Financial System of any country consists of financial markets, financial intermediation and financial instruments or financial products

Flow of funds (savings)

Seekers of funds (Mainly business firms and government) Suppliers of funds (Mainly households)

Flow of financial services Incomes , and financial claims

Organized Indian Financial System

Regulators Financial Instruments Financial Markets Financial Intermediaries

Forex Market

Capital Market

Money Market

Credit Market

Primary Market Secondary Market

Money Market Instrument

Capital Market Instrument

A market for short-term lending and borrowing. Money market provides a platform for providers and user of short term funds to fulfill their borrowing and investment requirements at an efficient market clearing price. It recognizes cost of holding excessive cash even for short duration. Money market instruments have the characteristics of liquidity, minimum transaction cost and no loss in value Money market performs the crucial role of providing an equilibrating mechanism to even out short-term liquidity and in the process, facilitating the conduct of monetary policy.

Money market is a whole sale market. It is conducted over network of telephone and internet, followed by written confirmation from both the borrower and lenders. Central bank( RBI) occupies a strategic position in the money market The bank influences liquidity and interest rates by open market operation, Repo transactions, changes in bank rate, cash reserve requirements and by regulating access to its accommodation.

It provides a stable source of fund to banks in addition to deposits ,allowing alternative financing structure. A liquid money market provides an effective source of long term finance to borrower A liquid and vibrant money market is necessary for the development of a capital market, foreign exchange market and market in derivative instruments. Helps in pricing different floating interest products.

It was a highly regulated and segmented market. Participants were very limited Limited number of money market instrument Interest are also not market determined Lack of proper secondary market for the money market instrument.

The RBI has given the highest priority to the development of a vibrant money market in India since it is the vital link in the implementation of monetary policy to ensure a broad based growth of the countries economy, and initiated following reform: Set up the Discount and Finance House of India Ltd in April 1988 as a money market institution to provide a secondary market for money instruments and create liquidity in these instrument. Completely withdrew interest rate ceiling for all operation in call/notice money market and also rediscounting of commercial bill in may 1989.

In may 1990 ,allowed GIC,IDBI and NABARD to enter the call money market as lenders. Allowed certain non-banking institutions to lend in call money market through DFHI in 1991 Issued Primary dealer (PD) license to DFHI and STCI(State Trading Corporation of India) for orderly development of secondary market by 1996. Clearing Corporation of India Limited(CCIL) was set up to institutionalize the settlement mechanism in debt, forex and money market A unique product CBLO(Collateralized Borrowing and Lending Obligation)

Treasury Bills Certificate of deposit Commercial paper Call/notice Money Term money Repo CBLO

T-bills are short-term instrument issued by RBI on behalf of the govt. to tide over short-term liquidity shortfalls. This instrument is issued by the govt. to raise short term funds to bridge seasonal or temporary gap between its receipt(revenue & capital) and expenditure. T-bills are repaid at par on maturity. The difference between the amount paid by the tenderer at the time of purchases (which is less than the face value) and the amount received on maturity represent the interest amount on T-bills and is known as the discount. Feature of T-bills. They are negotiable securities. They are highly liquid as they are of shorter tenure and there is a possibilities of inter-bank repos in them. There is an absence of default risk.

They have an assured yield ,low transaction cost and are eligible for inclusion in the securities for SLR purposes They are not issued in scrip form. The purchases and sales are effected through the subsidiary General Ledger (SGL) account At present ,there are 91-day ,182-day and 364-day T-bills in vogue. The 91-day T-bills are auctioned by RBI every Friday and 363- day Tbill every alternate Wednesday i.e. the Wednesday preceding the reporting Friday T-bills are available for a minimum amount of Rs 25000 and in multiples theirof.

The sale of T-bill is conducted through an auction.

Type of auction Multiple price auction Uniform price auction Bidding process: Competitive bid Participants: primary dealers, banks, corporate, mutual fund etc. Non-competitive bid Participants: state government provident fund, government provident fund, pension fund

The call money market is a market for very short-term funds repayable on demand and with maturity period varying between one day to a fortnight. When money is lent for a day ,it is known as call(overnight) money. Intervening holidays and /or Sundays are excluded for this purpose. When money is is borrowed or lent for more than a day and up to 14 days, It is known as notice money. It is highly liquid market and extremely volatile . No collateral security is required to cover these transaction.

The call money market is pre-dominantly an inter-bank till 1971 when UTI and LIC were allowed as to operate as lenders. In the 1990s the participation was gradually widened to include DFHI,STCI,GIC,NABARD, IDBI, money market mutual fund, corporate as lenders in this market. In 1996-97,the RBI permitted Primary Dealer to participate in this market as both lenders and borrowers. Those entities that could provide evidence of surplus fund were permitted to route their lending through PD. The call money market is now a purely inter-bank money market with effect from Aug 6,2005.

The RBI intervenes in the call money indirectly in two ways By providing lines of finance/additional funding to the DFHI and other call money dealers By conducting repo auction Additional funding is provided through REPO auctions which increase liquidity in the market and bring down call money rates. RBIs reverse repo auction absorb excess liquidity in the economy and push up the call rates.

There is inverse relation between call rates and short-term money market instrument such as certificate of deposit and commercial paper. When call rates peak to high level ,bank raise more funds through CD. When call rates are lower ,many bank fund CP by borrowing from call money and earn profits through arbitrage between money market segment. A large issue of Govt.securities also affect call money rates. when banks subscribe to large issue of G-sec, liquidity is sucked out from banking system. This increases the demand for fund in call money market which pushes up call money rates. Increase in CRR also increases call money rates. Call money market and foreign exchange market are related. When call rates rise , bank borrow dollars from their overseas branches, swap them for rupees and lend them in the call money market.

At the same ,they buy dollars forward in anticipation of their repayment liability. This pushes forward the premia on the rupee-dollar exchange rate. It happens many a times that bank fund foreign currency positions by withdrawing from the call money market, causing upsurge in call rate.

Certificate of deposit( CD) are unsecured, negotiable, short-term instrument issued by commercial banks and development financial institutions. CD are issued by banks during periods of tight liquidity ,at relatively high interest rates. They represent a high cost liability. Bank resort to this source when the deposit growth is sluggish but credit demand is high. Minimum amount of CD should be Rs 1lakh i.e. the minimum deposit that could be accepted from a single subscriber should not be less than Rs 1lakh and in the multiple of Rs 1lakh thereafter.

Eligibility: CD can b issued by bank, select financial institution. Maturity: 7day to 1year. Discount: CD can b issued by at a discount on face value. The issuing bank is free to determine the discount /coupon rate. Transferability: It is freely transferable .

Commercial paper is an unsecured short-term promissory note ,negotiable and transferable by endorsement and delivery with fixed maturity period. It is generally issued at a discount by leading creditworthy and highly rated corporate to meet their working capital requirements A CP is usually privately placed ,either through merchant banker or banks. A specified credit rating of P2 of CRISIL or its equivalent is to be obtained from credit rating agency. CP is issued as an unsecured promissory note or in dematerialized form at a discount .The discount rate is freely determined by market forces. The paper is usually priced between the lending rate of scheduled commercial bank and a representative money market rate. Corporates are allowed to issue CPs up to 100% of their fund- based working capital limits.

Repo is useful money market instrument enabling the smooth adjustment of short-term liquidity among varied market participant such as bank and financial institutions. Repo refers to a transaction in which a participant acquires immediate funds by selling securities and simultaneously agrees to repurchase of the same or similar securities after a specified time at a specified rate. It is also referred as ready forward transaction REVERSE REPO is exactly the opposite of Repo- a party buy a security from another party with a commitment to sell it back to latter at a specified time and price. In otherworld ,while for one party the transaction is repo , for another party it is reverse repo.

Collateralized Borrowing and Lending Obligation (CBLO)", a money market instrument as approved by RBI, is a product developed by CCIL for the benefit of the entities who have either been phased out from inter bank call money market or have been given restricted participation in terms of ceiling on call borrowing and lending transactions and who do not have access to the call money market. CBLO is a discounted instrument available in electronic book entry form for the maturity period ranging from one day to ninety Days (can be made available up to one year as per RBI guidelines). In order to enable the market participants to borrow and lend funds, CCIL provides the Dealing System through: - Indian Financial Network (INFINET), a closed user group to the Members of the Negotiated Dealing System (NDS) who maintain Current account with RBI. - Internet gateway for other entities who do not maintain Current account with RBI.

Membership to CBLO segment is extended to entities who are RBI- NDS members viz. Nationalized Banks, Private Banks, Foreign Banks, Cooperative Banks, Financial Institutions, Insurance Companies, Mutual Funds, Primary Dealers etc.
Associate Membership to CBLO segment is extended to entities who are not members of RBI- NDS viz. Co-operative Banks, Mutual Funds, Insurance companies, NBFC's, Corporate, Provident/ Pension Funds etc.

RBI and Monetary Policy in India

The term monetary policy refers to actions taken by central banks to affect
monetary magnitudes or other financial conditions.

Monetary Policy operates on monetary magnitudes or variables such as

money supply, interest rates and availability of credit.

Monetary Policy ultimately operates through its influence on expenditure flows in the economy.

In other words affects liquidity and by affecting liquidity, and thus credit, it
affects total demand in the economy.

MP is a part of general economic policy of the govt. Thus MP contributes to the achievement of the goals of economic policy. Objective of MP may be: Full employment Stable exchange rate Healthy BoP Economic growth Reasonable Price Stability Greater equality in distribution of income & wealth Financial stability

There is convergence of views in developed and developing economies, that price stability is the dominant objective of monetary policy. Price stability does not mean complete year-to-year price stability which is difficult to attain. Price stability refers to the long run average stability of prices. Price stability involves avoidance of both inflationary and deflationary pressures.

Price Stability contributes improvements in the standard of living of people.

It promotes saving in the economy while discouraging unproductive

investment.

Stable prices enable exports to compete in international markets and

contribute to the strengthening of BoP.

Price stability leads to interest rate stability, and exchange rate stability (via export import stability).

It contributes to the overall financial stability of the economy.

Inflation
A sustained rise in the prices of commodities that leads to a fall in the purchasing power of a nation is called inflation. Although inflation is part of the normal economic phenomena of any country, any increase in inflation above a predetermined level is a cause of concern.

Types of inflation Demand pull inflation Supply shock inflation (cost push) Built in inflation

Types of money in the Indian system

Reserve Money (M0): Currency in circulation + Bankers deposits with the RBI + Other deposits with the RBI = Net RBI credit to the Government + RBI credit to the commercial sector + RBIs claims on banks + RBIs net foreign assets + Governments currency liabilities to the public RBIs net non-monetary liabilities. M1: Currency with the public + Deposit money of the public (Demand deposits with the banking system + Other deposits with the RBI). M2: M1 + Savings deposits with Post office savings banks. M3: M2+Time deposits with the banking system. = Net bank credit to the Government + Bank credit to the commercial sector + Net foreign exchange assets of the banking sector + Governments currency liabilities to the public Net non-monetary liabilities of the banking sector (Other than Time Deposits). M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates). As defined by the Reserve Bank of India (RBI.)

Instruments 1. Discount Rate (Bank Rate) 2.Reserve Ratios 3. Open Market Operations

Operating Target
Monetary Base Bank Credit Interest Rates Intermediate Target Monetary Aggregates(M3) Long term interest rates

Ultimate Goals Total Spending Price Stability Etc.

Variations in Reserve Ratios Discount Rate (Bank Rate) (also called rediscount rate), Repo rate, reverse repo rate Open Market Operations (OMOs) Other Instruments

Banks are required to maintain a certain percentage of their

deposits in the form of reserves or balances with the RBI

It is called Cash Reserve Ratio or CRR Since reserves are high-powered money or base money, by varying CRR, RBI can reduce or add to the banks required

reserves and thus affect banks ability to lend.

Discount rate is the rate of interest charged by the central bank for providing funds or loans to the banking system.

Funds are provided either through lending directly or rediscounting or buying commercial bills and treasury bills.

Raising Bank Rate raises cost of borrowing by commercial banks, causing

reduction in credit volume to the banks, and decline in money supply.

Variation in Bank Rate has an effect on the domestic interest rate, especially the short term rates.

Market regards the increase in Bank rate as the official signal for beginning of a tight money situation.

It is introduced through which RBI can add to liquidity in the banking system. Through repo system RBI buys securities from the bank and there by provide funds to them. Repo refers to agreement for a transaction between RBI and banks through which RBI supplies funds immediately against government securities and simultaneously agree to repurchase the same or similar securities after a specified time which may be one day to 14 days.

Repo Rate: Repo rate is the rate at which banks borrow funds from RBI to meet the gap between the demand they are facing for money (loans) and how much they have on hand to lend. It is a short-term measure. Reverse repo rate: Bank rate: This is the rate at which RBI lends money to other banks. It is uncollateralized lending.

A tool used in monetary policy that allows banks to borrow money through repurchase agreements. This arrangement allows banks to respond to liquidity pressures and is used by governments to assure basic stability in the financial markets.
Liquidity adjustment facilities are used to aid banks in resolving any short-term cash shortages during periods of economic instability or from any other form of stress caused by forces beyond their control. Various banks will use eligible securities as collateral through a repo agreement and will use the funds to alleviate their short-term requirements, thus remaining stable.

OMOs involve buying (outright or temporary) and selling of govt securities

by the central bank, from or to the public and banks.

RBI when purchases securities, pays the amount of money by crediting the

reserve deposit account of the sellers bank, which in turn credits the
sellers deposit account in that bank.