1. Copy Right: Rai University11.671.3 1MANAGEMENT OF FINANCIAL SERVICESLESSON 1:FINANCIAL SERVICEUNIT IFINANCIAL SERVICESLesson ObjectivesTo understand the Concept of Financial Services, its classifica-tionand activities.In general, all types of activities, which are of a financial naturecould be brought under the term financial services. The termfinancial services in a broad sense means mobilizing andallocating savings. Thus it includes all activities involved in thetransformation of savings into investment.The financial services can also be called financial intermediation.Financial intermediation is a process by which funds aremobilized from a large number of savers and make themavailable to all those who are in need of it and particularly tocorporate customers.Thus, financial services sector is a key area and it is very vital forindustrial developments. A well developed financial servicesindustry is absolutely necessary to mobilize the savings and toallocate them to various invest able channels and thereby topromote industrial development in a country.Classification of Financial ServicesIndustryThe financial intermediaries in India can be traditionallyclassified into two :i. Capital Market intermediaries andii. Money market intermediaries.The capital market intermediaries consist of term lendinginstitutions and investing institutions which mainly providelong term funds. On the other hand, money market consists ofcommercial banks, co-operative banks and other agencies whichsupply only short term funds. Hence, the term financial servicesindustry includes all kinds of organizations which intermediateand facilitate financial transactions of both individuals andcorporate customers.Scope of Finacial ServicesFinancial services cover a wide range of activities. They can bebroadly classified into two, namely :i. Traditional Activitiesii. Modern activities.Traditional ActivitiesTraditionally, the financial intermediaries have been rendering awide range of services encompassing both capital and moneymarket activities. They can be grouped under two heads, viz.a. Fund based activities andb. Non-fund based activities.Fund based activities : The traditional services which comeunder fund based activities are the following :i. Underwriting or investment in shares, debentures, bonds,etc. of new issues (primary market activities).ii. Dealing in secondary market activities.iii. Participating in money market instruments like commercialpapers, certificate of deposits, treasury bills, discounting ofbills etc.iv. Involving in equipment leasing, hire purchase, venturecapital, seed capital.v. Dealing in foreign exchange market activities.Non fund based activities : Financial intermediaries provideservices on the basis of non-fund activities also. This can becalled fee based activity. Today customers, whether individualor corporate, are not satisfied with mere provisions of finance.They expect more from financial services companies. Hence awide variety of services, are being provided under this head.They include :i. Managing the capital issue i.e. management of pre-issueand post-issue activities relating to the capital issue inaccordance with the SEBI guidelines and thus enabling thepromoters to market their issue.ii. Making arrangements for the placement of capital and debtinstruments with investment institutions.iii. Arrangement of funds from financial institutions for theclients project cost or his working capital requirements.iv. Assisting in the process of getting all Government andother clearances.Modern ActivitiesBeside the above traditional services, the financial intermediariesrender innumerable services in recent times. Most of them arein the nature of non-fund based activity. In view of theimportance, these activities have been in brief under the headNew financial products and services. However, some of themodern services provided by them are given in brief hereunder.i. Rendering project advisory services right from thepreparation of the project report till the raising of funds forstarting the project with necessary Government approvals.ii. Planning for M&A and assisting for their smooth carry out.iii. Guiding corporate customers in capital restructuring.iv. Acting as trustees to the debenture holders.v. Recommending suitable changes in the managementstructure and management style with a view to achievingbetter results.vi. Structuring the financial collaborations / joint ventures byidentifying suitable joint venture partners and preparingjoint venture agreements.vii.Rehabilitating and restructuring sick companies throughappropriate scheme of reconstruction and facilitating theimplementation of the scheme.

2. Copy Right: Rai University2 11.671.3MANAGEMENT OF FINANCIAL SERVICESviii.Hedging of risks due to exchange rate risk, interest rate risk,economic risk, and political risk by using swaps and otherderivative products.ix. Managing the portfolio of large Public Sector Corporations.x. Undertaking risk management services like insuranceservices, buy-back options etc.xi. Advising the clients on the questions of selecting the bestsource of funds taking into consideration the quantum offunds required, their cost, lending period etc.xii. Guiding the clients in the minimization of the cost of debtand in the determination of the optimum debt-equity mix.xiii. Undertaking services relating to the capital market, such asa. Clearing servicesb. Registration and transfers,c. Safe custody of securitiesd. Collection of income on securitiesxiv. Promoting credit rating agencies for the purpose of ratingcompanies which want to go public by the issue of debtinstruments.Sources of RevenueThere are two categories of sources of income for a financialservices company, namely : (i) Fund based and (ii) Fee based.Fund based income comes mainly from interest spread (thedifference between the interest earned and interest paid), leaserentals, income from investments in capital market and realestate. On the other hand, fee based income has its sources inmerchant banking, advisory services, custodial services, loansyndication, etc. In fact, a major part of the income is earnedthrough fund-based activities. At the same time, it involves alarge share of expenditure also in the form of interest andbrokerage. In recent times, a number of private financialcompanies have started accepting deposits by offering a veryhigh rate of interest. When the cost of deposit resources goesup, the lending rate should also go up. It means that suchcompanies have to compromise the quality of its investments.Fee based income, on the other hand, does not involve muchrisk. But, it requires a lot of expertise on the part of a financialcompany to offer such fee-based services.Causes For Financial InnovationFinancial intermediaries have to perform the task of financialinnovation to meet the dynamically changing needs of theeconomy and to help the investors cope with the increasinglyvolatile and uncertain market place. There is a dire necessity forthe financial intermediaries to go for innovation due to thefollowing reasons :i. Low profitability : The profitability of the major FI,namely the banks has been very much affected in recenttimes. There is a decline in the profitability of traditionalbanking products. So, they have been compelled to seek outnew products which may fetch high returns.ii. Keen competition : The entry of many FIs in the financialsector has led to severe competition among them. This keencompetition has paved the way for the entry of variednature of innovative financial products so as to meet thevaried requirements of the investors.iii. Economic Liberalization : Reform of the Financial sectorconstitutes the most important component of Indiasprogramme towards economic liberalization. The recenteconomic liberalization measures have opened the door toforeign competitors to enter into our domestic market.Deregulation in the form of elimination of exchangecontrols and interest rate ceilings have made the marketmore competitive. Innovation has become a must forsurvival.iv. Improved communication technology : Thecommunication technology has become so advanced thateven the worlds issuers can be linked with the investors inthe global financial market without any difficulty by meansof offering so many options and opportunities.v. Customer Service : Now a days, the customersexpectations are very great. They want newer products atlower cost or at lower credit risk to replace the existing ones.To meet this increased customer sophistication, the financialintermediaries are constantly undertaking research in orderto invent a new product which may suit to the requirementof the investing public.vi. Global impact : Many of the providers and users of capitalhave changed their roles all over the world. FI have comeout of their traditional approach and they are ready toassume more credit risks.vii.Investor Awareness : With a growing awareness amongstthe investing public, there has been a distinct shift frominvesting the savings in physical assets like gold, silver, landetc. to financial assets like shares, debentures, mutual funds,etc. Again, within the financial assets, they go from risk freebank deposits to risky investments in shares. To meet thegrowing awareness of the public, innovations has becomethe need of the hour.Financial EngineeringThe growing need for innovation has assumed immenseimportance in recent times. This process is being referred to asfinancial engineering. Financial engineering is the design,development and implementation of innovative financialinstruments and process and the formulation of creativesolutions to the problems in finance.New Financial Products and ServicesIn these days of complex finances, people expect a financialservice company to play a very dynamic role not only as aprovider of finance but also as a departmental store of finance.With the opening of the economy to multinationals, the freemarket concept has assumed much significance. As a result, theclients both corporate and individuals are exposed to thephenomena of volatility and uncertainty and hence they expectthe financial services company to innovate new products andservices so as to meet their varied requirements.As a result of innovations, new instruments and new productsare emerging in the capital market. The capital market and themoney market are getting widened and deepened. Moreover,there has been a structural change in the international capital 3. Copy Right: Rai University11.671.3 3MANAGEMENT OF FINANCIAL SERVICESmarket with the emergence of new products and innovativetechniques of operation in the capital market. Many financialintermediaries including banks have already started expandingtheir activities in the financial services sector by offering a varietyof new products. As a result, sophistication and innovationshave appeared in the arena of financial intermediations. Someof them are briefly explained hereunder :i. Merchant Banking : A merchant banker is a financialintermediary who helps to transfer capital from those whopossess it to those who need it. Merchant banking includesa wide range of activities such as management of customersecurities, portfolio management, project counseling andappraisal, underwriting of shares and debentures, loansyndication, acting as banker for the refund orders, handlinginterest and dividend warrants etc. Thus, a merchant bankerrenders a host of services to corporate, and thus promoteindustrial development in the country.ii. Loan Syndication : This is more or less similar toconsortium financing. But this work is taken up by themerchant banker as a lead manager. It refers to a loanarranged by a bank called lead manager for a borrower whois usually a large corporate customer or a governmentdepartment. It also enables the members of the syndicateto share the credit risk associated with a particular loanamong themselves.iii. Leasing : A lease is an agreement under which a companyor a firm acquires a right to make use of a capital asset likemachinery, on payment of a prescribed fee called rentalcharges. In countries like USA, the UK and Japan,equipment leasing is very popular and nearly 25% of plantand equipment is being financed by leasing companies. InIndia also, many financial companies have startedequipment leasing business.iv. Mutual Funds : A mutual fund refers to a fund raised by afinancial service company by pooling the savings of thepublic. It is invested in a diversified portfolio with a view tospreading and minimizing the risk The fund providesinvestment avenues for small investors who cannotparticipate in the equities of big companies. It ensures lowrisk, steady returns, high liquidity and better capitalization inthe long run.v. Factoring : Factoring refers to the process of managing thesales register of a client by a financial services company. Theentire responsibility of collecting the book debts passes onto the factor.vi. Forfaiting : Forfaiting is a technique by which a forfaitor(financing agency) discounts an export bill and pays readycash to the exporter who can concentrate on the exportfront without bothering about collection of export bills.vii. Venture Capital : A venture capital is another method offinancing in form of equity participation.viii. Custodial Services : Under this a financial intermediarymainly provides services to clients, for a prescribed fee, likesafe keeping of financial securities and collection of interestand dividends.ix. Corporate advisory services : Financial intermediariesparticularly banks have setup specialized branches for this.As new avenues of finance like Euro loans, GDRs etc. areavailable to corporate customers, this service is of immensehelp to the customers.x. Securitisation : Securitisation is a technique whereby afinancial company converts its ill-liquid, non-negotiable andhigh value financial assets into securities of small valuewhich are made tradable and transferable.xi. Derivative Security : A derivative security is a securitywhose value depends upon the values of other basicvariable backing the security. In most cases, these variablesare nothing but the prices of traded securities.xii. New products in Forex Markets : New products havealso emerged in the forex markets of developed countries.Some of these products are yet to make full entry in Indianmarkets. Among them are :a. Forward contract : A forward transaction is onewhere the delivery of foreign currency takes place at aspecified future date for a specified price. It may have afixed or flexible maturity date.b. Options : As the very name implies, it is a contractwhere in the buyer of options has a right to buy or sella fixed amount of currency against another currency ata fixed rate on a future date according to his options.c. Futures : It is a contract wherein there is an agreementto buy or sell a stated quantity of foreign currency at afuture date at a price agreed to between the parties onthe stated exchange.d. Swaps : A swap refers to a transaction wherein afinancial intermediary buys and sells a specified foreigncurrency simultaneously for different maturity dates.xiii. Lines of Credit : It is an innovative funding mechanismfor the import of goods and services on deferred paymentsterms. LOC is an arrangement of a financing institution ofone country with another to support the export of goodsand services to as to enable the importer to import ondeferred payment terms.Challenges Facing the Financial Services SectorThough financial services sector is growing very fast, it has itsown set of problems and challenges. The financial sector has toface many challenges in its attempt to fulfill the ever-growingfinancial demands of the economy. Some of the importantchallenges are briefly explained hereunder :i. Lack of qualified personnel : The financial services sectoris fully geared to the task of financial creativity. However,this sector has to face many challenges. The dearth ofqualified and trained personnel is an important impedimentin its growth.ii. Lack of investor awareness : The introduction of newfinancial products and instruments will be of no use unlessthe investor is aware of the advantages and uses of the newand innovative products and instruments.iii. Lack of transparency : The whole financial system isundergoing a phenomenal change in accordance with the 4. Copy Right: Rai University4 11.671.3MANAGEMENT OF FINANCIAL SERVICESrequirements of the national and global environments. It ishigh time that this sector gave up their orthodox attitudeof keeping accounts in a highly secret manner.iv. Lack of specialization : In the Indian scene, each financialintermediary seems to deal in a different financial servicelines without specializing in one or two areas. In othercountries, financial intermediaries specialize in one or twoareas only and provide expert services.v. Lack of recent data : Most of the intermediaries do notspend more on research. It is very vital that one shouldbuild up a proper data base on the basis of which onecould embark upon financial creativity.vi. Lack of efficient risk management system : With theopening of the economy to multinationals and exposure ofIndian companies to international competition, muchimportance is given to foreign portfolio flows. It involvesthe utilization of multi currency transactions which exposesthe client to exchange rate risk, interest rate risk andeconomic and political risk.The above challenges are likely to increase in number with thegrowing requirements of the customers. The financial servicessector should rise up to the occasion to meet these challenges byadopting new instruments and innovative means of financingso that it could play a very dynamic role in the economy.Present ScenarioThe Indian economy is in the process of rapid transformation.Reforms are taking place in every field / part of economy. Hencefinancial services sector is also witnessing changes. The presentscenario can be explained in following terms :i. Conservatism to dynamism : The main objective of thefinancial sector reforms is to promote an efficient,competitive and diversified financial system in the country.This is very essential to raise the allocative efficiency ofavailable savings, increase the return on investment andthus to promote the accelerated growth of the economy as awhole. At present numerous new FIs have startedfunctioning with a view to extending multifarious servicesto the investing public in the area of financial services.ii. Emergence of Primary Equity Market : The capitalmarkets, which were very sluggish, have become a verypopular source of raising finance. The number of stockexchanges in the country has gone up from 9 in 1980 to 22in 1994. After the lowering of bank interest rates, capitalmarkets have become a very popular mode of channelisingthe savings of medium class people.iii. Concept of Credit Rating : The investment decisions ofthe investors have been based on factors like namerecognition of the company, operations of the Group,market sentiments, reputation of the promoters etc. Nowgrading from an independent agency would help theinvestors in his portfolio management and thus, equitygrading is going to play a significant role in investmentdecision-making. From the companys point of view, Equitygrading would help to broaden the market for their publicoffer, to replace the name recognition by objective opinionand to have a wider investor base. Now it is mandatory forthe non-banking financial companies to get credit rating fortheir debt instruments.iv. Process of globalization : The process of globalizationhas paved the way for the entry of innovative andsophisticated products into our country. Since theGovernment is very keen in removing all obstacles thatstand in the way of inflow of foreign capital, thepotentialities for the introduction of innovative,international financial products in India are very great.Moreover, our country is likely to enter the full convertibilityera soon. Hence, there is every possibility of introductionof more and more innovative and sophisticated financialservices in our country.v. Process of liberalization : Our government has initiatedmany steps to reform the financial services industry. Thegovernment has already switched over to free pricing ofissues by the CCI. The interest rates have been deregulated.The private sector has been permitted to participate inbanking and mutual funds and the public sectorundertakings are being privatized. SEBI has liberalizedmany stringent conditions so as to boost the capital andmoney markets. 5. Copy Right: Rai University11.671.3 5MANAGEMENT OF FINANCIAL SERVICESLESSON 2:THE FINANCIAL SYSTEMLesson ObjectivesTo understand the Functions of Financial System,FinantialAssets, Intermediaries and Markets.The economic development of any country depends upon theexistence of a well organized financial system. It is the financialsystem which supplies the necessary financial inputs for theproduction of goods and services which in turn promotes thewell being and standard of living of the people of a country.Thus, the financial system is a broader term which bringsunder its fold the financial markets and the financial institutionswhich support the system.The major assets traded in the financial system are money andmonetary assets. The responsibility of the financial system is tomobilize the savings in the form of money and monetaryassets and invest them to productive ventures. An efficientfunctioning of the financial system facilitates the free flow offunds to more productive activities and thus promotesinvestment. Thus, the financial system provides the intermedia-tionbetween savers and investors and promotes fastereconomic development.Functions of The Financial SystemAs we know, financial system is very important for the eco-nomicand all round development of any country, its majorfunctions can be explained as following :1 Promotion of LiquidityThe major function of the financial system is the provision ofmoney and monetary assets for the production of goods andservices. There should not be any shortage of money forproductive ventures. In financial language, the money andmonetary assets are referred to as liquidity. In other words, theliquidity refers to cash or money and other assets which can beconverted into cash readily without loss. Hence, all activities in afinancial system are related to liquidity either provision ofliquidity or trading in liquidity.2 Mobilization of SavingsAnother important activity of the financial system is tomobilize savings and channelise them into productive activities.The financial system should offer appropriate incentives toattract savings and make them available for more productiveventures. Thus, the financial system facilitates the transforma-tionof savings into investment and consumption. Thefinancial intermediaries have to play a dominant role in thisactivity.Financial ConceptsAn understanding of the financial system requires an under-standingof the following concepts :1. Financial Assets2. Financial Intermediaries3. Financial markets4. Financial rates of returns5. Financial instrumentsFinancial AssetsIn any financial transaction, there should be a creation ortransfer of financial asset. Hence, the basic product of anyfinancial system is the financial asset. A financial asset is one,which is used for production or consumption or for furthercreation of assets. For instance, A buys equity shares and theseshares are financial assets since they earn income in future.One must know the distinction between financial assets andphysical assets. Unlike financial assets, physical assets are notuseful for further production of goods or for earning incomes.It is interesting to note that the objective of investment decidesthe nature of assets. For instance, if a building is bought forresidence purposes, it becomes a physical asset, if the same isbought for hiring it becomes a financial asset.Classification of Financial AssetsFinancial assets can be classified differently under differentcircumstances. Like :A. (i) Marketable assets and (ii) Non-marketable assetsB. (i) Money/cash asset (ii) Debt asset and (iii) Stock assetsMarketable Assets : Marketable assets are those which can beeasily transferred from one person to another without muchhindrance. Example Equity shares of listed companies,Bonds of PSUs, Government Securities.Non-marketable Assets : If the assets cannot be transferredeasily, they come under this category. Example : FDRs, PF,Pension Funds, NSC, Insurance policy etc.Cash Assets : All coins and currencies issued by the Govern-mentor Central Bank are cash assets. Besides, commercial bankscan also create money by means of creating credit.Debt Asset : Debt asset is issued by a variety of organizationsfor the purpose of raising their debt capital. There are differentways of raising debt capital. Ex.- issue of debentures, raising ofterm loans, working capital advances etc.Stock Asset : Stock is issued by business organizations for thepurpose of raising their fixed capital. There are two types ofstock namely equity and preference.Financial IntermediariesThe term financial intermediaries includes all kinds of organiza-tionswhich intermediate and facilitate financial transactions ofboth individuals and corporate customers. Thus, it refers to allkinds of FIs and investing institutions which facilitate financialtransactions in financial markets. They may be in the organizedsector or in the unorganized sector. They may also be classifiedin to two :i. Capital Market Intermediariesii. Money Market Intermediaries. 6. Copy Right: Rai University6 11.671.3MANAGEMENT OF FINANCIAL SERVICESCapital Market IntermediariesThese intermediaries mainly provide long term funds toindividuals and corporate customers. They consist of termlending institutions like financial corporations and investmentinstitutions like LIC.Money Market IntermediariesMoney market intermediaries supply only short term funds toindividuals and corporate customers. They consist of commer-cialbanks, cooperative bank.Financial MarketsGenerally speaking, there is no specific place or location toindicate a financial market. Wherever a financial transaction takesplace it is deemed to have taken place in the financial market.Hence financial markets are pervasive in nature since financialtransactions are themselves very pervasive throughout theeconomic system. However, financial markets can be referred toas those centers and arrangements which facilitate buying andselling of financial assets, claims and services. Sometimes, wedo find the existence of a specific place or location for a financialmarket as in the case of stock exchange.Classification of Financial MarketsThe classification of financial markets in India can be asfollowing :Unorganized Markets : In unorganized markets, there are anumber of money lenders, indigenous bankers, traders, etc.who lend money to the public. Indigenous bankers also collectdeposits from the public. There are also private finance compa-nies,chit funds etc whose activities are not controlled by theRBI. The RBI has already taken some steps to bring unorga-nizedsector under the organized fold.Organized Markets : In the organized markets, there arestandardized rules and regulations governing their financialdealings. There is also a high degree of institutionalization andinstrumentalization. These markets are subject to strict supervi-sionand control by the RBI or other regulatory bodies. Theseorganized markets can be further classified into two. They arei. Capital Market andii. Money Market.Capital MarketThe capital market is a market for financial assets which have along or indefinite maturity. Generally, it deals with long termsecurities which have a maturity period of above one year.Capital market may be further divided into three, namely :1. Industrial Securities Market2. Government Securities Market and3. Long-term Loans Market.1 Industrial Securities MarketAs the very name implies, it is a market for industrial securities,namely : (i) equity shares (ii) Preference shares and (iii) Deben-turesor bonds. It is a market where industrial concerns raisetheir capital or debt by issuing appropriate instruments. It canbe further subdivided into two. They area. Primary market or New Issue Market,b. Secondary market or Stock Exchange.Primary Market : Primary market is a market for new issues ornew financial claims. Hence it is also called New Issue Market.The primary market deals with those securities which are issuedto the public for the first time. In the primary market, borrow-ersexchange 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 aprimary market. They are (i) Public issue (ii) Right issue and (iii)Private placement.The most common method of raising capital by new compa-niesis through sale of securities to the public. It is called publicissue. When an existing company wants to raise additionalcapital, securities are first offered to the existing shareholders ona pre-emptive basis. It is called rights issue. Private placement isa way of selling securities privately to a small group of inves-tors.Secondary Market : Is a market for secondary sale of securities.In other words, securities which have already passed throughthe new issue market. Generally, such securities are quoted inthe stock exchange and it provides a continuous and regularmarket for buying and selling of securities. This market consistsof all stock exchanges recognized by the Government.2 Government Securities MarketIt is otherwise called Gilt-Edged securities market. It is a marketwhere government securities are traded. In India there are manykinds of Government securities short term and long term.Long-term securities are traded in this market while short termsecurities are traded in money market.The secondary market for these securities is very narrow sincemost of the institutional investors tend to retain thesesecurities until maturity.3 Long-term Loans MarketDevelopment banks and commercial banks play a significantrole in this market by supplying long term loans to corporatecustomers. Long term loans market may further be classifiedinto (i) Term loans, (ii) Mortgages and (iii) Financial Guaran-teesmarkets. 7. Copy Right: Rai University11.671.3 7MANAGEMENT OF FINANCIAL SERVICESLESSON 3:DEVELOPMENT OF FINANCIAL SYSTEM IN INDIALesson ObjectivesTo understand the Growth and Development of FinancialSystem in India.At the time of Independence in 1947, there was no strongfinancial institutional mechanism in the country. There wasabsence of issuing institutions and non-participation ofintermediary financial institutions. The industrial sector also hadno access to the savings of the community. The capital marketwas very primitive and shy. The private as well as the unorga-nizedsector played a key role in the provision of liquidity. Onthe whole, chaotic conditions prevailed in the system. Only afterthe launching of planning era some serious attention was paidto development of a sound financial system in India.With the adoption of the theory of mixed economy, thedevelopment of the financial system took a different turn so asto fulfill the socio-economic and political objectives. Thegovernment started creating new financial institutions to supplyfinance both for agricultural and industrial development and italso progressively started nationalizing some importantfinancial institutions so that the flow of finance might be in theright direction.The development of financial system in India can be discussedin following headlines.Nationalization of Financial Institutions : Reserve Bank ofIndia, which was started as a private institution in 1935, wasnationalized by the Government in 1948 and given thecontrolling authority of the financial system. Later on variousother large financial institutions like banks and insurancecompanies were nationalized to avoid the concentration ofeconomic power.Starting of Unit Trust of India : Another landmark in thedevelopment of Indian financial system was starting of UTI in1964 as a public sector institution to mobilize small savings forcorporate / large ventures. UTI is countrys largest and oldestmutual fund. Later on various financial institutions and privatesector companies started mutual funds to mobilize publicdeposits.Establishment of Development Banks : Many developmentbanks were started not only to extend credit facilities to financialinstitutions but also to render advisory services. These bankswere multipurpose institutions which provide medium andlong term credit to industrial undertakings, discover investmentprojects, undertake the preparation of project reports, providetechnical advice and managerial services and assist in themanagement of Industrial units. Among them are IFCI (1948),ICICI (1955), RCI (1958), IDBI (1964), IRCI (1971), IRBI(1997) and SIDBI (1990) are important DFIs.Institutions for Financing Agriculture, Foreign Trade andHousing : The Government took serious steps to providesector specific finance facilities. RBI established ARDC (1963)and NABARD (1982), EXIM Bank (1982) and NHB (1988).Recently in 1987 Stock Holding Corp. of India Ltd. was set upto tone up the stock and capital markets in the country.Venture Capital Institutions : Venture capital is anothermethod of financing in the form of equity participation. Aventure capitalist finances a project based on the potentialitiesof a new innovative project. The IDBI venture capital fund wasset up in 1986. The Risk Capital and Technology Finance Corp.was started by IFCI. Likewise ICICI and UTI jointly setupTDICI in 1988.Credit Rating Agencies : Of late, many credit rating agencieshave been established to help investors to make a decision oftheir investment in various instruments and to protect themfrom risky ventures. At the same time it has the effect ofimproving the competitiveness of the companies so that onecan excel the other. Credit rating is now mandatory for all debtinstruments.Multiplicity of Financial Instruments : The expansion insize and number of FIs has consequently led to a considerableincrease in the financial instruments also. Different types ofinstruments are available in the financial system so as to meetthe diversified needs of the various people.Legislative support : The Indian financial system has been wellsupported by suitable legislative measures taken by the Govern-mentthen and there for its proper growth and smoothfunctioning. The Indian Companies Act, 1956, SecuritiesContacts (Regulation) Act, 1956, MRTP Act, 1970, SEBI Act arefew examples of legislative support available to financial system.Apart from the above act.Weakness of Indian Financial SystemAfter the introduction of planning, rapid industrialization hastaken place. It has in turn led to the growth of the corporatesector and the Government sector. In order to meet thegrowing demand of the Government and Industries, manyinnovative financial instruments have been introduced. TheIndian financial system is now more developed and integratedtoday than what it was few years ago. Yet it suffers from someweaknesses. Let us discuss these weaknesses in detail.i. Lack of Coordination between different FinancialInstitutions : There are a large number of FIs. Most of thevital FIs are owned by the Government. At the same time,the Government is also the controlling authority of theseinstitutions. In these circumstances, the problem of co-ordinationarises. As there is multiplicity of institutions inthe Indian Financial system, there is lack of coordination inthe working of these institutions.ii. Monopolistic Market Structures : In India, some FIs areso large that they have created a monopolistic marketstructure of financial system. For instance, almost entire lifeinsurance business is in the hands of LIC of India. So large 8. Copy Right: Rai University8 11.671.3MANAGEMENT OF FINANCIAL SERVICESstructures could retard development of financial system ofthe country itself.iii. Dominance of Development Banks in IndustrialFinancing : The development banks constitute thebackbone of the Indian financial system occupying animportant place in the capital market. The industrialfinancing today in India is largely through the FI created bythe government, both at the national and regional levels. Assuch, they fail to mobilize the savings of the public.However, in recent times attempts have been made to raisefunds from public through the issue of bonds, units,debentures and so on.iv. Inactive and Erratic Capital Market : The Indian capitalmarket is not strong and dependable. Because of regularscams and frauds, general public is not having faith in theCapital Markets. The weakness of the capital market is aserious problem in our financial system.v. Imprudent Financial Practices : The dominance ofdevelopment banks has developed imprudent financialpractice among corporate customer. The development banksprovide most of the funds in the form of term loans. Sothere is a predominance of debt capital has made the capitalstructure of the borrowing concerns uneven and lopsided.However in recent times, all efforts have been made to activatethe capital market. Integration is also taking place betweendifferent FIs. Similarly, the refinance and rediscounting facilitiesprovided by the IDBI aim at integration. Thus, the IndianFinancial System is undergoing fast changes, to become a welldeveloped one.Following are the references available in various journals forfurther knowledge and study.Regulation of the Financial Sector Freedom of the RegulatorBy - N. Rangachary , Chairman, IRDA, 23 April 2003Which way should I take? asked Alice.It all depends on where you want to go. replied the rabbit. Alice In Wonderland by Lewis CarrollIntroductionI am delighted to be here among many affectionate friends. Iam thankful to Shri M.Narasimham, Chairman, AdministrativeStaff College Of India, Hyderabad and the author of economicreforms in this country to have asked me to deliver this lecture.I am happy that Administrative Staff College of India has nowmy friend Dr. E.A.S.Sarma directing it. I consider it a privilegeto be talking to you in a subject of my choice. I deliberateddeeply for a little while on what I should talk today. Convincedthat the financial sector of which I am a part today has stillsome way to go to be fully reflective of the reforms that oneshould like to see. I chose the subject of regulation of thefinancial sector. It is coincidental that Shri K.L.N.Prasad, onwhose memory this lecture has been arranged was also con-nectedto this sector.In this heterogeneous time of modernity the altering of theboundaries between a state and its market encompasses, what isvariously described as, realigning government, structuralreforms towards liberalisation or deregulation, and a change ofmix of the mixed economy. To enable an appreciation of thischanging mix between State and market in India, a combinationof descriptive and analytical approaches is adopted in thisaddress, with a focus on what may be described as relevantfunctions, processes and balances.In the year 1990-91 which nominally marks the high water-markof economic reforms in this country, a de-professionalisedintellectual saw for the first time in an organised mannerrecognition of systemic problems, particularly in the areas offiscal, public enterprises and overall competitive strength ofindustry. It also became clear to the policy makers that growthfinanced by unsustainable fiscal as well as trade deficits lackedinstitutional underpinning to take the economy to a highergrowth path or ensure social justice. Given the fiscal situation,the public enterprises which saw the fiscal support drying upstarted clamoring for market access, autonomy and even someprivatisation. The private sector, including the corporate sector,realised that the capacity of Government to support them wasgetting eroded due to fiscal compulsions, while regulatory andother demands from Government continued to be perceived asa burden on them. In the absence of fiscal support fromGovernment, they found it worthwhile to seek deregulationand liberalisation, arguing against what they described as over-regulationand under-governance. There was a widespreadrealisation that the basic assumption of efficiency and effective-nessof State vis--vis market appear to be less valid thanbefore, mainly due to technological progress and the institu-tionalcharacteristics of public sector. The success of alternatemodels elsewhere, in achieving both higher growth and socialjustice was impressive and sustained, and was too apparent tobe ignored by the public opinion in India.Redrawing the BoundariesIn the functional approach to the role of the State in the lateeighties, it was argued that redrawing the boundaries betweenState and market could be analysed in terms of different rolesof State. States role in economic activity can be broadly classifiedinto that of a Producer-State, i.e. producer of commercial goodsand services; Regulatory-State, involving setting and enforcingof rules that govern, encourage or discourage economic activitiesof market participants; Facilitator-State, involving provision ofpublic goods such as police, judiciary, street lighting; and aWelfare State, ensuring a provision of a wide variety of meritgoods such as education and health.As a producer of commercial goods and services, the majoroption exercised by the Government was to permit entry ofprivate sector in activities that were reserved for public owner-ship.This option does not necessarily involve retreat of State inabsolute terms though in relative terms, it does amount to it.While attempts were on to reduce the role of State as a pro-ducer,correspondingly, there has been deregulation in someand expansion of State in others as a regulator. For example, incapital markets, insurance, telecommunications, electricity andports national level regulatory authorities under appropriatestatutes have been established. Similar initiatives are beingconsidered in some other sectors also. The regulatory authoritiesare expected to exercise independence from the ministries of the 9. Copy Right: Rai University11.671.3 9MANAGEMENT OF FINANCIAL SERVICESGovernment or the enterprises concerned and provide a broadframework for entry and operating conditions, especially tariff,in a way that would ensure protection and to build the confi-denceof the investors and consumers, whose interests oftenget ignored in a monopoly-like situation.Though at a macro-level there has been deregulation, it is oftenargued institutional intolerance is undermining the full impactof deregulation. The process of expanding the regulatory role issometimes described as incomplete, if not inadequate, on theground that the constitution of regulatory authorities is notnecessarily apolitical or designed to counter political cycles; thatthey are being undermined by Ministries concerned either onaccount of the narrow and sectarian interests of the publicenterprises or to serve what the Ministry perceives to be a largerpublic interest, and that the regulatory authorities are inad-equatelyprovided for, in regard to physical, financial or humanresources, to perform their task efficiently and effectively.However, it is undeniable that, a basic framework for a moretransparent, accountable and, expanded role of State as aregulator has been put in place in many crucial sectors, though afocused attention to the strengthening of these authorities maystill be necessary.In its role as a facilitator State in India, the major thrust is toensure provision of a public-good that is relevant and notnecessarily whether State does it on its own or through use ofprivate sector. For example, health services for an accident victimmay be a public good while health services for a by passsurgery is a pure commercial good. It must be recognised that asignificant part of provision of public goods falls in thejurisdiction of state governments and not in Central Govern-ment.Overall, there is a significant scope and a need for reviewof the states role as facilitator.While in some developed countries, a major source of fiscalstress and consequently a major area of reform has beenrevamping or cutting down on role of State as a Welfare State,in India there is a large consensus on expanding rather thancontracting the role of the State in the provision of welfare. Theconsensus covers entitlements such as medical attention and oldage pensions. Some states are attempting to overcome thisthrough effective decentralisation of initiatives and manage-ment.Improvements to inefficient provision by public sectorand a regulatory framework to govern unbridled private sectorin addition to evolving appropriate mix of funding andprovision by public and private partnerships appear to be thereform agenda for the future in the realm of State as welfareprovider.Thus the expectations from reforms in India are not in termsof across the board retreat of State in favor of market but, interms of enhancing States capacity to permit efficiency-gainsand expand availability of public and merit goods. While Stateis retreating in some areas, such as pure commercial goods orservices, it is both retreating and expanding in other areas suchas regulations and is expected to expand further in public andmerit goods. In general, the direction of reform is a retreat as aproducer State and a retreat coupled with expansion as aregulatory State.New EquilibriumThe evolution of the mix between State and market in India,during the recent reforms, reveals many interesting aspects,especially on the nature of changing mix relevant to us, as alsothe variety of options exercised. To assess the dynamics of thechanging mix, it would be useful to track what may be termedas new equilibrium levels that are emerging as both causes andconsequences of a changing mix between State and market. Thechanging balance between State and market does not happen inisolation, but is related to other factors as well.As reform progresses, it appears that the relative balancebetween Centre and state tends to tilt in favor of states. Themost important areas for the Central Governments responsi-bilitiesare in international trade, financial sector,telecommunications, aviation, and especially banking andcorporate law/practices. In most of these areas, factors such asmultilateral agreements ( say GATS), globalisation, andrecommended best practices of the world, tend to get con-strained,over a period, since the free and rapid flow ofcommodities, skills and finances among the countries wouldrequire us to be not too much out of alignment.The balance between the Ministries representing the combina-tionof political executive and Government bureaucraciesvis--vis the exercise of ownership functions as well as regula-toryfunctions may also change somewhat adverse to Ministries.The process of privatisation, diversified ownership andautonomy of public enterprises may erode the discretionaryelement of the Ministries. Once separate regulatory bodies on astatutory basis are established and strengthened, they are meantto be autonomous and report to Parliament through anadministrative ministry. Often, their membership need notcoincide with political cycles and thus may impart greaterstability to regulatory regime. Increasing role of semi-autono-mousregulatory bodies tilts the balance away from theMinistries and in favour of less volatility in policies.The relationship among public enterprises and between publicand private enterprises could be subject to new balances inseveral ways. Public enterprise will have to reckon with growingcompetition from private sector. Regulatory agencies as part oftheir charter insist on a level playing field between public andprivate sectors. The public enterprises faced with hard budgetconstraints, antiquated and non-responsive business practicesand procedures, threat of private sector entry and accountabilityto the new private shareholders where they exist, may have tocarve out a new pattern of relationships with the Governmentand within the organisation.Strategic cooperation and cross holdings between public andprivate sectors are inevitable, thus replacing water tightcompartmentalisation between them. In fact, this process maynecessitate ultimately in the termination of the concept ofgovernment companies under Companies Act.The evolution of new balances between public and privatesectors is clearly in the horizon. There are large areas, likehealthcare, where a public-private mix is dictating new balances,in regard to ownership, funding, official recognition andgovernmental regulation. The traditional water tight divisionbetween Government or public and private sector each combin- 10. Copy Right: Rai University10 11.671.3MANAGEMENT OF FINANCIAL SERVICESing within itself separate concepts of resourcing and a provisionmay get blurred and larger scope demanded for the closeintermingling of the two. Further, such intermingling mayinvolve non Governmental organisations as well as localinitiatives.Questions of social reforms and social relevance of theglobalisation and liberalisation measures are being raised in thecontext of reform on whether the poor will be worse off thanbefore in absolute terms due to the reforms and whether thebalance between poor and non-poor, in relative terms, willworsen as a result of reform. Given the stalemate in State actionthe poor may not be worse off than before and may even beable to articulate their needs better in the absence of bureaucrati-callydetermined services. There is evidence that rural prosperityhas been improving significantly in the recent years. The rural-urbancontinuum would perhaps assert itself, but in any case,rural-urban linkages are set to get strengthened especially whenthe services sector is growing rapidly and replacing the tradi-tionalrural-urban divide.Changing the Fulcrum in the Financial SectorIn India, individual sectors of the finance industry have beenseparately regulated and in different time perspectives. Theregulatory system has evolved on a piecemeal basis with newlegislation being introduced to deal with perceived problems,aided by the occasional fundamental review of the entiresystem. Generally, however, it has been recognised that thereshould be a fairly sharp distinction between banking, securitiesand insurance business. Even at the international level, co-ordinationhas tended to be within these three broad groupsrather than between them.In India, the system has apparently worked very well comparedwith other countries. However, as part of the finger pointingculture in which we now seem to live, any failure of a financialinstitution is seen to be a failure of regulation. Even on thisscore, India has been remarkably successful compared with, say,the United States, Japan and France. Of course, there have beenfailures, but there is no way of running a financial system in acompetitive marketplace without an occasional failure. Not onlyhas prudential regulation developed in different ways for thedifferent types of institution, but in addition there has been aseparate conduct of business regulation for the three sectors.Besides being subject to statutory regulation, there has beenofficial pressure today to ensure that adequate self-regulatorymechanisms are in place.An observer from another country looking at the system inIndia in the mid-1990s would have concluded that it did notwork very well in theory, but that, at least comparativelyspeaking; it did work rather well in practice perhaps a rathertypical Indian result. But there is a limit to the extent to whichtheory and practice can diverge. As financial markets developedduring the 1990s, so the system of regulation began to lookincreasingly inadequate.The major factors justifying a comprehensive change stem fromthe radical change in the nature of financial markets and acompelling trend of universalisation and convergence ofmarkets. No longer are markets dominated by specialistinstitutions serving specialist markets. Liberalisation of thefinancial markets, partly as a result of policy decisions but partlyalso in response to the increasing globalisation of the economyand technological developments, has broken down barriersbetween markets and products. There have been mergers ofbanks and introduction of new private insurance companies,individual banks have established insurance companies, somebank products look increasingly like insurance products, somesecurities look like insurance products and so on.There is an additional factor which points towards the change inthe Indian markets regulatory history. Legislation passed by theParliament was designed to meet a very real need, which is togive greater protection to customers of investment andinsurance related businesses. It provided for a regulatory regimewhich included within it the seeds of self regulatoryorganisations being overseen by the quasi bodies with statutorypowers thereby ensuring prudential supervision on profes-sionallines. This two tier system ensures that inefficiency,tensions and bureaucracy are not built in to the regulatorystructure. I have no doubt that the industry played its part bysimilarly demanding clarity and even longer rulebooks. It isperhaps no surprise that the first few years of the new regula-toryregime everybody was too busy building the new regime tobother too much about operating it.Ideally, the time has now become ripe for the government togive careful thought to a medium term plan for reforming thearchitecture of financial regulation. This process should notonly take account of the past as I have just described it but, asimportantly, also the future. It would also be reasonable toexpect a continued rationalisation of the financial services sector.Defining RegulationIn the present context the term regulation may be taken torefer to the control of corporate and commercial activitiesthrough a system of norms and rules which may be promul-gatedeither by governmental agencies (including legislatures andcourts) or by private actors, or by a combination of the two.The direct involvement of the State is not a necessary conditionfor the existence of regulation in this sense, since rules may bederived from the activities of industry associations, professionalbodies or similarly independent entities.There is often a close symbiosis between private law andregulatory law although there may be some value in distinguish-ingbetween them. While this is widely used in discussion andhas some merit as an analytical device, it can also give rise todifficulties if it is applied in a non reflexive way. This is because,firstly, many rules of private law, such as those relating toimplied contract terms, fiduciary obligations, and duties ofdisclosure, have a regulatory impact in the sense of controllingtransactions. Secondly, private law rules may form the basis forself-regulation in the sense that contractual associations ofcommercial actors may produce codes governing the conduct oftheir trade or profession (or, at a further extreme, imposerestrictions on trade which may or may not escape the reach ofcompetition or monopoly or restrictive trade practices law).It also follows that the term deregulation needs to be usedwith care. In practice, it tends to be used when referring to theremoval of statutory controls. Often, however, this processgives rise to the replacement of one form of regulation by 11. Copy Right: Rai University11.671.3 11MANAGEMENT OF FINANCIAL SERVICESanother the common law, or self-regulation, replacing statute -rather than to a diminution in regulation. The picture iscomplicated further if is assumed that deregulation is necessar-ilya process leading to the restoration of market forces whichhad previously been constricted by regulatory controls. Rather, itis often the case that sustainable competition rests uponregulation of a prescriptive or interventionist kind. Thus invarious contexts policies or practices aimed at promotingcompetition have employed regulatory techniques to this end. Agood example of this is provided by the operation of thesecurities markets.There needs, then, to be recognition of the varieties ofregulation and self regulation, and some understanding ofhow they operate in relation to commercial activity in particularsettings. Good policy analysis is not about choosing betweenthe free market and government regulation. Nor is it simplyabout deciding what the law should proscribe. It is aboutunderstanding private regulation by industry associations, byfirms, by peers, and by individual consciences and how it isinterdependent with state regulation.Reflexive RegulationThe aim of reflexive or responsive regulation is, therefore, toensure that regulation be responsive to industry structure, andthat different structures will be conducive to different degreesand forms of regulation. In some accounts, reflexive law can beused to steer self-regulation: The use of regulatory interven-tionto induce certain desired ends through second-order effectsis characteristic of reflexive or procedural regulation whichaims to achieve its intended effects by encouraging self-regulationat the level of the practices and processes operated bythe parties themselves.An example of this type of regulation is enforced self-regulationand which can be distinguished from co-regulation.Co regulation is the process whereby associations of firms orprofessionals at the level of the industry concerned promulgategeneralised standards for the conduct of trade. The rules inquestion are arrived at through a process of negotiation anddeliberation within the industry. The government exercisesloose supervision or oversight in the sense of interveningthrough competition law to curb rules which plainly have ananti-competitive effect or purpose.Enforced self-regulation, by contrast, is a form of self-regula-tionin which regulatory functions are sub-contracted by thestate to private commercial actors who, in this case, may be thefirms themselves rather than the industry-level associations. Thedifference from co-regulation is that the state is ready tointervene with more stringent and less firm-specific or tailoredstandards if private actors do not agree their own rules. Thestate thereby encourages a negotiated solution which is, inprinciple, better attuned to local conditions than would be thecase with a generalised or imposed set of rules. The use ofproscriptive norms and legal (including criminal) sanctions isnot ruled out altogether, but, rather, is kept in reserve forsituations of extreme noncompliance.Pyramid of Regulatory ComplianceAn important aspect of understanding enforced self-regulationis the pyramid of regulatory compliance. Sanctions arestructured in such a way as to combine persuasion in themajority of cases with direct enforcement in a smaller number.At the base of the pyramid, most actors are persuaded tocomply through indirect intervention; full sanctions, such ascriminal penalties or the withdrawal of a licence to operate, arereserved for the few cases at the top.1. License Revocation2. License Suspension3. Criminal Penalty4. Civil Penalty5. Warning Letter6. Persuasion7. Command regulation with nondiscretionary punishment8. Command regulation with discretionary punishment9. Enforced self-regulation10.Self-regulationThe purpose of the pyramid is to provide regulatees withmaximum incentives for early compliance. This is anacknowledgement that, where persuasive strategies are used,the regulator and the regulatee are, in effect, engaged in bargain-ingover the terms and timing of compliance, and that withoutthe threat of escalating sanctions, the regulatee may haveincentives to hold out in the expectation of being able tonegotiate a better deal. It follows that an essential aspect ofenforced self-regulation, in contrast to co-regulation, is theretention of a legal sanction (or, ideally, of a series of sanctionsor interventions) which can be deployed in the last resort. Noris it necessarily fatal to the effectiveness of the law in questionthat sanctions are rarely deployed.Social Norms and ConventionsAt the other extreme of the enforcement pyramid, the useful-nessof a strategy of enforced self-regulation may depend onthe existence of shared norms of behavior among commercialactors within a particular industry or other context. Where selfenforcing norms of this kind are found, the costs of regulatoryintervention can be substantially reduced in a number of ways.Where there are interpretive communities of actors, the risk ofopportunistic or creative compliance with rules may bereduced. It also allows regulators to frame rules as generalizedstandards, that is to say, as open-ended norms whose interpre-tationand application can be left up to the parties, to whomthey are addressed, hence reducing the complexity of rules. Thisalso enables rules to evolve in response to a changing economicenvironment. To be inside an interpretive community means tobe already and always thinking and perceiving within the norms,standards, definitions, routines of that community and toshare an understanding of the goals that both define and aredefined by that context. The greater the degree to which theseare common amongst those writing, applying and enforcing therules, the less it has to be rendered explicit. This has implica-tionsboth for the degree to which rules have to use precision inan attempt to control and cope with a greater range of contin-genciesor changes which may arise. What is important is notthe weight of regulation in any one system, but rather theeffectiveness of the links between regulations at different levels. 12. Copy Right: Rai University12 11.671.3MANAGEMENT OF FINANCIAL SERVICESThis is not to suggest that the social norms and conventions ofinterpretive communities should always be regarded as efficientor desirable. They could operate against the interests of thirdparty groups who are excluded from the rule-making process oragainst what is perceived to be the public interest in a widersense. Rather, what is being suggested is that one route bywhich more formal regulation can be made effective is for it towork in conjunction with social norms. Even if this is notpossible, an awareness of the existence and effect of informalregulation should be an important aspect of the design ofmore formal rules.Strengths and Weaknesses of Self-regulationThe value of reflexive regulation depends upon the particularcommercial context in which it is applied, and, in particular, onsuch factors as the effectiveness of self-regulation and thepresence of social norms and conventions guiding thebehaviour of commercial actors. In this vein, it may be useful tosum up the strengths and weaknesses of systems of enforcedself-regulation.i. StrengthsRules would be tailored to match the company. Unlike general-izedrules, self-regulation can be adapted to local conditions andindustry-specific factors affecting firms.Rules would adjust more quickly to changing business environ-ments.Rules which are specific to particular firms or industriescan be changed more quickly and easily than statutory rules, andso may evolve in response to changing economic and techno-logicalconditions.Regulatory innovation would be fostered. By allowing a varietyof approaches to be adopted by firms and commercial actors,the conditions for innovative solutions (and for a degree ofcompetition between alternative solutions) would be enhanced.Rules would be more comprehensive in their scope. Self-regulationencourages companies to deal with a wider range ofhazards and abuses than legislatures can efficiently consider.Companies would be more committed to the rules they wrote.The direct involvement of corporate actors in rule makingwould make it more difficult to stigmatise legal intervention asillegitimate. The confusion and cost from having tworulebooks (the companys and governments) would be reduced.Self-regulation helps to avoid duplication which might other-wisearise.Business would bear more of the costs of its own regulation.The costs of enforcement and inspection would be internalizedto those particular firms and industries which are particularlyprone to creating certain hazards.More offenders would be caught more often. There would bebroader coverage by inspection under self-regulation andcompanies would have an incentive to engage in internalcompliance and enforcement. In addition, internal procedureswould be more likely to result in an efficient application of therules and fewer opportunities for creative interpretations andappeal to the vagaries of inadequately worded legislation.Compliance would take the path of least corporate resistance.Companies would have powerful incentives to avoid publicexposure and enforcement, in part precisely because it would berare.Government regulation inevitably generates more costs sincethere appear to be attenuated incentives for cost control. Costadvantages from self regulation may come from staffingcharacteristics; from the speed and flexibility with which rules areadministered; from reduced size of the civil service and theshifting of regulatory costs to industry. The agency problemsinherent in cutting costs are arguably greater in governmentdepartments than in a situation where members of theinvestment community, for instance, are able to monitor a self-regulatorybody.ii. WeaknessesRegulatory agencies would bear the costs of approving a vastlyincreased number of rules. The extent to which this was aproblem would depend on how far the rules in question weresubject to scrutiny and how far there was a tendency for certainmodel rules (in the manner of standard form contracts) to beadopted as a matter of common practice.State monitoring would sometimes be more efficient thanprivate monitoring. Direct government monitoring might beexpected to be more efficient where companies themselves donot have the expertise to develop effective internal governancesystems, or where the state has an important educational role toplay.Co-optation of the regulatory process by business would beworsened. There would be an increased risk of insider controlof the regulatory process or in other words the danger ofindustrial absolutism, but this would depend on how farother affected groups were given representative status in relationto the rule making process.Particularistic rules might weaken the moral force of laws thatshould be universal. How far this becomes a problem woulddepend on the degree to which overarching standards could beenforced, in the last resort, by public agencies. The role ofgeneral standards in informing local-level rule making would bean important issue here (as in the degree to which the legalprinciple of fiduciary obligation informs, in practice, the rulesadopted by companies for dealing with conflicts of interests bydirectors).Companies would write their rules in ways that would assistthem to evade the spirit of the law. The problem of creativecompliance is a problem whatever form of regulation isadopted - the business communitys resourcefulness at lawevasion will be a cause for weakness in any system of control.Companies cannot command compliance as effectively asgovernment. This is not a problem if the State lends its powersof enforcement to the rules put in place by the corporate actorsthemselves.The independence of the internal compliance group could neverbe fully guaranteed. This is a problem which must be addressedby specific institutional devices aimed at enhancing the prestigeand status of the internal inspection and compliance process.Therefore it is a function of the particular regulatory design ofenforcement systems, rather than a fundamental objection toresponsive regulation. 13. Copy Right: Rai University11.671.3 13MANAGEMENT OF FINANCIAL SERVICESRole of a RegulatorThe existing legislative enactments do not bestow adequatepowers on the regulator to make rules, to interpret rules, toinvestigate breaches of rules, to fine people for breaches ofrules, and to keep and retain the fines in all areas which they aresupposed to supervise. The essence of having an independentregulator within the flexibility to rule by regulation makingensures that matters which previously could be changed onlywith the consent of Parliament will be capable of being changedmerely by a decision of the respective financial supervisoryauthority. There is quite properly a very lively debate about this.On the one hand there is much to be said for a flexible system.Legislation can never foresee all eventualities and, furthermore,legislation can never be perfect. Legislation in many cases cannotalso be quick enough to correct market aberrations. In manyareas sensible actions have been thwarted by faulty legislation.Often industry and regulators combine to try to get roundunintended effects of legislation. Surely, according to thisargument, it is far preferable if the regulation is as flexible aspossible allowing regulators to take account of changingcircumstances. Moreover, it is argued, one has to work with andtrust the regulators and, if they cannot be trusted, then really itdoes not matter what sort of legislation one has.But there is a contrary argument. No one doubts the motives,competence and qualities of the people at the top of theregulatory set up, but that can change. Moreover, sometimesmajor decisions can be taken some way down a regulatory bodywhere perhaps the staff concerned does not have thebroadminded approach of people at the top. If one wants tohear criticisms of any regulatory body, then people who workfor other regulatory bodies and civil servants are often ready tooblige. There are a number of regulatory bodies operating todayin India which are subject to criticism within government circles.Presumably the Insurance Regulatory And DevelopmentAuthority, to which I belong, is not entirely immune from thisdanger at some time in the future.Normally regulatory bodies are accountable by being subject toparliamentary approval for key variables, for example fees andlevies, and they are also subject to a ministerial power ofdirection - ministers themselves being accountable to Parlia-ment,or perhaps more nowadays to the media.Objectives of Financial SupervisionThe objectives of financial supervision are: Maintaining public confidence in the financial system; Promoting public understanding of the financial system,including promoting awareness of the benefits and risksassociated with different kinds of investment or otherfinancial dealing; Securing the appropriate degree of protection forconsumers, having regard to the differing degrees of riskinvolved in different kinds of investment or othertransaction, the differing degrees of experience and expertisewhich different consumers may have in relation to differentkinds of regulated activity and the general principle thatconsumers should take responsibility for their decisions;and Reducing the extent to which it is possible for a businesscarried on by a regulated person to be used for a purposeconnected with financial crime, with particular regard to thedesirability of regulated persons being aware of the risk oftheir businesses being used in connection with thecommission of financial crime and taking adequatemeasures to prevent, facilitate the detection, and monitorthe incidence of financial crime.In addition, in discharging its general functions the financialregulators must have regard to: the need to use its resources inthe most efficient and economic way; the responsibilities ofthose who manage the affairs of authorised persons; theprinciple that a burden or restriction that is placed on a person,or on the carrying on of a regulated activity, should be propor-tionateto the benefit the provision is generally intended toconfer; the desirability of facilitating innovation in connectionwith regulated activities; the international character of financialservices and markets and the desirability of maintaining thecompetitive position in India; and the principle that competi-tionbetween authorised persons should not be impeded ordistorted unnecessarily.Recent Market Developments and Financial SupervisoryRegimesThe financial services sectors of most countries have long beenmuch influenced by market developments. These include theremoval or weakening of barriers to entry and of restrictions ondiversification and on various types of ownership structure;innovation and technological progress (which has had adramatic impact on the cost of entering some markets forfinancial services); greater competition; and internationalisation.These developments are interrelated and mutually reinforcing.The result has been a blurring within the financial services sectorof the traditional distinctions which used to apply across typesof firm, types of product and types of distribution channel,albeit to different a extent and in different ways across differentcountries.For financial services firms, this has been manifested as anincrease in the number of institutions which cut acrosstraditional sectoral boundaries. This growth in financialconglomerates has resulted in part from the impact of mergersand acquisitions. This also reflects the result of financial servicesfirms extending through internal growth into new areas (forexample, insurance companies setting up banks and vice-versa,insurance companies selling investment products, and bankssetting up securities and fund management operations), and ofnew entrants to the financial services sector choosing to offer arange of financial services to their customers. In all of thesecases the resulting mix of functions undertaken by the firm hasbeen determined primarily by anticipated profits and the scopefor cross-selling products to customers, rather than by anytraditional linkages between, or separations across, products.With the growth of options, increasingly elaborate ways ofunbundling, repackaging and trading risks have weakened thedistinction between equity, debt and loans, and even betweenbanking and insurance business. Equally, channels of distribu-tionare no longer as specialised as they once were. Banks haveused their branches as a sales point for an increasing range of 14. Copy Right: Rai University14 11.671.3MANAGEMENT OF FINANCIAL SERVICESproducts, while many of the new entrants to parts of thefinancial services sector have introduced new sales methods such as telephone and internet channels to a wide range ofproducts which had previously been available only throughmore traditional channels.The disappearance of a neat conjunction between a particulartype of firm and a limited range of products being supplied bythat firm means that it is difficult to regulate on a functionalbasis, since the traditional functional approach no longermatches the structure of either firms or markets. The emergenceof financial conglomerates has challenged traditional demarca-tionsbetween regulatory agencies and the boundaries betweenregulators simply no longer reflect the economic reality of theindustry.There is a clear need for regulatory oversight of a financialconglomerate as a whole, since there may be risks arising withinthe group that are not adequately addressed by any of thespecialist prudential supervisory agencies that undertake theirwork on a solo basis. Many of the threats to the solvency of theinstitution can be assessed adequately only on a group-widebasis. This includes the assessment not only of whether thegroup as a whole has adequate capital, but also of the quality ofits systems and controls for managing risks, and the caliber ofits senior management. Indeed, the importance of systems andcontrols and of senior management to the standards ofcompliance achieved by a firm against both the prudential andthe conduct of business standards and requirements set byfinancial services regulators means that it is not possible to drawa clear dividing line between prudential and conduct of businessregulation, since, in this respect, both types of regulation havean interest in the same aspects of a firms business. Moreover,there needs to be an effective exchange of information and a co-ordinationof regulatory requirements across the regulatorsresponsible for different parts of a conglomerates business, aswell as mechanisms for coordinated action when problems arisein a conglomerate.The rationale for an integrated financial services regulator reflectsthe benefits of clear and consistent objectives and responsibili-ties,and in resolving any trade offs among those within a singleagency. There is a school of thought that feels the develop-mentson the financial markets are associated with increasedrisks to their stability, which can best be counteracted in thefuture not only through improved collaboration betweenregulatory authorities but through integrated regulation.A convergence effect is seen wherein banks, insurance companiesand securities firms are now competing in the same market forthe same customers, with similar or often even identicalproducts and via the same distribution channels, whichorganisationally separate regulation cannot cope, with a view tosecuring the future stability of the financial system.However, this does not imply that there is any one model thatis optimal for all countries in all circumstances, in part becausefinancial markets have developed and will continue to develop differently in different countries. A single regulator need notnecessarily deliver these advantages. Specialist divisions/areaswill exist even within a single agency, thus creating potentialproblems in communication, information sharing, co-ordina-tionand consistency. A single regulator in other words couldpotentially become an over-mighty bully, a bureaucratic leviathandivorced from the industry it regulates. Moreover, there is nosingle blueprint even for single financial services regulators countries that have adopted this model developed differentapproaches to how their integrated regulator operates in practice.These differences include the responsibilities, powers andorganizational structure of these regulators, and the legislationsunder which they operate.There remain, and will remain for the foreseeable future, majordifferences between banks, securities firms and insurancecompanies in the nature of their business or the type ofcontracts they issue, and hence the nature and form of assettransformation. Firms in all sub sectors have diversified, butalmost invariably their core business remains dominant. Thenature of the risks is sufficiently different to warrant a differenti-atedapproach to prudential regulation. The rationale for thisapproach (or for other possible objective-based models withmore than one regulator) is attractive giving regulators clearmandates and ensuring appropriate differentiation in theregulation of different types of activity.But even if there is a strong case for an institution-wideoverview of a financial conglomerate, is it necessary for this tobe undertaken by a lead regulator (or coordinator) ap-pointedfrom among the solo regulators responsible forspecialised aspects of the institution. This lead regulator wouldbe responsible for taking a consolidated view of the capitaladequacy and liquidity of the institution as a whole; takingsimilarly a group-wide view of more qualitative factors such asthe caliber of senior management and the high-level systemsand controls of the financial conglomerate; and coordinatingand encouraging the exchange of information among therelevant regulatory bodies both under ordinary and abnormalcircumstances. Most countries still follow the lead regulatorapproach.Risk Based SupervisionRisk-based supervision is a framework that establishes com-monterminology and approaches to evaluating themanagement of risk in financial institutions. While it is acommon approach, it is flexible enough to be adaptable tovirtually all, if not all, financial products and services, and toinstitutions large and small. The disaggregation of the risksthat make up the risk profiles of individual products andservices is at the heart of risk-based supervision. By un-blurringthe risks that make up each product and service, managers andsupervisors are able to understand better risk profiles andevaluate actions taken to minimize the adverse consequences ofrisk-taking. It is the responsibility of the management of eachfinancial institution to understand the risks associated with thebusiness they are running and to take steps to minimize theadverse consequences of these risks. Risk-based supervisionlooks at how well management identifies, measures, controls,and monitors risks.Risk-based supervision requires a deeper understanding of theinstitutions being supervised and of the environment in whichthey operate. It requires an understanding of the risk profile ofthe institution under examination in order to identify areas of 15. Copy Right: Rai University11.671.3 15MANAGEMENT OF FINANCIAL SERVICESthe greatest risk deserving of closer attention. It requires anunderstanding of the nature of risks, together withmanagements ability to deal with both internal and externalrisks. Once the areas of the greatest risk have been identified,the examiner reviews the risk-management systems in thoseareas.That risk-based supervision could have done a better job inreducing the adverse consequences of the Asian crisis which hadits origins in three aspects of risk-based supervision: Understanding the environment in which financial systemsoperate; Understanding the risk profiles of individual institutions; Understanding the risk profiles of the products, servicesand activities that make up the individual institutions, andaggregating these individual risk profiles into a profile ofthe institution as a whole.Good risk management is not an expense to be avoided orminimized; it is not even revenue-neutral; it is a revenueenhancement tool and therefore leads to a capital enrichment.Good risk management allows an institution to operate with ahigh level of precision. Too much risk with too few controlsresults in loss. Too many controls and limits, given thecorresponding risks, result in loss by incurring unproductiveand unnecessary expenses and by foregoing opportunities.Understanding the risk profiles of products and services, andbalancing them with actions taken to reduce the adverseconsequences of risk-taking, allows an institution to optimizerevenues and maximize the use of capital.Risk-based supervision enhances top-down supervision inthree ways. First, it focuses supervisory resources on the areasof the highest risk within individual financial institutions.Second, it uses a common framework and common terminol-ogy,developed specifically for risk-based supervision, to assessrisks and evaluate management practices, policies, and proce-duresin the context of managing risks; that is, optimizingreturns while minimizing the adverse consequences of risk-taking.Finally, it incorporates an assessment of managementsability to deal with risks beyond the control of management,such as systemic risks and risks in the economic environment inwhich the financial institution operates.Regulatory ArbitrageIt is not always the best that all of us should think alike; it isvariety that makes life challenging. Regulatory choices anddiversity help mitigate potential regulatory abuses. Financialsupervision and regulation can only benefit from the variety ofviewpoints and checks and balances of a system of more thanone regulatory authority. A system in which financial institu-tionshave choices, and in which regulations result from the giveand take involving more than one agency, stands a better chanceof avoiding the extremes of supervision. A single regulator islikely to have a tendency to suppress risk taking. A system ofmultiple supervisors and regulators creates checks on thispropensity.The financial services industry today is extremely complex.Regulators, whether rule makers or supervisors cannot beexpected to meet the challenge of understanding the issuesfacing the industry without direct and frequent contact with theregulated institutions.The current regulatory system does however create someopportunity for regulatory arbitrage. Within the context ofour current regulatory scheme, however, regulatory arbitrage canbe good particularly during cycles of over-zealous regulationwhen regulators focus on actual or perceived negative outcomes.Regulatory arbitrage can put some practical limits on the powerof any one regulator.Separating the rule making and supervisory functions wouldcreate the very high risk of an ivory tower of rule making,detached from the realities of the financial services industry.Most financial institutions would agree that a supervisoryagency is positioned the best to write regulations for thefinancial institutions that it supervises, and can readily gauge theimpact that any regulation will have on those entities.Regulatory arbitrage will occur whether you have one supervi-soryor rule making authority or multiple authorities. With onlya single rule making or supervisory agency, regulatory arbitragecan go unchecked and have disastrous consequences.Conflict ResolutionIt must also be recognised that in practice governments havebeen slow and ineffective in resolving conflicts of interestbetween different objectives and responsibilities betweenmultiple specialist regulators. These problems arise because theyeither do not have clear objectives and responsibilities orbecause the institutions were set at different times and areinconsistent with each other. Thus even if all specialist regula-torsare focused effectively on delivering their own specificmandates, the sum of the parts need to add up to a coherentand consistent overall outcome. Governments may lack thenecessary information and experience to take decisions here, andmay also be reluctant to do so if it brings them too close to theregulation of individual financial institutions.Appropriated DifferentiationMultiple regulators however ought to be able to avoid theunjustifiable differences in supervisory approaches and thecompetitive inequalities imposed on regulated firms throughinconsistent rules. However, this does not mean the adoptionof a one size fits all approach. What is required isharmonisation, consolidation and rationalization of the variousprinciples, rules and guidance in the regulatory material issuedby the specialist regulators so that similar risks are treatedsimilarly irrespective of where they arise and the need to createand to preserve appropriate differentiation to reflect thedifferent degrees of protection required by different types ofconsumers.Institutional Structure for Financial Services Regulation inIndiaThe institutional structure of financial services regulation isimportant because of the impact of the efficiency and effective-nessof this on the direct and indirect costs of regulation andon the success of regulation in meeting its statutory objectives.To what extent should the structure of financial regulation bedriven by the functions which financial services firms undertake,reflecting market developments in the financial services indus- 16. Copy Right: Rai University16 11.671.3MANAGEMENT OF FINANCIAL SERVICEStry? Is there a first-best institutional arrangement which isindependent of these market developments, arising perhapsfrom economies of scale and scope in undertaking financialregulation, or from some underlying logical of the structure ofregulation with the objectives of regulation or with theinstitutional arrangements for monetary policy and for address-ingsystemic risk? Are there also implications here for thestructure of regulation internationally, not just within nationalborders?The existing arrangements for financial regulation involve a largenumber of regulators, each responsible for different parts ofthe industry. In recent years as has been seen earlier there is ablurring of the distinction between different kinds of financialservices business.We now turn to a more specific examination of particular areasof regulation in India, beginning with the regulation offinancial services. The main regulatory functions are carried outby non-governmental bodies. These responsibilities are largelyconferred by different Acts. Financial services have beenregulated based on tripod based regulatory structure, compris-ingof the Reserve Bank Of India, Securities Exchange Boardof India and Insurance Regulatory And Development Author-ity.A High level Capital Markets Committee presentlyco-ordinates and monitors the financial regulatory system.The second tier consists of a number of organisations belong-ingto various categories of statutorily recognised bodies. Theseinclude Self-Regulating Organisations, Recognised ProfessionalBodies, Recognised Investment Exchanges and RecognisedClearing Houses. Together they perform front-lineauthorisation of financial services businesses and markets.The Ministry of Finance is responsible for the overall institu-tionalstructure of regulation and for the legislation whichgoverns it; for the overall stability of the financial system, forthe financial system infrastructure, for the efficiency andeffectiveness of the financial sector and, under specifiedconditions, to undertake financial support operations.The financial regulators are responsible for the authorisationand supervision of financial services firms, for the supervisionof financial markets and of clearing and settlements systems,and for regulatory policy in all these areas.Corporate GovernanceAn area where self-regulation should dominate is that ofcorporate governance regulation. A number of corporategovernance codes have followed in fairly rapid succession toaddress perceived corporate governance weakn