UNIT 4 Regulatory framework for financial markets and institutions For the past decade, post liberalisation, riding

on the crest of the globalisation wave, the protected Indian economy has been buffetted by a series of changes. The decade of the 90s has particulary seen significant changes in the Indian financial markets ? in terms of institutions, instruments and the regulatory framework. The National Stock Exchange with its computerised systems, SEBI and its reform of the capital markets, mutual funds, portfolio consultants, and insurance companies, both domestic and global, represent the changing face of institutions. Innovative financial instruments providing more leeway for corporates, reforms in the regulatory framework led by institutions such as SEBI, RBI and IRDA have ushered in a new era. Reserve Bank of India The origins of the Reserve Bank of India can be traced to 1926, when the Royal Commission on Indian Currency and Finance also known as the Hilton-Young Commission recommended the creation of a central bank for India to separate the control of currency and credit from the Government and to augment banking facilities throughout the country. The Reserve Bank of India Act of 1934 established the Reserve Bank and set in motion a series of actions culminating in the start of operations in 1935. Since then, the Reserve Banks role and functions have undergone numerous changes, as the nature of the Indian economy and financial sector changed. Starting as a private shareholders bank, the Reserve Bank was nationalized in 1949. It then assumed the responsibility to meet the aspirations of a newly independent country and its people. The Reserve Banks nationalization aimed at achieving coordination between the policies of the government and those of the central bank. Functions of RBI As a central bank, the Reserve Bank has significant powers and duties to perform. For smooth and speedy progress of the Indian Financial System, it has to perform some important tasks. Among others it includes maintaining monetary and financial stability, to develop and maintain stable payment system, to promote and develop financial infrastructure and to regulate or control the financial institutions. For simplification, the functions of the Reserve Bank are classified into the traditional functions, the development functions and supervisory functions. Traditional Functions of RBI Traditional functions are those functions which every central bank of each nation performs all over the world. Basically these functions are in line with the objectives with which the bank is set up. It includes fundamental functions of the Central Bank. They comprise the following tasks. 1. Issue of Currency Notes: The RBI has the sole right or authority or monopoly of issuing currency notes except one rupee note and coins of smaller denomination. These currency notes are legal tender issued by the RBI. Currently it is in denominations of Rs. 2, 5, 10, 20, 50, 100, 500, and 1,000. The RBI has powers not only to issue and withdraw but even to exchange these currency notes for other denominations. It issues these notes against

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the security of gold bullion, foreign securities, rupee coins, exchange bills and promissory notes and government of India bonds. Banker to other Banks: The RBI being an apex monitory institution has obligatory powers to guide, help and direct other commercial banks in the country. The RBI can control the volumes of banks reserves and allow other banks to create credit in that proportion. Every commercial bank has to maintain a part of their reserves with its parent's viz. the RBI. Similarly in need or in urgency these banks approach the RBI for fund. Thus it is called as the lender of the last resort. Banker to the Government: The RBI being the apex monitory body has to work as an agent of the central and state governments. It performs various banking function such as to accept deposits, taxes and make payments on behalf of the government. It works as a representative of the government even at the international level. It maintains government accounts, provides financial advice to the government. It manages government public debts and maintains foreign exchange reserves on behalf of the government. It provides overdraft facility to the government when it faces financial crunch. Exchange Rate Management: It is an essential function of the RBI. In order to maintain stability in the external value of rupee, it has to prepare domestic policies in that direction. Also it needs to prepare and implement the foreign exchange rate policy which will help in attaining the exchange rate stability. In order to maintain the exchange rate stability it has to bring demand and supply of the foreign currency (U.S Dollar) close to each other. Credit Control Function: Commercial bank in the country creates credit according to the demand in the economy. But if this credit creation is unchecked or unregulated then it leads the economy into inflationary cycles. On the other credit creation is below the required limit then it harms the growth of the economy. As a central bank of the nation the RBI has to look for growth with price stability. Thus it regulates the credit creation capacity of commercial banks by using various credit control tools. Supervisory Function: The RBI has been endowed with vast powers for supervising the banking system in the country. It has powers to issue license for setting up new banks, to open new braches, to decide minimum reserves, to inspect functioning of commercial banks in India and abroad, and to guide and direct the commercial banks in India. It can have periodical inspections an audit of the commercial banks in India.

Developmental / Promotional Functions of RBI Along with the routine traditional functions, central banks especially in the developing country like India have to perform numerous functions. These functions are country specific functions and can change according to the requirements of that country. The RBI has been performing as a promoter of the financial system since its inception. Some of the major development functions of the RBI are maintained below. 1. Development of the Financial System: The financial system comprises the financial institutions, financial markets and financial instruments. The sound and efficient financial system is a precondition of the rapid economic development of the nation. The RBI has encouraged establishment of main banking and non-banking institutions to cater to the credit requirements of diverse sectors of the economy. 2. Development of Agriculture: In an agrarian economy like ours, the RBI has to provide special attention for the credit need of agriculture and allied activities. It has successfully

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rendered service in this direction by increasing the flow of credit to this sector. It has earlier the Agriculture Refinance and Development Corporation (ARDC) to look after the credit, National Bank for Agriculture and Rural Development (NABARD) and Regional Rural Banks (RRBs). Provision of Industrial Finance: Rapid industrial growth is the key to faster economic development. In this regard, the adequate and timely availability of credit to small, medium and large industry is very significant. In this regard the RBI has always been instrumental in setting up special financial institutions such as ICICI Ltd. IDBI, SIDBI and EXIM BANK etc. Provisions of Training: The RBI has always tried to provide essential training to the staff of the banking industry. The RBI has set up the bankers' training colleges at several places. National Institute of Bank Management i.e NIBM, Bankers Staff College i.e BSC and College of Agriculture Banking i.e CAB are few to mention. Collection of Data: Being the apex monetary authority of the country, the RBI collects process and disseminates statistical data on several topics. It includes interest rate, inflation, savings and investments etc. This data proves to be quite useful for researchers and policy makers. Publication of the Reports: The Reserve Bank has its separate publication division. This division collects and publishes data on several sectors of the economy. The reports and bulletins are regularly published by the RBI. It includes RBI weekly reports, RBI Annual Report, Report on Trend and Progress of Commercial Banks India., etc. This information is made available to the public also at cheaper rates. Promotion of Banking Habits: As an apex organization, the RBI always tries to promote the banking habits in the country. It institutionalizes savings and takes measures for an expansion of the banking network. It has set up many institutions such as the Deposit Insurance Corporation-1962, UTI-1964, IDBI-1964, NABARD-1982, NHB1988, etc. These organizations develop and promote banking habits among the people. During economic reforms it has taken many initiatives for encouraging and promoting banking in India. Promotion of Export through Refinance: The RBI always tries to encourage the facilities for providing finance for foreign trade especially exports from India. The Export-Import Bank of India (EXIM Bank India) and the Export Credit Guarantee Corporation of India (ECGC) are supported by refinancing their lending for export purpose.

Supervisory Functions of RBI The reserve bank also performs many supervisory functions. It has authority to regulate and administer the entire banking and financial system. Some of its supervisory functions are given below. 1. Granting license to banks: The RBI grants license to banks for carrying its business. License is also given for opening extension counters, new branches, even to close down existing branches. 2. Bank Inspection: The RBI grants license to banks working as per the directives and in a prudent manner without undue risk. In addition to this it can ask for periodical information from banks on various components of assets and liabilities.

3. Control over NBFIs: The Non-Bank Financial Institutions are not influenced by the working of a monitory policy. However RBI has a right to issue directives to the NBFIs from time to time regarding their functioning. Through periodic inspection, it can control the NBFIs. 4. Implementation of the Deposit Insurance Scheme: The RBI has set up the Deposit Insurance Guarantee Corporation in order to protect the deposits of small depositors. All bank deposits below Rs. One lakh are insured with this corporation. The RBI work to implement the Deposit Insurance Scheme in case of a bank failure. Monetary Policy The term monetary policy is also known as the 'credit policy' or called 'RBI's money management policy' in India. How much should be the supply of money in the economy? How much should be the ratio of interest? How much should be the viability of money? etc. Such questions are considered in the monetary policy. From the name itself it is understood that it is related to the demand and the supply of money. Definition of Monetary Policy Many economists have given various definitions of monetary policy. Some prominent definitions are as follows. According to Prof. Harry Johnson, "A policy employing the central banks control of the supply of money as an instrument for achieving the objectives of general economic policy is a monetary policy." According to A.G. Hart, "A policy which influences the public stock of money substitute of public demand for such assets of both that is policy which influences public liquidity position is known as a monetary policy." From both these definitions, it is clear that a monetary policy is related to the availability and cost of money supply in the economy in order to attain certain broad objectives. The Central Bank of a nation keeps control on the supply of money to attain the objectives of its monetary policy. Objectives of Monetary Policy The objectives of a monetary policy in India are similar to the objectives of its five year plans. In a nutshell planning in India aims at growth, stability and social justice. After the Keynesian revolution in economics, many people accepted significance of monetary policy in attaining following objectives. 1. Rapid Economic Growth 2. Price Stability 3. Exchange Rate Stability 4. Balance of Payments (BOP) Equilibrium 5. Full Employment 6. Neutrality of Money 7. Equal Income Distribution These are the general objectives which every central bank of a nation tries to attain by employing certain tools (Instruments) of a monetary policy. In India, the RBI has always aimed at the controlled expansion of bank credit and money supply, with special attention to the seasonal needs of a credit.

Let us now see objectives of monetary policy in detail:1. Rapid Economic Growth: It is the most important objective of a monetary policy. The monetary policy can influence economic growth by controlling real interest rate and its resultant impact on the investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged. This increased investment can speed up economic growth. Faster economic growth is possible if the monetary policy succeeds in maintaining income and price stability. 2. Price Stability : All the economics suffer from inflation and deflation. It can also be called as Price Instability. Both inflation are harmful to the economy. Thus, the monetary policy having an objective of price stability tries to keep the value of money stable. It helps in reducing the income and wealth inequalities. When the economy suffers from recession the monetary policy should be an 'easy money policy' but when there is inflationary situation there should be a 'dear money policy'. 3. Exchange Rate Stability : Exchange rate is the price of a home currency expressed in terms of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy. The monetary policy aims at maintaining the relative stability in the exchange rate. The RBI by altering the foreign exchange reserves tries to influence the demand for foreign exchange and tries to maintain the exchange rate stability. 4. Balance of Payments (BOP) Equilibrium : Many developing countries like India suffers from the Disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to maintain equilibrium in the balance of payments. The BOP has two aspects i.e. the 'BOP Surplus' and the 'BOP Deficit'. The former reflects an excess money supply in the domestic economy, while the later stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium, then the BOP equilibrium can be achieved. 5. Full Employment: The concept of full employment was much discussed after Keynes's publication of the "General Theory" in 1936. It refers to absence of involuntary unemployment. In simple words 'Full Employment' stands for a situation in which everybody who wants jobs get jobs. However it does not mean that there is a Zero unemployment. In that senses the full employment is never full. Monetary policy can be used for achieving full employment. If the monetary policy is expansionary then credit supply can be encouraged. It could help in creating more jobs in different sector of the economy. 6. Neutrality of Money: Economist such as Wicksted, Robertson have always considered money as a passive factor. According to them, money should play only a role of medium of exchange and not more than that. Therefore, the monetary policy should regulate the supply of money. The change in money supply creates monetary disequilibrium. Thus monetary policy has to regulate the supply of money and neutralize the effect of money expansion. However this objective of a monetary policy is always criticized on the ground that if money supply is kept constant then it would be difficult to attain price stability. 7. Equal Income Distribution: Many economists used to justify the role of the fiscal policy is maintaining economic equality. However in resent years economists have given the opinion that the monetary policy can help and play a supplementary role in attainting an economic equality. Monetary policy can make special provisions for the neglect supply

such as agriculture, small-scale industries, village industries, etc. and provide them with cheaper credit for longer term. This can prove fruitful for these sectors to come up. Thus in recent period, monetary policy can help in reducing economic inequalities among different sections of society.

SEBI Securities and Exchange Board of India (SEBI) is an apex body for overall development and regulation of the securities market. It was set up on April 12, 1988. To start with, SEBI was set up as a non-statutory body. Later on it became a statutory body under the Securities Exchange Board of India Act, 1992. The Act entrusted SEBI with comprehensive powers over practically all the aspects of capital market operations. Role or Functions of SEBI The role or functions of SEBI are discussed below. 1. To protect the interests of investors through proper education and guidance as regards their investment in securities. For this, SEBI has made rules and regulation to be followed by the financial intermediaries such as brokers, etc. SEBI looks after the complaints received from investors for fair settlement. It also issues booklets for the guidance and protection of small investors. 2. To regulate and control the business on stock exchanges and other security markets. For this, SEBI keeps supervision on brokers. Registration of brokers and sub-brokers is made compulsory and they are expected to follow certain rules and regulations. Effective control is also maintained by SEBI on the working of stock exchanges. 3. To make registration and to regulate the functioning of intermediaries such as stock brokers, sub-brokers, share transfer agents, merchant bankers and other intermediaries operating on the securities market. In addition, to provide suitable training to intermediaries. This function is useful for healthy atmosphere on the stock exchange and for the protection of small investors. 4. To register and regulate the working of mutual funds including UTI (Unit Trust of India). SEBI has made rules and regulations to be followed by mutual funds. The purpose is to maintain effective supervision on their operations & avoid their unfair and anti-investor activities. 5. To promote self-regulatory organization of intermediaries. SEBI is given wide statutory powers. However, self-regulation is better than external regulation. Here, the function of SEBI is to encourage intermediaries to form their professional associations and control undesirable activities of their members. SEBI can also use its powers when required for protection of small investors. 6. To regulate mergers, takeovers and acquisitions of companies in order to protect the interest of investors. For this, SEBI has issued suitable guidelines so that such mergers and takeovers will not be at the cost of small investors. 7. To prohibit fraudulent and unfair practices of intermediaries operating on securities markets. SEBI is not for interfering in the normal working of these intermediaries. Its

function is to regulate and control their objectional practices which may harm the investors and healthy growth of capital market. 8. To issue guidelines to companies regarding capital issues. Separate guidelines are prepared for first public issue of new companies, for public issue by existing listed companies and for first public issue by existing private companies. SEBI is expected to conduct research and publish information useful to all market players (i.e. all buyers and sellers). 9. To conduct inspection, inquiries & audits of stock exchanges, intermediaries and selfregulating organizations and to take suitable remedial measures wherever necessary. This function is undertaken for orderly working of stock exchanges & intermediaries. 10. To restrict insider trading activity through suitable measures. This function is useful for avoiding undesirable activities of brokers and securities scams Powers of SEBI - Securities and Exchange Board of India 1. Powers relating to stock exchanges & intermediaries SEBI has wide powers regarding the stock exchanges and intermediaries dealing in securities. It can ask information from the stock exchanges and intermediaries regarding their business transactions for inspection or scrutiny and other purpose. 2. Power to impose monetary penalties SEBI has been empowered to impose monetary penalties on capital market intermediaries and other participants for a range of violations. It can even impose suspension of their registration for a short period. 3. Power to initiate actions in functions assigned SEBI has a power to initiate actions in regard to functions assigned. For example, it can issue guidelines to different intermediaries or can introduce specific rules for the protection of interests of investors. 4. Power to regulate insider trading SEBI has power to regulate insider trading or can regulate the functions of merchant bankers. 5. Powers under Securities Contracts Act For effective regulation of stock exchange, the Ministry of Finance issued a Notification on 13 September, 1994 delegating several of its powers under the Securities Contracts (Regulations) Act to SEBI. SEBI is also empowered by the Finance Ministry to nominate three members on the Governing Body of every stock exchange. 6. Power to regulate business of stock exchanges SEBI is also empowered to regulate the business of stock exchanges, intermediaries associated with the securities market as well as mutual funds, fraudulent and unfair trade practices relating to securities and regulation of acquisition of shares and takeovers of companies. IRDA- Insurance Regulatory & Development Authority Insurance Regulatory & Development Authority is the controlling and regulatory apex body in the country for insurance sector and its chairman and members are appointed by Government of India. IRDAs headquarter is located at Hyderabad. As per the section 4 of IRDA Act' 1999, Insurance Regulatory and Development Authority (IRDA, which was constituted by an act of parliament) specify the composition of Authority

DUTIES, POWERS AND FUNCTIONS OF IRDA Section 14 of IRDA Act, 1999 lays down the duties, powers and functions of IRDA: 1. Issue to the applicant a certificate of registration, renew, modify, withdraw, suspend or cancel such registration; 2. protection of the interests of the policy holders in matters concerning assigning of policy, nomination by policy holders, insurable interest, settlement of insurance claim, surrender value of policy and other terms and conditions of contracts of insurance; 3. specifying requisite qualifications, code of conduct and practical training for intermediary or insurance intermediaries and agents 4. specifying the code of conduct for surveyors and loss assessors; 5. promoting efficiency in the conduct of insurance business; 6. promoting and regulating professional organisations connected with the insurance and reinsurance business; 7. levying fees and other charges for carrying out the purposes of this Act; 8. calling for information from, undertaking inspection of, conducting enquiries and investigations including audit of the insurers, intermediaries, insurance intermediaries and other organisations connected with the insurance business; 9. control and regulation of the rates, advantages, terms and conditions that may be offered by insurers in respect of general insurance business not so controlled and regulated by the Tariff Advisory Committee under section 64U of the Insurance Act, 1938 (4 of 1938); 10. specifying the form and manner in which books of account shall be maintained and statement of accounts shall be rendered by insurers and other insurance intermediaries; 11. regulating investment of funds by insurance companies; 12. regulating maintenance of margin of solvency; 13. adjudication of disputes between insurers and intermediaries or insurance intermediaries; 14. supervising the functioning of the Tariff Advisory Committee; 15. specifying the percentage of premium income of the insurer to finance schemes for promoting and regulating professional organisations referred to in clause (f); 16. specifying the percentage of life insurance business and general insurance business to be undertaken by the insurer in the rural or social sector; and 17. exercising such other powers as may be prescribed INTEREST RATE: An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. According to Prof. Meyers, interest is the price paid for the use of loanable funds. Different rates of interest are charged for the same sum of loan for the same period because of the fact that some loans involve more risk, more inconvenience and more incidental work. Term Structure of Interest Rate The term structure of interest rates denotes to the relationship among market rates of interest on short term and long term securities. It is the interest rate contrast on fixed earning securities due to dissimilarities in time of maturity. It is therefore, also phrased as time configuration or maturity configuration of interest rates which gives explanation the association among yields and maturities of the same type of security.

If two securities are indistinguishable in every value apart from maturity, it is probable that they will sell in the market at diverse prices. Usually their prices will vary in the same course. If the short term securities mount in price, the long term securities will also hike in price. People usually hold both short term securities and they adjust their holdings of securities based on the relative yields. Normally the long term securities is likely to vary more in price than the short term securities, even though their yields do not fluctuate as much. Factors Determining the Term Structure of Interest Rate 1. Risk Preference Long term security prices are responsive to variations in interest rates for the reason that the variations to evasion are more on long term securities as related to short term securities has indistinguishable acquiesce. This would push up short term prices of securities and bring down the yield. Therefore the yield curve inclines upward. On the other hand, borrowers desires to borrow for long period for the reason that they will not have to be bothered about rising interest rates or to renovate their loans constantly. They are hence, willing to pay more for long term securities as related to short term securities. This will also tend the capitulate curve to incline upward. Therefore, the penchants of both lenders and borrowers tend to low rates on short term securities and high rates on long term securities thus fetching about an upward sloping yield curve. 2. Supply Demand Stipulation When the supply of short term securities drops and that of long term securities hikes, the short term interest rate comes down and the long term interest rate is shifted up. The yield curve is upward inclining and contra. If the demand for securities is large in the short run market and low less in long run interest rates and the yield curve will be downward inclining. The contra supply-demand stipulations will tend to an upward sloping yield curve. 3. Expectations and Uncertainty Other aspects affecting yield curve are expectations and uncertainty. The expectation of the hike in the long run interest rate describes that the short term interest rate remains much below the long term interest rate for any length of time. This creates an upward inclination yield curve. Moreover, specified risks and uncertainties and jeopardy may tend to the same consequents. For example, if people expect war, social disturbances, political upheavals, uncertainties, inflationary pressures etc, they will not purchase long term securities other than at a low price or low current yield. LEVEL OF INTEREST RATES Interest is the price the borrowers must pay to lenders to obtain the use of money for a period of time. As all the other prices are determined in different markets, the equilibrium rate of interest is also determined in financial markets. Given below are three theories about the determination of interest rates:

The Classical Theory: This Theory states that the rate of interest is determined by real factors, namely the supply of savings and the demand for investment, the productivity of capital goods providing the elements of demand and the peoples time preference limiting the supply. The Loanable Fund Theory: This theory states that the supply of savings plus the credit creation by the financial system on the one hand, and total borrowing in the economy on the other, determine the rate of interest. The keynesian Theory: This theory states that the rate of interest is a reward for parting with liquidity, and it is determined by the demand for and supply of money in the economy. Theory of term structure of interest rates Interest rates are also related to the term to maturity of a security. This relationship is often called as the term structure of interest rates or yield curve. The term structure of interest rates compares the interest rates on securities assuming that all characteristics (i.e., default risk, liquidity risk) except maturities are same. There are three theories that economists use to explain the term structure of interest rates: 1) Expectations Hypothesis 2) Segmented Markets Theory 3) The Liquidity Premium (preferred habitat) Theory. Expectation theory Expectations theory, also termed expectations hypothesis, is one of the most common economic theories of term structure. It comes in several variations, the most widely known being the unbiased expectations theory. The unbiased expectations theory contends that the long-term rate is the geometric mean of the intervening short-term rates. Further, it suggests that if the term structure is upward sloping, inflation rates are expected to rise in the future. A flat term structure, according to the theory, indicates little change in inflation is expected, and if the term structure is downward sloping, inflation is expected to fall over the period. Another variation is local expectations theory, which says that the expected rate of return on future maturities is actually equal to the short-term risk-free rate (e.g., current Treasury bill yield) adjusted for inflation. Market segmentation theory This theory is also called the segmented market hypothesis. In this theory, financial instruments of different terms are not substitutable. As a result, the supply and demand in the markets for short-term and long-term instruments is determined largely independently. Prospective investors decide in advance whether they need short-term or long-term instruments. If investors prefer their portfolio to be liquid, they will prefer short-term instruments to longterm instruments. Therefore, the market for short-term instruments will receive a higher demand. Higher demand for the instrument implies higher prices and lower yield. Liquidity premium theory The Liquidity Premium Theory is an outcome of the Pure Expectations Theory. The Liquidity Premium Theory asserts that long-term interest rates not only reflect investors assumptions about future interest rates but also include a premium for holding long-term bonds (investors prefer short term bonds to long term bonds), called the term premium or the liquidity premium.

This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty. Because of the term premium, long-term bond yields tend to be higher than short-term yields, and the yield curve slopes upward. Long term yields are also higher not just because of the liquidity premium, but also because of the risk premium added by the risk of default from holding a security over the long term. The liquidity preference theory, in conjunction with the unbiased expectations theory, suggests that an upward sloping term structure would be expected to occur more often than a downward sloping term structure. Determinants of general structure of interest rates 1. Default risk: Risk that a security issuer will default on the security by missing an interest or principal payment. All financial assets, except governments securities are subject to some degree of default risk although they differ in their degree of risk. 2. Tax status: tax features cause difference on similar financial assets or claims. 3. Marketability or liquidity: The financial assets differ in their marketability or liquidity that is they differ in respect of the possibility that a significant amount of security can be sold relatively quickly without price concessions. 4. Inflation: The continual increase in the price level of a basket of goods and services. 5. Special Provisions: Provisions (e.g., convertibility) that impact the security holder beneficially or adversely and as such are reflected in the interest rate on security that contains such provisions.