Module 4 - Financial Environment of Business

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<p>1</p> <p>FINANCIAL ENVIRONMENT OF BUSINESS</p> <p>Sub topics covered</p> <p>Indian Financial system Financial Market Money &amp; Capital Current trends in Banking</p> <p>References3</p> <p>Indian Financial System by Bharati V. Pathak Indian Financial System by M Y Khan Fundamentals of Indian Financial System by Vasant Desai Financial Institutions and Markets by L M Bhole</p> <p>What is a Financial System?</p> <p>It implies a set of complex and closely connected or interlinked institutions, agents, practices, markets, transactions, claims, and liabilities in the economy.</p> <p>The financial system is concerned about these three terms: money, credit and financeThe objective of Financial System is to supply funds to various sectors and activities of economy in ways that promote fullest possible utilization of resources</p> <p>Financial SystemFinancial System Savings Finance Investment Capital Formation Economic Growth</p> <p>Primary function of financial system is mobilizing savings, their distribution for industrial investment and stimulating capital formation to accelerate the process of economic growth. 5</p> <p>Indian Financial System6</p> <p>Can be broadly classified into organized and unorganized Organized Financial System comes under the purview of Ministry of Finance, RBI, SEBI and other regulatory bodies Unorganized Financial System consists of individual money lenders, groups of persons operating as unregistered chit fund, etc</p> <p>Components of Organized Financial System7</p> <p>Financial IntermediariesFinancial Markets Financial Instruments</p> <p>Financial Services</p> <p>Indian Financial System - OrganizedFinancial Intermediaries Financial Markets</p> <p>Financial Instruments</p> <p>Financial Services</p> <p>BanksCommercial Co-operative</p> <p>Non Banking InstitutionsNBFCs Development Financial Institutions</p> <p>Mutual Funds</p> <p>Insurance</p> <p>Shares Debentures Debt Instruments Derivatives</p> <p>Depositors Credit Rating Merchant Banking Leasing Portfolio Mgt Underwriting Stock Broking</p> <p>8</p> <p>Financial Intermediaries</p> <p>Banks Commercial Cooperative Regional</p> <p>- Private, Public &amp; Foreign</p> <p>Rural Banks (RRBs)</p> <p>Non Banking Financial Companies (NBFCs) Development Financial Institutions (DFIs)</p> <p>9</p> <p>What is Banking?10</p> <p>Section 5(l)(b) of the Banking Regulation Act defines "banking" as the accepting, for the purpose of trading or investment, of deposits of money from the public, repayable on demand or otherwise and withdrawable by cheque, draft, order or otherwise. The essential characteristics of the banking business as defined in section 5(b) of the Banking Regulation Act are: acceptance of deposits from the public, for the purpose of lending or investment, repayable on demand or otherwise, and withdrawable by means of any instrument whether a cheque or otherwise. From the definition, two important functions of commercial banks emerge; acceptance of deposits and lending of funds. These two functions are the core activities of banking.</p> <p>Commercial Banks v/s Cooperative banks11</p> <p>In India, the Commercial Banks are required to be registered under Banking Regulation Act, 1949. In India, the Cooperative Banks are required to be registered under the Cooperative Societies Act, of the concerned state. The main objective of a Commercial Bank is to accept deposits from public for the purpose of lending to industry and commerce. The main objective of a Co-operative Bank is to accept deposits from the members and the public for the purpose of providing loans to farmers and small businessmen with a motto of service. Commercial banks operate over a larger area. Some commercial banks even have branches in foreign countries. The area of operations of Co-operative Banks is limited and mostly confined to State. They do not operate at national</p> <p>Commercial Banks v/s Cooperative banks12</p> <p>Commercial Banks provide merchant banking services such as advising the companies regarding the public issue of shares. Co-operative Banks do not provide merchant banking services. Commercial Banks in India such as Canara Bank, Bank of India, State Bank of India, do operate mutual funds. At present co-operative banks in India do not operate mutual funds. Commercial banks operates on the commercial principles. They operate to earn a profit. The basis of operations is on co-operative lines, i.e. service to its members and the society.</p> <p>RBIs new banking license discussion paper:</p> <p>Though the Indian financial system has made impressive strides in resource mobilization, geographical and functional reach, financial viability, profitability and competitiveness, vast segments of the population, especially the underprivileged sections of the society, have still no access to formal banking services. The Reserve Bank is therefore considering providing licenses to a limited number of new banks. A larger number of banks would foster greater competition, and thereby reduce costs, and improve the quality of service. More importantly, it would promote Financial Inclusion and ultimately support inclusive economic growth, which is a key focus of public policy.</p> <p>Latest guidelines14</p> <p>Minimum capital of Rs 500cr, 49% foreign investment limit, mandatory listing in 2 yrs are a few of the recommendations. Groups with diversified ownership, sound credentials and integrity that have a successful track record for at least 10 years shall be eligible to promote banks and RBI may seek feedback on applicants from other regulators and agencies like Income Tax, CBI, Enforcement Directorate, etc. This, in effect, rules out a first-generation entrepreneur setting up a new bank. RBI has made an exception for promoters with a large exposure to real estate and broking activities as they have inherently riskier businesses model and business culture. The central bank has also looked at the international developments after the financial crisis three years ago where there is a movement for separating banking from proprietary trading and has made a sharp remark on its dissatisfaction with the past experience of brokers on the boards of banks. Accordingly, groups that have significant (10 per cent or more) income or assets or both from such activities, including real estate construction and broking activities taken together in the last three years, shall not be eligible to promote banks.</p> <p>Contd..15</p> <p>Foreign Shareholding The aggregate non-resident shareholding from FDI, NRIs and FIIs in the new private sector banks shall not exceed 49 per cent for the first five years from the date of licensing of the bank. It has added that no nonresident shareholder, directly or indirectly, individually or in groups, will be permitted to hold 5 per cent or more of the paid-up capital of the bank. Currently, foreign shareholding in private sector banks is allowed up to a ceiling of 74 per cent of the paid-up capital.</p> <p>Contd..16</p> <p>Corporate Governance At least 50 per cent of the directors should be totally independent of the promoter/promoter group entities, their business associates and their customers and suppliers. The bank shall get its shares listed on the stock exchanges within two years of licensing of the bank. The bank shall be required to maintain a minimum capital adequacy ratio of 12 per cent for a minimum period of three years after the commencement of its operations subject to such higher percentage, as may be prescribed by the RBI from time to time.</p> <p>Financial Inclusion Definition</p> <p>The process of ensuring access to financial services and timely and adequate credit where needed by vulnerable groups such as weaker sections and low income groups at affordable cost. ---- NABARD</p> <p>What is Financial InclusionCredit cards Lack of Assets for collateral</p> <p>Insurance</p> <p>Bank account Affordable credit</p> <p>Financial advice</p> <p>What is Financial ExclusionNo savings</p> <p>No assets</p> <p>No Insurance</p> <p>No bank account No affordable credit</p> <p>No access to money advice</p> <p>Retail Banking</p> <p>Retail banking refers to banking in which banking institutions execute transactions directly with consumers, rather than corporations or other banks. Services offered include: savings and checking accounts, mortgages, personal loans, debit cards, credit cards, and so forth.</p> <p>Universal Banking</p> <p>Universal Banking is a multi-purpose and multifunctional financial supermarket (a company offering a wide range of financial services e.g. stock, insurance and real-estate brokerage) providing both banking and financial services through a single window. Universal Banking is a superstore for financial products under one roof. The term 'universal banking' refers to those banks that offer a wide range of financial services, beyond the commercial banking functions like Mutual Funds, Merchant Banking, Factoring, Credit Cards, Retail loans, Housing Finance, Auto loans, Investment banking, Insurance etc. This is most common in European countries.</p> <p>Advantages of Universal Banking</p> <p>Economies of Scale. The main advantage of Universal Banking is that it results in greater economic efficiency in the form of lower cost, higher output and better products. Many Committees and reports by Reserve Bank of India are in favor of Universal banking as it enables banks to attain economies of scale and scope. Profitable Diversions. By diversifying the activities, the bank can use its existing expertise in one type of financial service in providing other types. So, it entails less cost in performing all the functions by one entity instead of separate bodies.</p> <p>Resource Utilization. A bank possesses the information on the risk characteristics of the clients, which can be used to pursue other activities with the same clients. A data collection about the market trends, risk and returns associated with portfolios of Mutual Funds, diversifiable and non diversifiable risk analysis, etc, is useful for other clients and information seekers. Automatically, a bank will get the benefit of being involved in the researching Easy Marketing on the Foundation of a Brand Name. A bank's existing branches can act as shops of selling for selling financial products like Insurance, Mutual Funds without spending much efforts on marketing, as the branch will act here as a parent company or source. In this way, a bank can reach the client even in the remotest area without having to take resource to an agent.One-stop shopping. The idea of 'one-stop shopping' saves a lot of transaction costs and increases the speed of economic activities. It is beneficial for the bank as well as its customers.</p> <p>Prime Lending rate</p> <p>Interest rate charged by banks to their largest, most secure, and creditworthy customers. This rate is used as a guide for computing interest rates for other borrowers. The rate is almost always the same amongst major banks. Generally PLR across banks are aligned with those of a few major banks who provide signals for changes in PLR</p> <p>PLR OF BANKS is based on positive correlation with it.</p> <p>Bank rate and has</p> <p>Base rate24</p> <p>Base Rate shall include all those elements of the lending rates that are common across all categories of borrowers. While each bank may decide its own Base Rate, some of the criteria that could go into the determination of the Base Rate are: (i) cost of deposits; (ii) adjustment for the negative carry in respect of CRR and SLR; (iii) unallocatable overhead cost for banks such as aggregate employee compensation relating to administrative functions in corporate office, directors and auditors fees, legal and premises expenses, depreciation, cost of printing and stationery, expenses incurred on communication and advertising, IT spending, and cost incurred towards deposit insurance; and (iv) profit margin.</p> <p>Base rate25</p> <p>Base Rate System is for the banks to set a level of minimum interest rates charged while giving out the loans.However, the base rate system will not be applicable for the following type of loans: Agricultural Loans</p> <p>Loans given to own employeesLoans against deposit Export Credit</p> <p>Advantages of Base Rate26</p> <p>To avoid sub PLR loans It will bring uniformity in interest rates and end predatory pricing Banks will now be compelled to tap cost effective resources, improve operational efficiency, and include profit spread margin and risk premium along with the clients credibility while determining the base rate.</p> <p>Regional Rural Banks (RRBs)</p> <p>The Narsimham committee conceptualized the creation of RRBs in 1975 as a new set of regionally oriented rural banks, Subsequently, the RRBs were set up through the promulgation of RRB Act1 of 1976. Their equity is held by the Central Government, concerned State Government and the Sponsor Bank in the proportion of 50:15:35. RRBs were supposed to evolve as specialised rural financial institutions for developing the rural economy by providing credit to small and marginal farmers, agricultural labourers, artisans and small entrepreneurs. Over the years, the RRBs, which are often viewed as the small mans bank, have taken deep roots and have become a sort of inseparable part of the rural credit structure . They have played a key role in rural institutional financing in terms of geographical coverage, clientele outreach and business volume as also contribution to development of the rural economy .27</p> <p>Regional Rural Banks (RRBs)</p> <p>Maharashtra Marathwada Gramin Bank Aurangabad-Jalna Gramin Bank Wainganga Kshetriya Gramin Bank Vidharbha Kshetriya Gramin Bank Solapur Gramin Bank Thane Gramin Bank Ratnagiri-Sindhudurg Gramin Bank Gujarat Dena Gujarat Gramin Bank</p> <p>Baroda Gujarat Gramin BankSaurashtra Gramin Bank</p> <p>28</p> <p>Regional Rural Banks (RRBs)Why were they in the news? The Reserve Bank of India in its discussion paper on grant of bank licences to corporate houses said that if corporate were keen on improving financial inclusions, they could look at taking over some of the weaker RRBs and strengthen them through capital and technology infusion. Is this likely to happen? There are several impediments. Firstly, the RRB Act will need to be amended. Secondly, there will be resistance from employee unions and state governments. Thirdly, corporates themselves may not be inclined to get into rural banking where the payback may take many more years.29</p> <p>Current Status (RRBs)The worst appears to be behind the RRBs, a large number of which were in the red for most of the previous decades. The process of consolidation through amalgamation of RRBs is now almost complete, resulting in a decline in the total number of RRBs to 84 as on August 31, 2009 . The process of recapitalization of RRBs with negative net worth as on March 31, 2007, is also almost complete, with 27 RRBs fully recapitalized with an amount of Rs 1,796 crore as on July 31, 2009. The assets in the consolidated balance sheets of RRBs have increased by 16.5% in March 2009 to Rs 1.46 lakh crore. They now open no-frills accounts and issue general credit cards. An RBI working group on technology in RRBs has observed that RRBs could not remain isolated from the technological developments sweepi...</p>