationalised and then 19 more were nationalised by Bank Nationalisation Act, 1969.
Life Insurance Corporation was nationalised by Government of India in 1956 with twin objective for spreading information about greater social security and secondly mobilize public’s savings. LIC also became an ally of the government’s planned economy by buying government securities and equities in PSU’s.
General Insurance Corporation was nationalised in 1971 and was designated in 2002 as the Reinsurer of India. When an insurance company gets insurance coverage on its insurance policies, it is considered a case of reinsurance. Reinsurance becomes an essential precondition if the economy is trying to develop and expand insurance with the active participation of the private sector insurance companies.
SEBI has no power to regulate unlisted companies. These are regulated by Ministry of Corporate affairs. But SEBI has jurisdiction over any investment scheme by listed or unlisted company if over 50 people are investing.
The Financial and Deposit Insurance Bill, 2017 proposes to create a framework for monitoring financial firms such as banks, insurance companies, and stock exchanges; pre-empt risk to their financial position; and resolve them if they fail.
To ensure continuity of a failing firm, it may be resolved by merging it with another firm, transferring its assets and liabilities, or reducing its debt. If resolution is found to be unviable, the firm may be liquidated, and its assets sold to repay its creditors.
What is the current framework to resolve financial firms? What does the Bill propose?
Currently, there is no specialised law for the resolution of financial firms in India. Provisions to resolve failure of financial firms are found scattered across different laws.
Resolution or winding up of firms is managed by the regulators for various kinds of financial firms (i.e. the Reserve Bank of India (RBI) for banks, the Insurance Regulatory and Development Authority (IRDA) for insurance companies, and the Securities and Exchange Board of India (SEBI) for stock exchanges.)
However, under the current framework, powers of these regulators to resolve similar entities may vary (e.g. RBI has powers to wind-up or merge scheduled commercial banks, but not co-operative banks.)
The Bill seeks to create a consolidated framework for the resolution of financial firms by creating a Resolution Corporation.
The Resolution Corporation will include representatives from all financial sector regulators and the ministry of finance, among others. The Corporation will monitor these firms to pre-empt failure, and resolve or liquidate them in case of such failure.
How does the Resolution Corporation monitor and prevent failure of financial firms?
Risk based classification: The Resolution Corporation will classify financial firms under five categories, based on their risk of failure. This classification will be based on adequacy of capital, assets and liabilities, and capability of management, among other criteria. The Bill proposes to allow both, the current regulator and the Corporation, to monitor and classify firms based on their risk to failure.
Corrective Action: Based on the risk to failure, the Resolution Corporation or regulators may direct the firms to take certain corrective action. For example, if the firm is at a higher risk to failure (under ‘material’ or ‘imminent’ categories), the Resolution Corporation or the regulator may: (i) prevent it from accepting deposits from consumers, (ii) prohibit the firm from acquiring other businesses, or (iii) require it to increase its capital. Further, these firms will formulate resolution and restoration plans to prepare a strategy for improving their financial position and resolving the firm in case it fails.
While the Bill specifies that the financial firms will be classified based on risk, it does not provide a mechanism for these firms to appeal this decision. One argument to not allow an appeal may be that certain decisions of the Corporation may require urgent action to prevent the financial firm from failing. However, this may leave aggrieved persons without a recourse to challenge the decision of the Corporation if they are unsatisfied.
How will the Resolution Corporation resolve financial firms that have failed?
The Resolution Corporation will take over the administration of a financial firm from the date of its classification as ‘critical’ (i.e. if it is on the verge of failure.) The Resolution Corporation will resolve the firm using any of the methods specified in the Bill, within one year.
This time limit may be extended by another year (i.e. maximum limit of two years). During this period, the firm will be immune against all legal actions.
The Resolution Corporation can resolve a financial firm using any of the following methods: (i) transferring the assets and liabilities of the firm to another firm, (ii) merger or acquisition of the firm, (iii) creating a bridge financial firm (where a new company is created to take over the assets, liabilities and management of the failing firm), (iv) bail-in (internally transferring or converting the debt of the firm), or (v) liquidate the firm to repay its creditors.
If the Resolution Corporation fails to resolve the firm within a maximum period of two years, the firm will automatically go in for liquidation. The Bill specifies the order of priority in which creditors will be repaid in case of liquidation, with the amount paid to depositors as deposit insurance getting preference over other creditors.
While the Bill specifies that resolution will commence upon classification as ‘critical’, the point at which this process will end may not be evident in certain cases. For example, in case of transfer, merger or liquidation, the end of the process may be inferred from when the operations are transferred or liquidation is completed, but for some other methods such as bail-in, the point at which the resolution process will be completed may be unclear.
Does the Bill guarantee the repayment of bank deposits?
The Resolution Corporation will provide deposit insurance to banks up to a certain limit.
This implies, that the Corporation will guarantee the repayment of a certain amount to each depositor in case the bank fails.
Currently, the Deposit Insurance and Credit Guarantee Corporation (DICGC) provides deposit insurance for bank deposits up to 1 lakh rupees per depositor.
The Bill proposes to subsume the functions of the DICGC under the Resolution Corporation
Q.The term ‘Base Erosion and Profit Shifting’ is sometimes seen in the news in the context of (UPSC CSAT 2016)
mining operation by multinational companies in resource-rich but backward areas
curbing of the tax evasion by multinational companies
exploitation of genetic resources of a country by multinational companies
lack of consideration of environmental costs in the planning and implementation of developmental projects
Ans . B
Q. There has been a persistent deficit budget year after year. Which action/actions of the following can be taken by the Government to reduce the deficit?
1. Reducing revenue expenditure
2. Introducing new welfare schemes
3. Rationalizing subsidies
4. Reducing import duty
Select the correct answer using the code given below.(UPSC CSAT 2016)
2 and 3 only
1 and 3 only
1, 2, 3 and 4
Ans . C
Introducing new welfare schemes and Reducing import duty wont reduce deficit.
Q.Which of the following is/are included in the capital budget of the Government of India?
1. Expenditure on acquisition of assets like roads, buildings, machinery, etc.
2. Loans received from foreign governments
3. Loans and advances granted to the States and Union Territories
Select the correct answer using the code given below. (UPSC CSAT 2016)
2 and 3 only
1 and 3 only
1, 2 and 3
Ans . D
Q.With reference to the ‘Trans-Pacific Partnership’, consider the following statements:
1. It is an agreement among all the Pacific Rim countries except China and Russia.
2. It is a strategic alliance for the purpose of maritime security ONLY
Which of the statements given above is/are correct? (UPSC CSAT 2016)
Both 1 and 2
Neither 1 nor 2
Ans . D
TPP is meant for free trade
North Korea and Columbia also Pacific rim countries. But not in TPP list of countries
Q.European Stability Mechanism’, sometimes seen in the news, is an (UPSC CSAT 2016)
agency created by EU to deal with the impact of millions of refugees arriving from Middle East
agency of EU that provides financial assistance to eurozone countries
agency of EU to deal with all the bilateral and multilateral agreements on trade
agency of EU to deal with the conflicts arising among the member countries
Ans . B
European Stability Mechanism is a European Union agency that provides financial assistance, in the form of loans, to eurozone countries
Q. The term ‘Regional Comprehensive Economic Partnership’ often appears in the news in the context of the affairs of a group of countries known as(UPSC CSAT 2016)
Ans . B