1. Financial System 10 Pages

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FINANCIAL SYSTEM

There are two Financial Systems prevalent in the world today:

(a) Bank Dominated Financial System – Stage I – In undeveloped countries

(b) Market Dominated Financial System – Stage III – In developed countries.

In between the two, there is a second stage which is a transitory stage between Stage I and III. This stage is often found in

developing countries like ours who are in the process of transition from Bank Dominated to Market Dominated Financial

System.

When the equity market is fully evolved, industrialists raise finance from the market. However, in case the market is notfully developed, govt facilitates easy finance for industrial development through banks.

Market Dominated Financial System is prevalent in US and UK. Such system is possible only in countries where Debt

and Equity market has fully evolved. Therefore, Financial System in countries like Germany and Japan, which otherwise

are well developed, have still got Bank Dominated System.

Notes –

SBI and Associate Banks have been listed separately because, unlike Nationalised Banks, their major stake holderis RBI and not Govt of India. However, there is a proposal to transfer RBI share holding to Govt of India since RBI being

the regulator of Banks should not be a shareholder at the same time.

Old Private Banks are the ones which existed prior to liberalisation in Financial System.

The institution of Regional Rural Banks (RRBs) was created to meet demand for institutional credit in the rural

areas, particularly among the economically and socially marginalised sections. In order to provide access to low-cost

banking facilities to the poor, the Narasimham Working Group (1975) proposed the establishment of a new set of banks

as institutions which "combine the local feel and the familiarity with dynamics of rural economy which the cooperative

possess and the degree of business organization, ability to mobilize deposits, access to central money markets and

modernized outlook which the commercial banks have". The idea was opposed by most banks but Govt persisted. (Even

Mr Narasimham, post retirement, had different views). They had three stake holders; Sponsoring Bank, Central Govt and

State Govt. However, major responsibility for running these banks fell on Sponsoring Banks.

Non Banking Financial Companies (NBFCs)

Advent of NBFCs

Indian Banks were of the British mindset. They preferred to deal in short term advances. However, Industry needed long

term finance which Commercial Banks were not willing to provide. Thus, various Development Institutions, like IFCI

(Industrial Finance Corporation of India), SIDBI (Small Industries Development Bank of India), etc were born. Theseinstitutions were funded by the RBI and the Govt at concessional rate of interest. Thus, the skewed interest rate policy,

wherein long term loans were cheaper than short term loans, emerged. However, it was felt prudent in order to give

impetus to the industrial development of the country.

In addition to the Govt and RBI financed development/finance institutions, some other private institutions like ICICI (laterreverse merged with ICICI Bank) came up. ICICI was financed by World Bank.

Non Banking Financial Companies can be divided into following groups:

Banking System

Commercial BanksCo-O Banks

Scheduled Co-opBanks

Non Scheduled Co-op Banks

SBI andAssociated

Banks(08)

NationalisedBanks (19)

Old PrivateBanks (22)

New Private

Banks (08)

Foreign

Banks (40)

RuralRegional

Banks (196)



1. Leasing Companies – Lease Finance was an alternative to term lending. However, certain changes in the tax

laws like sales tax /VAT levy, service tax and TDS have led to decline in its popularity in the past few years.

2. Hire Purchase Companies – Especially popular in vehicles and house finance.

3. Primary Dealers and Secondary Dealers – These are the institutions which provide short term finance in the market.

4. Factoring Companies – These companies purchase the receivables at a discount. Factoring is supposed to be

without recourse (if debtor fails to pay, factoring company loses. No liability on company which sold the

receivable). However, in India, factoring is not without recourse. SBI Factors was the first factoring company

CanBank Factors is another company. In the private world, Cosmos Factors was one of the companies.

Factoring can be Domestic or International. Global Trade Finance Company was started by EXIM Bank for

international factoring facility.

Forfeiting – While factoring is necessarily for short term receivables, Forfeiting is for long term receivables and

therefore carries more risk.

Roles and Functions of Commercial Banks

Roles –

1. Intermediation – Common public has money (though little sum with each one but very large collectively) bu

few safe avenues to invest. Industrialists have investment avenues but not enough money. Banks work as

intermediatory by collecting surplus funds from public and lending them on their behalf to the industry. But this

intermediation costs the investors money. Their return on the investment is lower than what they would have got by

direct lending. Risks in Direct Lending –

(a) Adverse Selection – Investor do not have full information about business and management of the

company. Therefore, they can land up with unscrupulous companies. Banks, being in this business, have wherewithal

to analyse the company’s performance and credentials before investing.

(b) Moral Hazard – Often companies call for funds citing one purpose and then divert those funds for

other purposes. Banks are able to keep tab on utilisation of funds.

2. Transformation of Funds –

(a) Geographical Transformation – Funds that are deposited with banks cross the boundaries of state

and country. Thus, funds collected from Mumbai investors could be utilised by an industrialist in Manipur or

Manhattan.

(b) Maturity Transformation – Few investors are willing to invest funds for 10, 15 and 20 years needed

by the industry. Banks convert short term maturity deposits by investors into long term finance for industries by

rotation of funds and investors.

3. Payment Role – Banks facilitate payment of cash from one centre to other. (In the yester years in Gujarat,

and to a large extent even today, this role is performed in unorganised sector by people called Angadias. But these people work more as diamond courier than money courier).

4. Guarantor Role – Banks often play the role of guarantor for providing payment guarantee for loan as well as

performance guarantee. (We have often heard of Bank Guarantee to be provided in contract documents).

5. Agency Role – Banks also act as Trusty in many cases like Debenture Trusty. Banks usually have a separate

Trust Deptt for such functions.

6. Thrift Role – Banks provide services for saving by the community.7. Policy Role – Banks are the primary medium for implementing monetary and many other policies by the govt

Functions –

1. Credit (Lending)

2. Thrift or Saving Function

3. Investment – Banks also invest money in various market instruments like Govt Bonds to maintain liquidity.

The list of instruments in which banks can invest is specified.

4. Payments – By Cable Transfers, Telegraphic Transfers etc

5. Cash Management for customers



6. Investment Banking or Underwriting Functions – In USA this function was not allowed for a long time after

Glass Steagall Act prohibited it in 1933. It has now been permitted, though through the subsidiary.

7. Brokerage Function – Again permitted through subsidiary, like HDFC Securities.

8. Insurance – Insurance Function is also allowed through subsidiary only.

Off late, the concept of Universal Banking is catching up. Universal Banking is term used for merging of Banking and

non banking function (last three of the above are non banking functions).

Trends in Commercial Banking

1. Deregulation – Deregulation does not mean absence of regulations. Deregulation merely reduces externalregulation and substitutes them with internal prudential regulation norms. Contrary to wide belief, US has one of themost comprehensive control regimes for the banks.

(a) Geographical

(i) Federally Chartered Banks – Banks which are allowed to open branches any where in the

country.

(ii) State Chartered Banks – Such banks can open branches only in the state where they obtained

licence to operate.

(b) Product and Services are also deregulated.

(c) Pricing – Pricing of products was strictly controlled. Deposit rates on dollars on foreigners were

considerably lower (Regulation ‘Q’). This gave rise to Eurodollar phenomenon. (People preferred to deposit their

dollars in Europe where interest rates were higher). Eventually, after the cost of such moves were highlighted, USCentral Bank came up with Off Shore Banking Units. (They are given exemption from local laws and operate under

laws more convenient to non resident investors. In India Offshore Banking Units are permitted to be set up in Special

Economic Zones. These banks are virtually foreign branches of the local banks but located in India. These OBUs are

exempted from CRR, SLR and provide SEZ units and SEZ developers access to finance at international rates).

2. Disintermediation – Intermediation role has been declining with the growth of markets and the rise of mutual

fund industry. As the market regulation is improving with time, investment in shares is becoming safer and more

people are investing in shares.

3. Increase in Interest Cost due to requirement to pay market rate of interest to depositors.

4. External Regulations get substituted by Internal Regulations (Prudential Regulations).

5. Technological Developments – e-banking, ATMs, mobile banking, etc.

6. Consolidation and geographical expansion in number of branches and subsidiaries.

7. Globalisation of banking- Especially American banks

8. Rising expectations of customers

9. Rising expectations of shareholders

10. Increasing exposures to risks

11. Increased competition due to convergence.

With technological developments, it was expected that branch banking (customers visiting bank branches for various

jobs) will diminish. However, experience shows that branch banking continues to flourish.

Regulation and Supervision of Banks

Why are the banks so heavily regulated?

1. Safety of Public Savings – Banks are mobilisers of public deposits. Placing your hard earned money

in some ones else’s hand is matter of tremendous faith. This faith, once broken, can have contagious effect. It canquickly spread to loss of faith in the entire banking system and collapse of economy. We have seen country wide run on ICICI

bank in 2002.

2. Credit Creation Capacity of Banks – Financial Regulations also affect credit creation capacity of

banks.

3. Impact on Money Supply – Banks are primary tool of controlling money supply in the market and

controlling inflation and interest rates.

4. Fairness in Bank Dealings



5. Avoid concentration of financial resources in hands of a few individuals – Large amount of liquid

cash in hands of private individuals can lead to market manipulation to the detriment of general public.

6. Resources and Credit for Govt – Govts extract discounted credit from banks by manipulating SLR

(Statutory Liquidity Ratio – Funds to be parked in Govt Securities, gold and cash).

7. Provide Finance for Certain Special Sectors – Through regulations, govt ensures credit flow for

priority sectors like agriculture, exports, housing, Small Scale Industries, etc.

Regulatory norms can be divided into two parts

(a) Prudential Regulations

(b) Monetary Regulations

Many European Countries have separate authorities for two kinds of regulations. In Belgium, while Central Bank of

Belgium regulates monetary matters, another authority, Belgian Banking and Finance Commission, regulates

prudential matters. Till 1996 Bank of England was the single regulator for both regulations like RBI in India

However, in 1997, control of prudential regulations was divested to Financial Services Authority.

Classical Tools of Bank Regulations

1. Bank Rate – The rate at which central bank lends to other commercial banks. (Reverse of Bank Rate is Repo

rate. Repo rate is the rate which RBI pays to commercial banks for its borrowings from commercial banks (purpose is

to suck out liquidity in short term). It is essentially a short term rate ie one day rate. Call rate is the overnight

interbank lending rate resorted to meet liquidity).

2. Open Market Operations – Central banks control the money supply in the market by purchase and selling ofgovt and other similar securities. Sale of securities leads to reduced funds in the market while purchases do the

opposite.

3. Reserves – Various statutory reserves, like SLR, CRR (Cash Reserves Ratio – percentage of deposits kept in

cash and with RBI in order to satisfy withdrawal demands of customers), etc. Higher these reserves, lesser the money

available for lending to the customers. There was a time in late 1980s, when available funds for commercial lending

had fallen to just about 19% of resources generated from deposits.

4. Moral Suasion – These are informal communications to commercial banks to do the bidding of central bank.

However, effectiveness of these tools have got somewhat diluted over the time due to development of markets. Alternate

resources of funds (like loans from overseas) have become available. Thus, there is need to devise alternate ways to regulate.

Adverse Effects of Regulat ions

1. Higher Cost. A commission in USA had studied the cost of controls applied through regulations. They hadarrived at a figure of USD 60 billions per annum.

2. Restricted number and quality of services.

3. Lack of competition.

Regulatory Set up in India

Reserve Bank of India is the regulator of financial services industry in India.

History

The Reserve Bank of India was set up on the basis of the recommendations of the Hilton Young Commission. The

Reserve Bank of India Act, 1934 (II of 1934) provides the statutory basis of the functioning of the Bank, which

commenced operations on April 1, 1935.

The Bank was constituted to(a)Regulate the issue of banknotes

(b)Maintain reserves with a view to securing monetary stability and

(c)To operate the credit and currency system of the country to its advantage.

The Bank began its operations by taking over from the Government the functions so far being performed by the

Controller of Currency and from the Imperial Bank of India, the management of Government accounts and public

debt.

Till 1949, RBI had only supervisory role and no regulatory powers. Banking Companies Act was passed in 1949 which

conferred various powers like licensing of banks, etc. In 1965, the Act was modified and also renamed as Banking

Regulation Act.



Some of the important sections of amended act are as follows: -

Section 5(b) – Defines banking business as acceptance of deposits from public repayable on demand or otherwise and

withdrawable by cheque/draft/order or otherwise.

Section 6 – Deals with other functions that banks can perform.

Section 8 – Prohibits certain activities on part of banks like trading in goods or commodities.

Section 11 – Owned funds and capital

Section 19 – Formation of subsidiaries

Section 20 – Loans and advances restrictions. Section 42(2) – Cash Reserve Ratio (To be maintained between 3 – 15%. Parliamentary approval necessary for reducing

it below 3%. Parliament has recently approved Finance Ministry’s proposal for reducing it to below 3%).

Section 46 – Punitive actions

Refinance System – RBI provides refinance for priority sector lending against those assets. Thus, banks can get

refinance from RBI for the amount financed to priority sectors like export, food procurement, etc against the

mortgages obtained for such loans. This is basically indirect lending by RBI since RBI can not lend directly to

individuals.

Selective Credit Controls – Such controls were imposed on commercial banks to discourage loan for activities which the

govt wants to curb. Take for instance – wood processing industries due to environmental protection requirement. This

control has not been applied for last few decades.

CRR (Cash Reserve Ratio) – CRR is percentage of funds which are kept in the form of cash in bank vaults and RBI tomeet demand liabilities.

Demand Liabilities/Deposits – Are those which have to be met on demand/paid instantaneously like savings account

and current account deposits.

Time Liabilities/Deposits – Are those which are not demand liabilities (Whose maturity date is known).

SLR (Statutory Liquidity Ratio) – Percentage of demand and time liabilities (in simple terms – total deposits) which are

to be kept in certain forms, like.

(a) In cash, or

(b) In gold valued at a price not exceeding the current market price, or

(c) In unencumbered approved securities valued at a price as specified by the RBI from time to time.

Money Market borrowings are excluded from SLR calculations. Similarly, NRI deposits were excluded for calculatingSLR requirement. Like stated earlier, there was a time when 67% of the funds generated from deposits mobilisation were

to be kept in SLR and CRR. Out of the remaining 33%, 40% were to be lent to priority sectors. Thus, only 19% of the

funds were available for market lending. The returns on SLR, CRR and priority sector loans were quite low. Bad debts

on priority sector loans were high. Thus, market rate of loans were considerably high touching almost 19-20%.

As per Mr Narsimham, Indian Financial Sector was over regulated and over administered. Once decision to liberalise

financial sector was taken post BOP crisis, deregulation progressed at a very deliberate pace. We have been at it for past

15 years and are still a long way off from the target. Convertibility on capital account is still a few years away even

though current account convertibility has been permitted.

History of Deregulation Efforts –

In 1991, a committee to suggest reforms in Banking Sector was appointed which came to be known as “Narasimham

Committee on Banking Sector Reforms”. (Subsequently in 1998 another committee under the chairman of same Mr

Narsimhnan was constituted to draw further roadmap for reforms) Reforms in non financial sector had already beeninitiated by Mr Rajeev Gandhi in 1984. But it was realised that Real Sector reforms could not succeed without reforms in

the financial sector. How could a producer, with cost of finance exceeding 16-17%, compete with foreign manufacturers

whose cost of funds was just 2-3%?

Prior to Narasimham Committee, a Banking Commission was set up in 1969 to suggest reforms in Banking Sector. There

was a clamour for nationalisation of banks at that time. This committee was set up essentially to find ways and means of achieving

the growth objectives (social banking – lending to priority sectors and marginalised sections of society at less than commercial rates)

without nationalisation. However, report got junked after banks were nationalised in a hurry by Mrs Gandhi.

Narasimham Committee Report had a very broad sweep and was comprehensive. It covered the issues in great details and

covered Non Banking Finance Companies as well. Following issues were covered in the report: -

1. Committee’s approach to financial sector reforms.



2. Two decades of progress in Financial Sector (Euphemism for analysis of impact of

nationalisation on the banking sector in the years since 1969)

3. Major issues in financial sector

4. Directed investments (Euphemism SLR and CRR) and credit (Priority Sector lending)

and regulated interest rates.

5. Capital Adequacy, Accounting policies and other related matters to ensure that

deregulation does not lead to unregulation.

6. Structural organisation of Banks.

7. Internal Management/Organisation methods and procedures of Banks.

8. Development Financial Institutions

9. Other money and capital market institutions

10. Regulation and supervision of financial sector.

11. Legislative Measures.

Factoring

Factoring and Forfeiting are two related trade finance products. Both relate to purchase of receivables at appropriatediscount but differ in tenure. While factoring refers to purchase of short term receivables, forfeiting refers to purchase of

long term receivables.

Factoring in a way is an alternative for Letter of Credit. Factoring has been gaining importance at the cost of Letter of

Credit as many companies find cost of LC a little too high.

Factoring originated in US in 1950s and 60s and later spread to Europe. It was initially connected to textile trade and

helped in a large way towards its growth. In Asia, it started in 1980s in Singapore, Hong Kong and China. In India, RBI

set up Kalyan Sundaram Committee for developing export trade. The committee recommended setting up of Factoring

Committees in the country. SBI and Canara Bank were first to set up SBI Factors and CanBank Factors.

For a long time, above two companies had virtual monopoly in this business. Later EXIM bank entered into export

factoring and yet later Global Trade Finance entered the fray.

Factoring is essentially without recourse (Factoring company bears the credit risk. If the debtor defaults, factoring

company suffers). However, in India factoring is done with recourse (if debtor defaults, risk is borne by the company

which sold the receivable).

Factoring as a concept is yet to become popular in India. There are various reasons for this. Firstly, no concerted effort has

been made to popularise this concept among the industry and most people are still ignorant about it. Only of late, GlobaTrade Finance is taking some concrete steps towards popularising this product and concept in India. Secondly, given the

Priority Sector tag to the exports since early 1960s, export finance has been available at concessional rates to the

companies. The kind of services and facilities that have been made available to this sector by the govt through commercial

banks and NBFCs, precluded the need for availing factoring services.

Factoring Companies don’t finance the receivables (provide loan against receivables) but out right purchase them. While

receivable financing by banks is often in the range of 50-60% of the receivables value, factoring companies pay upto 95

and even 100% of the invoice value. Also banking companies at the best forward the documents for collection of payment

to the other party and the follow up is to be done by the exporter.

But Factoring company’s job is not limited to buying and collecting the receivables. They provide plenty of other services

in addition.

1. Sales ledger administration – Factoring companies also provide administrative support totheir clients and maintain their sales book.

2. Receivables Collection

3. Debtor Protection – Provide guarantee of payment by the other party.

4. Credit Insurance – Insurance provided by factoring companies is superior to normal

insurance because firstly, settlement of claims is much more smooth and secondly, factoring companies pay 100% of

invoice value as against only 90% value by insurance companies. However there are certain situations when factors

guarantee ceases, like dispute about quality or quantity.

Different Types of Factoring Services

1. Full Service Factoring – Such service includes all the services mentioned above. However, it is for custome

to choose which all services he wants.



2. Disclosed and Undisclosed Factoring – The fact that the invoice has been factoring may be mentioned on the

invoice or may not be.

3. With or without recourse

4. Export Factoring

5. Import Factoring – Most export factors like to process their invoices through another factor in the homecountry of the importer for the sake of convenience though they lose part of the commission they had earned.

Regulation

Factoring Companies are self regulated through two worldwide associations

1. International Factors Group (IFG) – Its headquarter is in Brussels and has 84 members in 50 countries

Members of this association pay 80% of invoice value upfront and balance on collection of the payment.

2. Factors Chain International (FCI) – This association is Headquartered in Sweden and has 212 members in 61

countries.

Following self regulatory codes have been formulated and implemented:

(a) Code of international factoring customs

(b) Arbitration Agreement

(c) UN Edifect Standards for factoring communication

(d) Educational activities – Correspondences courses for factoring companies.

(e) All the members need to pay one time membership fees and thereafter annual fees.

There are factoring companies’ associations in individual countries also.

Factoring can be further classified as Domestic or International Factoring. Indian Factoring companies started withdomestic factoring. International factoring factoring started much later with EXIM bank entering the fray.

Factors’ charges include three components: -

1. Interest on prepayment – Interest on time lag between payment to the party and the collection time of dues

Market rate of interest is charged for internal factoring and Libor + for international factoring

2. One time set-up fee

3. Service charges linked to amount of receivables.

Factoring companies normally insist that entire receivables collection be done through them rather than on selective

basis wherein only doubtful and risky collections would come to them. Factoring services are normally availed only by Small and Medium Enterprises. Big corporates rarely use factoring services as they have their own infrastructure

and also have sufficient liquidity.

Global trade finance has emerged as a major and aggressive player in factoring. It has recently launched a e-loan

facility where in loans are approved on application through internet.

Forfeiting

Purchase of long term export receivables is called forfeiting. Forfeiting is linked to export of capital goods like

machinery which are supplied on a long term payment basis. Such exports are undertaken against importing country’s

govt or bank’s guarantee. Thus, though the lending is for long term, risk associated with such export are

comparatively low.

Export of capital goods are promoted by Govt sponsored Export Finance Agency. Forfeiting provides a realalternative to the government backed export finance schemes. The benefits are that the exporter can obtain the full

value of his export contract on or near shipment without recourse. The importer on the other hand has extended

payment terms at fixed rate finance.

The forfeiture takes over the buyer and country risks.

Forfeiting originated in Switzerland after WWII but did not get much popularity in US as this system does not have

very elaborate paper work. In India also it did not gain much popularity due to various reasons.

Traditionally, raw materials and textiles were the main export items. But these are low value addition items and Indian

Govt was keen to diversify the export basket especially in sectors where there was lot of value addition. Thus, capital

goods export was promoted by various means. IDBI had launched various export promotion schemes for Capital



Goods. As a result need for forfeiting was not felt. IDBI at that time use to provide 50% of such finance and balance

was provided by the commercial bankers of the exporter.

Forfeiting in India started with expot of textile machinery to Egypt. Egypt State Trading Corporation was the

importer. Thereafter, there was an export of rail rolling stock to Iran by Tata. Next was export of Railway containers

to Yugoslavia.

Exports are done on three kinds of Credit:

1. Supplier’s Credit – Supplier provides the credit period to the importer.

2. Buyer’s Credit – If buyer is a cash rich company, or if the item is in short supply, buyers

pays the money in advance for the supplies. This is buyer’s credit.

3. Lines of Credit – This is credit facility made available to the banker of the importer who in

turn lends to the importer. Thus, the credit risk has been mitigated since banks are rare to default in their obligation to

other banks.

Major problem is that there is no secondary market for such kinds of loans. These loans once extended can not be sold

to a third party.

There are specialised finance houses that deal in this business and many are linked to some of the main banks. As

stated earlier, long term export credit is provided on the basis of either sovereign guarantee or at least importer’s bank

guarantee. Such guarantee is called ‘Aval’. Aval is defined as “ A guarantee added to a debt obligation by a third

party who ensures payment should the issuing person default ”.

Presently there is no forfeiting company in India. EXIM Bank was authorized to be an intermediary in forfeiting. RBI

has imposed a condition on max charges payable for forfeiting (involves payment of foreign exchange, so FERA isapplicable). Also, all such charges are to be recovered from the importer. There is also a minimum size of transaction

for forfeiting.

Investment/Merchant Bankers

There are 3 major financial markets in the country: -

1. Capital Markets – Equity and Debt Market

2. Money Market – Short Term lending

3. Government Securities Market – Long Term lending

Investment bankers operate in Capital Markets. They help in floating the new issues. Capital Markets have been in

existence for a long time. However, prior to 1960, there were not many new issues. 1970s saw a large number of public

issues by private companies primarily due to reason that companies having large share holding by foreign companies

needed to dilute it as per new regulation. That started a new chapter in Financial Markets in the form of MerchantBanking and SBI took the lead in offering this service.

Equity market has two segments. Primary Market and Secondary Market. While primary market provides finance for the

companies, secondary markets provide the liquidity which is a pre-requisite for people to invest in primary market. (Thus,

even though secondary markets are as speculative a place as Mahalakshmi Race Course and serve no direct purpose in providing capital for industrial development, yet they serve a very vital purpose).

As stated earlier, Merchant Banking is concerned with public issues. Following are the functions of Merchant Banker: -

1. Obtaining approval of SEBI (erstwhile Controller of Capital Issues)

2. Fulfil listing requirements

3. Appointment of Collecting Bankers (Where you deposit your

application and money), underwriters, brokers, etc.4. Decide pattern of advertisement, publicity and marketing.

5. Monitor daily reports about the collections.

6. Finalising basis of allotment in consultation with SEBI.

Second function of Merchant Bankers is Syndication of Loans. Besides, they also render advisory services.

But after a while, there were division of opinion among senior SBI management about keeping this Merchant Banking

Function as part of the bank or to hive it off as a subsidiary. One group favoured keeping it as part of the bank so that it

can tap bank funds whenever required, while other group favoured forming a subsidiary. Finally, second group won and

this function was hived off as a subsidiary.

Regulatory Framework



1. Prior to SEBI, merchant bankers were regulated by Controller of Capital Issues under the Securities and

Control Regulations Act.

2. They were also under RBI scanner because they were subsidiaries of banks. This dual control continued for

some time before RBI gave up its control on the condition that these merchant bankers can not accept any publicdeposits. Thus, their status as bank ended (by definition, a bank is one which can accept demand deposits from

public). However, old name continues as a misnomer.

Functions

1. Public Issues

2. Corporate Advisory Services

3. Offer project advisory services/structured financial divisions and Mergers and Acquisitions.

Mutual Funds

Mutual Funds are intermediaries who collect savings from a group of investors and invest in market instruments and share

income so earned with investors after deducting expenses. UTI was the first Mutual Fund established in 1964 on UK

model.

Parties of Mutual Funds

Sponsors – Group of shareholders create a trust through a Trust Deed and funds are managed by the Trust in UK model.

UTI had shareholding by RBI (50%), SBI & Subsidiaries (15%), LIC (15%), other scheduled entities IFCI and ICICI

(20%). Functions were governed by UTI (1964) Act

AD Shroff Committee on Finance for the private sector, set up by RBI in 1954, recommended setting up of a mutual fundindustry with private players. However, govt did not accept the recommendation. Primary reason for refusal to accept

recommendation lay in the fact that while UTI was given tax exemption, govt was not prepared to give similar tax

concessions to private players.

Eventually, in 1987, another MF was set up by SBI and a full fledged regulatory set up was then created. SEBI is nowempowered to authorise setting up of any mutual fund

Regulations

1. Licensed by SEBI.

2. All MFs are to be set up as Trust under Indian Trust Act 1882 by their sponsors.

3. Sponsors to execute a Trust Deed in favour of trustees.

4. Board of Trustees to appoint Asset Management Company to float scheme for mutua

fund and manage the mobilised funds.

SEBI guidelines were published as SEBI Mutual Funds Regulations 1993. After 1996, changes were made in the

regulations.

Pvt Sector entry started in 1993-94 when 5 MFs were set up in Private Sector. Between 1994-97, 17 more Mutual Fundswere set up.

When UTI launched the Mutual Fund , for a few years only UTI 64 scheme was there. It was a balanced fund (Part Equity part debt investment plan fund). Later, more schemes were introduced, like Children Growth Fund, Unit Linked

Income Plan (ULIP), etc.

UTI was subsequently disbanded due to problems.

Classification of Mutual Funds: Mutual Funds can be divided into

1. Growth Funds – Funds invested in equity market

2. Income Schemes – Funds invested in debt market

3. Balanced Funds – Part Equity and Part Debt instruments investments.

Once the private players entered the market, division of business among the constituents went for a change: -

Institution Before Pvt Sector Entry After Pvt Sector Entry



Amt (Rs Cr) Percentage Amt (Rs Cr) Percentage

UTI 35793 79.4 15980 30.4

Banks MF 7154 15.9 1686 3.2

Financial Institutions 2106 4.7 3569 6.8

Private Sector MFs 31309 59.6

Total 45053 100 52544 100

What is evident from above table is that after entry of pvt players, UTI and Banks MFs lost their market share heavily.

But another matter which needs to be noted that pvt players did not create additional constituency of mutual funds

investors (Rs 45053 Cr of Pre Pvt Sector Entry Vs Rs 52544 Cr Post Pvt Sector Entry). They just poached into the deposi

base of UTI and the Banks’ MF schemes.

Mutual Funds can be further classified as Close Ended or Open Ended . A Close Ended fund is one which is open for

subscription for a limited period only. An open ended fund allows entry and exit on continuous basis.

Operations and Control

Mutual Funds impose entry and exit loads. A fee is charged over and above the NAV when selling the units to investors(Entry Load) and again when those units are sold back by investor, a part of the sale proceeds @ NAV is deducted as Exit

Load. Unfortunately, there is no transparency in fixing this fees.

Association of Mutual Fund Industry (AMFI) is the Self Governing Body of Mutual Funds which is to draw a code of

conduct for MF industry.

Distributor of Mutual Funds is not controlled by SEBI. Liquid MFs were under control of RBI because they influenced

money supply in the market. However, that control has now been given up by RBI.

SEBI is required to approve individual product.

Mutual funds are a medium for individual investors. However, the industry needs to be more transparent and better self

regulated in order to develop in the long run.

Documents

1. Financial System 10 Pages