INDIAN FINANCIAL SYSTEM

Formal (Organised) Informal

Financial System (unorganised)
Financial
System
e.g.Money
Lenders, Local
Bankers,
Traders,
Landlords,
Brokers
 Formal System

Regulators, Financial Financial

Financial Financial
MOF, Institutions Markets
Instruments Services
SEBI,RBI, (Intermediaries)
IRDA
 FINANCIAL INSTITUTIONS (Intermediaries)

Non-Banking Mutual Insurance

Banking Funds & HFCs
Institutions
Institutions

Public Private
NBFCs DFIs Sector Sector
Scheduled Scheduled National
Commercial Co-operative e.g.IDFC, SFCs, SIDCs,
Banks Banks IFCI, NABARD, ICICI
EXIM Bank, NHB,
IDBI, SIDBI, ECGC

Public Private Foreign Regional

Sector Sector Banks Rural
Banks Banks In India Banks
 Financial Markets

Capital Money Market

Market (Treasury Bills,Call Money,
Commercial Bills, CPs,
CDs, Term Money)
Both Primary & Secondary
Equity Debt Market Segment
Market (Corporate Debt,
PSU Bonds, Govt.
Securities Market)
Both Primary & Secondary Segment

Primary Secondary Derivatives Market

Market Market (Exchange Traded)
(Public Issues, (NSE, BSE, OTCEI,
Private Placement) Regional SEs) F&O
Both Domestic & International (Index & StocK)
 Financial Instruments

Term : Short, Type

Medium, Long

Primary
Secondary
Securities
Securities
(Equity,
(Time
Preference,
Deposits,
Debt & various
MF units,
combinations)
Insurance
Policies)
 Financial Services
• Depositories
• Custodial
• Credit Rating
• Factoring
• Forfaiting
• Merchant Banking
• Leasing
• Hire Purchase
• Guaranteeing
• Portfolio Management
• Underwritting
KEY ELEMENTS OF A WELL-FUNCTIONING FINANCIAL SYSTEM

• Strong legal & regulatory environment

• Stable money
• Sound public finances & public debt management
• A central bank
• A sound banking system
• An efficient information system
• A well functioning securities market
 INDIAN FINANCIAL SYSTEM – AN OVERVIEW
A) Post-Independence Scenario (Upto1951)
• Traditional Economy, low per capital output.
• Lower activity levels of industrial entrepreneurship.
• Semi-organised and narrow industrial securities market.
• Devoid of securities issuing institutions.
• Virtual absence of participation by financial intermediaries.
• Financial system was not responsive to opportunities for industrial
investment.
• Incapable of sustaining a high rate of industrial growth.
B) 1951 TO MID-EIGHTIES
• Planned economic development.
• Public/Government ownership of FIs.
• Fortification of the institutional structure.
• Protection to investors.
• Participation of financial institutions in corporate management.
 C) POST-NINETIES

Major economic policy changes in post-nineties include --

• Macroeconomic stabilisation
• Delicensing of Industries
• Trade Liberalisation
• Currecy Reforms
• Reduction in subsidies
• Financial Sector/capital market/banking reforms
• Privatisation/Disinvestments in public sector units
• Tax Reforms
• Amendments in Company Law
• Reduction of dominance of govt. in financial system and emergence of
organised Capital Market.
Some recent trends include-
• Private sector participation in equity of IFCI,IDBI,ICICI
• Establishment of private sector MFs under the guidelines of SEBI
• A number of private & foreign banks under RBI guidelines

• Implementation of R.N.Malhotra committee’s scheme of reorganisation

of the insurance sector & enactment of IRDA Act 1999.
• Private insurance companies sponsored by both domestic & foreign
promoters have re-emerged.
ROLE OF FINANCIAL INTERMEDIARIES
• Financial Intermediaries are business organisations serving as a link
between savers and investors and so help in the credit allocation
process.
• Lenders and borrowers differ in regard to terms of risk, return and terms
of maturity. Intermediaries assist in resolving this conflict by offering
claims against themselves and, in turn, acquiring claims on the
borrowers.
They provide three types of transformation services:
• Liability, asset and size transformation consisting of mobilisation of
funds, and their allocation by providing large loans on the basis of
numerous small deposits.
 •Maturity transformation by offering the savers tailor-made short-term
claims or liquid deposits and so offering borrowers long-term loans
matching the cash-flows generated by their investment.
• Risk transformation by transforming and reducing the risk involved in
direct lending by acquiring diversified portfolios.
Through these services, FIs are able to tap savings that are unlikely to be
acceptable otherwise. Moreover, by facilitating the availability of finance,
FIs enable the consumer to spend in anticipation of income and the
entrepreneur to acquire physical capital.
Since the process of economic reforms began in 1991, the role of FIs has
undergone a tremendous transformation. Besides providing direct loans,
they have diversified into other areas of financial services such as-
• Merchant Banking
• Underwritting
• Issuing guarantees
 VARIOUS FINANCIAL INTERMEDIARIES

• Commercial Banks :- Collect savings primarily in the form of

deposits and traditionally finance working capital requirements of
corporate. However, in tune with the emerging needs of the
economic & financial system, banks have also entered into
i) Term lending business particularly in the infrastructure sector
ii) Capital market directly/indirectly
iii) Retail finance such as housing finance, consumer finance.
For the same reason, they have also enlarged their geographical &
functional coverage in terms of rural/agricultural and other priority
sector financing, namely exports, SME and so on.
• Non-Banking Financial Companies (NBFCs) :- They provide a
variety of fund/asset based and non-fund/advisory services. Most of
their funds are raised in the form of public deposits ranging between
one to seven years of maturity. Depending on the nature and type of
service provided they are categorised inter-alia into:
• Leasing Companies
 • Hire-Purchase and Consumer Finance Companies
• Housing Finance Companies
• Venture Capital Funds
• Merchant Banking Organisations
• Credit Rating Agencies
• Factoring & Forfaiting Organisations
• Stock-broking Firms
• Depositories
• Mutual Funds :- It is a special type of investment institution which acts as
an investment conduit. It pools the savings of relatively small investors and
invests them in a well diversified portfolio of sound investment. Mutual
funds issue securities (known as units) to the investors (known as unit-
holders) in accordance with the quantum of money invested by them. The
profit or losses are shared by the investors in proportion to their invetments.
MF is set up in the form of a trust which has i) a sponsor ii) Trustees iii)
AMC iv) Custodian.
The trust is established by the sponsor who is like promoter of the
company.
 The trustees are vested with the general power of superintendence and
direction over AMC. They monitor the performance and compliance of
the SEBI regulations.
The AMC manages the funds by making investment in various types of
securities. The custodian holds the securities of the various schemes
of the mutual fund in it’s safe custody. As an investment intermediary,
mutual funds offer a variety of services/advantages to the relatively
small investors who, on their own, can’t successfully construct and
manage an investment portfolio due to size of the funds, lack of
experience/expertise and so on. These, inter-alia include convenience
in terms of lower denomination of investment and liquidity, lower risk
through diversification, expert management and reduced transaction
cost due to economies of scale.
Insurance Companies :- They essentially invest the savings of their
policyholders (insurance premium) and in exchange promise them a
specified sum at a later stage (on maturity) or upon the happening of a
certain event ( in case of life policies, death of the policyholder). They
provide a risk cover to the policyholder.
Insurance organisations universally induce the savings for variety of
motives such as –
• To assist the individual in the creation of an emergency fund.
• To assist in the accumulation of a fund by the time of retirement from
active work.
BANKING SYSTEM
Section 5(1)(b) of the Banking Regulation Act defines banking as ‘the
accepting, for the purpose of lending or investment, of deposits of
money from the public, repayable on demand or otherwise and
withdrawable by cheque, draft, order or otherwise.
It defines banking company as any company which transacts the
business of banking in India.
The banking system is the fuel injection system which spurs economic
efficiency by mobilising savings and allocating them to high return
investment.
FUNCTIONS OF BANKING
• DEPOSITS – i) Demand Deposits ii) Time Deposits
• CREDIT CREATION- Leads to an increase in the total amount of
money for circulation.
• LENDING OF MONEY- Facilitate not only flow of funds but flow of
goods & services from producers to consumers.
ANCILLARY FUNCTIONS – These include transfer of funds, collection,
foreign exchange, safe deposit locker, gift cheques and merchant
banking.
TYPES OF BANKS
The structure of banking sector in India divides the banks into two
categories.
A) Scheduled Commercial Banks
B) Scheduled Co-operative Banks
Scheduled Commercial Banks are of following types-
• Public Sector Banks (28)
• Private Sector Banks (27)
• Foreign Banks (29)
• Regional Rural Banks (102)
Scheduled Co-operative Banks are of following types-
• Scheduled Urban Co-operative Banks
• Scheduled State Co-operative Banks
 SCHEDULED COMMERCIAL BANKS :- Scheduled commercial banks
are those included in the second schedule of RBI Act 1934.
• Public Sector Banks :- These banks are banks in which the govt. has
a major holding. They are classified into two groups.
i) State Bank of India & it’s associates(7):- The SBI holds a dominant
market position among all Indian Banks. It has the largest network of
14000 branches, 51 foreign branches,100million accounts and a
workforce of more than 2lakh. SBI has 20% market share and asset
base of more than Rs.4lakh crore. It has 54 offices in 28 countries
and expansion planned for 70 offices in 36 countries. Amendment of
SBI Act 1955, was done in Oct 1993 to enable the bank to access the
capital market in order to meet capital adequacy norms.
ii) Nationalised Banks(27) :- The major objectives of nationalisation
were –
a) To widen the branch network particularly in rural & semi-urban
areas.
b) Greater mobilisation of savings & flow of credit to neglected
sectors like agriculture, SSI
With amendment to the Banking Companies Act, they are allowed to
access capital markets to raise funds.
A ceiling of 20% on all types of foreign investment in the paid-up capital
has been stipulated for these banks. Overall, public sector banks
dominate with 75% deposits & 71% advances.
• Private Sector Banks :- There are 27 private sector banks- 19 old
one & 8 new one. The new banks have brought in state-of-the art
technology and aggresively marketed their products. The public
sector banks are facing stiff competition from the new private sector
banks.
Pursuant to the guidelines issued in January 1993 the old private
sector banks having net worth of less than 50cr were advised to
attain the level of Rs.50cr by 31st March 2001 and prepare action
plan for augmenting capital funds to the level of Rs.100cr.
The guidelines for entry of new banks in the private sector were
revised in Jan2001. The guidelines prescribed an increase in initial
minimum paid-up capital from Rs.100cr to Rs.200cr. Moreover, the
initial minimum paid-up capital shall be increased to Rs.300cr in
subsequent three years after commencement of business. The
guidelines also enable NBFCs to convert into a commercial bank, if
it satisfies prescribed criteria of -
Minimum net worth of Rs.200cr

A credit rating of not less than AAA or equivalent

Capital adequacy of not less than 12%

Net NPAs not more than 5%.
Guidelines do not permit large industrial houses to promote any new
bank, however they can participate in the equity upto a maximum of
10% but would not have controlling interest in the bank.
The level of foreign participation in private banks has been enhanced to
strengthen the corporate governance, risk management and
technological competence of these banks.
Foreign investment in private sector banks is permissible upto a
composite ceiling of 74% of the paid-up capital. This would include
FDI, investment under portfolio investment by FIIs, NRI investment,
shares acquired by OCBs (prior to 16/09/2003), private placements,
GDRs/ADRs. FII investment limit can’t exceed 49% within the
aggregate FI ceiling of 74%. All times atleast 26% of the paid-up
capital would have to be held by residents.
The recent draft guidelines on ownership in private banks, the RBI has
proposed that no individual entity can hold more than 10% stake in a
private sector bank. The cross-holding among private sector banks
including foreign banks operating in India is capped at 5%.
Foreign Banks :- There are 29 foreign banks from 19 countries operating
in India with 258 branches spread over 40 centres across 19 states/UT.
Foreign bank can set up a wholly owned non-banking subsidiary if it brings
in US $50 million.
• As per the norms a bank’s exposure to a single corporate entity is
restricted at 15% of it’s capital while for a group it is at 40%. Foreign
banks in India have a strong retail presence. They have also enabled
large Indian companies to access foreign currency resources from their
overseas branches. They are active players in money market & forex
market. Foreign Banks may operate in India through any one of the three
channels namely – i) Branches ii) A wholly owned subsidiary iii) A
subsidiary with aggregate foreign investment upto a maximum of 74% in
a private bank.
Regional Rural Banks :- These banks came into existence under RRB Act
1976. The main objective of RRBs is to develop the rural economy by
providing credit for the purpose of development of agriculture, trade,
commerce, industry & other productive activities in rural areas, credit &
other facilities particularly to the small & marginal farmers, agricultural
labourers, artisans and small entrepreneurs.
The authorised capital of RRB is Rs 1crore & issued capital is Rs.25lakh
Of the issued capital, 50% is authorised by GOI, 15% by concerned state
government and balance by the sponsor bank. Each RRB is sponsored by
a PSU bank.
RBI grant assistance to RRBs by way of loans & advances from National
Agricultural Credit Fund, required to maintain CRR 3% & not liable to
pay income tax as they are deemed to be co-operative societies.
The no. of RRBs rose from six in 1975 to 196 in 2001. They operate in
500 districts with a network of 14,313 branches.
RRBs are at par with scheduled commercial banks with respect to priority
sector lending, investment avenues, credit discipline and transparency.
Although RRBs have carved out a niche for themselves in terms of
geographical coverage, clientele outreach, business volume and
contributions for development of the rural economy but plagued by low
productivity, high transaction costs, negative margins, low recovery
rates and high NPAs.
 CO-OPERATIVE BANKING
• Co-operative banks came into existence with the enactment of the Co-
operative Credit Societies Act.
• Co-operative Credit Sector comprises rural co-operative credit institutions
& urban co-operative banks.
Organisational Structure of Co-operative credit institutions
I) Urban Co-operative Banks:- UCBs are mostly engaged in retail banking.
They are not permitted to deal in foreign exchange directly due to high
risk involved in forex business. UCBs are divided into-
A) Scheduled UCBs
B) Non-scheduled UCBs
Both of them may be either single-state or multi-state. There are in all 2090
UCBs. They are included in the second schedule of RBI Act, 1934, if their
NDTL are at least 250 cr and UCBs came under the purview of Banking
Regulation Act only in 1966 & currently supervised by RBI. State
registrars of co-operative societies also regulate certain functions. Multi-
state UCBs are regulated by central government as well and are
registered under the Multi-state Co-operative Societies Act. The area of
operation is confined to a single district or the adjoining districts. Only
UCBs with Rs.50 cr net worth or above can extend their area of
operation.
UCBs are mostly engaged in retail banking. RBI grants licenses to co-
operative banks based on certain entry point norms namely-
• A minimum share capital of Rs.4cr & membership of at least 3000 (for population
more than 10 lakh)
• A minimum share capital of Rs.2cr & membership of at least 2000 (for population
between 5 -10 lakh)
• A minimum share capital of Rs.1cr & membership of at least 1500 (for population
between 1-5 lakh)
• A minimum share capital of Rs.25 lakh & membership of at least 500 (for population
less than 1lakh)
The scheduled UCBs are required to maintain CRR at 7% of the NDTL & SLR to be
25%. Out of this 15% of SLR requirements are to be maintained in govt. securities
and the balance as cash deposits with other co-operative banks. From 01/04/2003
onwards only unscheduled UCBs will enjoy this facility while scheduled UCBs will
have to deploy the entire SLR requirements in government/approved securities. With
effect from February 2006 the non-scheduled UCBs having a deposit base of
Rs,100cr or less would be exempted from minimum SLR in the form of prescribed
assets upto maximum of 15% of their NDTL
 NON-PERFORMING ASSETS
• An asset, including a leased asset, becomes non-performing when
it ceases to generate income for the bank. A Non-Performing Asset
(NPA) is a loan or an advance whwn one of the following is
applicable.
a) Interest and/or installment of principal remain overdue for a
period of more than 90 days in respect of a term loan.
b) The account remains ‘out of order’ in respect of an overdraft/CC.
c) The bill remains overdue for a period of more than 90 days in the
case of bills purchased & discounted
d) A loan granted for short duration crops will be treated as NPA, if
the installment of principal or interest thereon remains overdue for
two crop seasons.
e) A loan granted for long duration crops will be treated as NPA, if
the installment of principal or interest thereon remains overdue for
one crop season.
 CATEGORIES OF NPAs
• NPAs are classified into three categories based on –
a) The period for which the asset has remained non-performing
b) The realisability of the dues.
• Substandard Assets :- W.E.F. 31st March 2005, a substandard asset
would be one, which has remained NPA for a period less than or
equal to 12 months. The following features are exhibited by
substandard assets: the current net worth of the borrower/ guarantor
or the current market value of the security charged is not enough to
ensure recovery of the dues to the banks in full; and the asset has
well-defined credit weaknesses that jeopardise the liquidation of the
debt and are characterised by the distinct possibility that the banks
will sustain some loss, if deficiencies are not corrected,
• Doubtful Assets :- An asset would be classified as doubtful if it has
remained in the substandard category for a period of 12 months. A
loan classified as doubtful has all the weaknesses inherent in assets
that were classified as substandard, with the added characteristic
that the weaknesses make collection or liquidation in full- on the
basis of currently known facts, conditions and values – highly
questionable and improbable.
 Loss Assets :- A loss asset is one which is considered uncollectible
and of such little value that it’s continuance as a bankable asset is not
warranted – although there may be some salvage or recovery value.

Also, these assets would have been identified as ‘loss assets’ by the bank or
internal or external auditors or the RBI inspection but the amount would
not have been written off wholly.
PROVISIONING NORMS
Adequate provisioning has to be made for impaired loans or NPAs. Taking
into account the time lag between an account becoming doubtful of
recovery, it’s recognition as an impaired loan, the realisation the security
charged to the bank and the likely erosion over time in the value of this
security, banks should classify impaired loans into ‘sub-standard’,
‘doubtful’. And ‘loss’ assets and make provisions against these.
Loss assets should be written off or 100% provided for.
Doubtful Assets :-
• Provision of 100% to the extent the advance is not covered by the
realisable value of the security (to which the bank has a valid recourse)
• That portion of the advances covered by realisable value of the
security will provided for on the following basis.

Period for which the advance has Provision Requirement

Remained in ‘doubtful’ category (%) (for the secured portion
Upto 1 year 20%
1 to 3 years 30%
More than 3 years
i) Outstanding stock of NPAs 60% wef 31st March 2005
as on 31st March 2004 75% wef 31st March 2006
100% wef 31st March 2007
ii) Advances classified as ‘doubtful’ 100% wef 31st March 2005
more than 3 years on or after
1st April 2004
 INTEREST RATES
• Interest is the cost of funds from borrower’s point of view while it is the
yield on capital from the lender’s point of view.
• ADMINISTERED INTEREST RATES REGIME :-
These are the rates which are not determined by the market forces but by
the monetary authorities. Following are the features of these rates.
• The deposit & lending rates of commercial and co-operative banks
were fixed by the central bank since 1969 and they were different for
different types of banks.
• The CCI fixed the ceiling on the coupon rates on industrial debentures
and preference shares.
• The Indian Banks Association had been fixing the ceiling on call rates
since 1973 until Oct.1988.
• Govt. fixed the rates on Treasury Bills & long-term govt. securities.
• The govt. had a great say in in the rates of term-lending by FIs.
• RBI fixed different rates for different category of borrowers & on loans
for different purposes.
• RBI also fixed rates on different financial instruments like BOE.
 REASONS FOR ADMINISTERED RATES

• To avoid unhealthy competition for borrowing & deposit accounts.

• To maintain uniformity of interest rates in all types of banks.
• To keep deposit rates in alignment with the lending rates and with
other market rates of interest.
• To aid deposit mobilisation.
• To lengthen the maturity structure of deposits.
• To enable the authorities to avoid frequent changes in the bank rate.
• MAJOR DIFICIENCIES IN THE ADMINISTERED RATES
Chakravarty committee highligted major dificiencies in the
administered rate system as follows.
• The system had grown to be unduly complex, and it contained features
which had reduced the ability of the monetary system to promote the
effective use of credit.
• The low yields on treasury bills and government securities had resulted
in the high level monetisation of public debt and consequent monetary
expansion.
 • The captive market for government securities had adversely affected
the growth of capital market and the profitability of banks
• Concessional rates of interest had allowed projects of doubtful viability to
be undertaken.
• Quantitative credit controls had come under severe stress in the
absence of support from any price rationing mechanism.
• The system had lacked the flexibility necessary for augmenting the pool
of financial savings.
DEREGULATION OF INTEREST RATES
Following important changes in the direction of deregulating the entire
interest rates structure have been made.
• The bank rate has been activated.
• Most of the money market rates have been deregulated
• The ceiling on the call rate was withdrawn w.e.f. May 1, 1989.
• The interest rates on treasury bills, certificates of deposits, commercial
paper and inter-bank participations are allowed to be flexible, variable
and market determined.
• The deposit & lending rates of commercial banks, RRBs, urban co-
operative banks and other co-operative banks have been freed.
•Interest rates on public deposits accepted by all non-banking companies
(both financial & non-financial) have been deregulated.
• The coupon rates on govt. dated securities have been made market-
related.
• The interest rates on convertible, non-convertible and other types of
debentures have been made free.
• The term lending institutions can charge interest rates unhindered by the
state intervention.
BANK RATE :- It is the rate of discount fixed by the central bank of the
country for rediscounting of eligible paper. This is an interest rate for the
Reserve Bank’s own market transactions with the financial institutions –
the rate at which the RBI will make short-term loans to banks and other
financial institutions. The bank rate is the central bank’s key rate signal,
which banks use to price their loans. The impact of bank rate
announcements have been pronounced in the PLRs of commercial
banks.
PRIME LENDING RATE :- The PLR is the minimum lending rate charged
by the bank from it’s best corporate customers or prime borrowers. PLRs
have been deregulated gradually since April1992 and the interest rate
structure for commercial banks simplified.
 The norms relating to the PLR have been progressively liberalised.
From October 18, 1994, interest rates on loans above Rs.2lakhs were
freed and banks were permitted to determine their own PLRs.
• From April 1998 banks were given freedom to determine the interest
rates on loans upto Rs.2lakhs subject to condition that small borrowers
being charged at rates not exceeding the PLR. The RBI advised the
banks to reduce the maximum spreads over their PLRs and announce it
to public along with the announcement of their PLR. The freedom to
evolve differential PLRs was also given. Differential PLRs are differential
rates for different levels of maturities.
• In April 2001, banks were allowed to offer loans at sub-PLR rates.
• Banks’ PLR presently is on a ‘cost plus’ basis i.e. banks have to take
into account their – i) Actual cost of funds ii) Operating expenses and
iii) A minimum margin to cover regulatory requirement of
provisioning/capital charge and profit margin.
PLR of the banks is based on the Bank Rate and has a positive correlation
with it.
 REFINANCE FROM RESERVE BANK
• RBI uses refinancing as an instrument –
1) To relieve the liquidity shortages in the banking system.
2) Control the monetary & credit conditions.
3) To direct credit to selective sectors.
The Reserve Bank has directed certain sector specific refinance facilities
such as food credit, export credit, government securities and
discretionary standby refinance to scheduled banks. The refinance rate
has now been linked to the bank rate.
Currently, there are only two refinance schemes available to banks –
• Export credit refinance
• General refinance
From April 1, 2002 export credit refinance is being provided to scheduled
banks at 15% of their outstanding export credit eligible for refinance as
at the end of preceding fortnight.
General refinance is provided to tide over temporary liquidity shortages
faced by banks. The general refinance window has now been replaced
by a collteralised lending facility within the overall framework of the
interim liquidity adjustment facility.
 LIQUIDITY ADJUSTMENT FACILITY (LAF)
• The Narsimhan committee on Banking sector Reforms(Report II, 1998)
recommended that the RBI provide support to the market through LAF
scheme. This facility would help in the development of a short-term
money market with adequate liquidity. As per the recommendations, the
RBI decided to introduce the LAF in phases.
• The interim LAF, introduced in April 1999, provided a mechanism for
liquidity management through a combination of repos, export credit
refinance, supported by open market operations at set rates of interest.
Banks could avail of a collateralised lending facility of up to 0.25% of the
fortnightly average outstanding aggregate deposits available for few
weeks at the bank rate.
• The interim LAF was gradually converted into full-fledged LAF scheme.
LAF is operated through repos and reverse repos. The LAF is a tool of
day-to-day liquidity management through the absorption or injection of
liquidity by way of sale or purchase of securities followed by their
repurchase or resale under the repo/reverse repo operations.
• Repo/Reverse Repo auctions are conducted on a daily basis (Except
Saturday).
The following measures relating to LAF are announced.

• The standing liquidity facilities available from RBI are split into two parts.
1) Normal facility constituting about two-thirds of the limit at the bank rate.
2) Back-stop facility constituting about one-third of the limit at a variable
daily rate, which is linked to cut-off rates emerging in regular LAF
auctions. In the absence of such rates, the back-stop facility will be
linked to NSE MIBOR.
• Minimum bid size for the LAF reduced from Rs.10 cr to Rs.5 cr to
facilitate the participation from small operators.
• In order to provide quick interest rate signals, the RBI has chosen an
additional option for switching over to fixed rate repos on an overnight
basis.
• The RBI also has the option of introducing long-term repos of upto 14
days as and when required. It has introduced, a fortnightly repo auction.
 REPOS
• Repo is a useful money0market instrument enabling the smooth
adjustment of short-term liquidity among varied market participants
such as banks & financial institutiions.
• Repo refers to transaction in which a participant acquires immediate
funds by selling securities and simultaneously agrees to the
repurchase of the same or similar securities after a specified time at a
specified price. In other words, it enables collateralised short-term
borrowing and lending through sale/purchase operations in debt
instruments. It is temporary sale of debt involving full transfer of
ownership of the securities. Repo is also referred to as a ready
forward transaction as it is a means of funding by selling a security
held on a spot basis and repurchasing the same on forward basis.
• REVERSE REPO :- It is exactly the opposite of repo – a party buys a
security from anther party with a commitment to sell it back to the
latter at a specified time & price. Here the transaction is repo for one
party and reverse repo for another party. Reverse repo is undertaken
to earn additional income on idle cash. In India, repo transactions are
basically fund management/SLR management devices used by
banks.
• It is also a good hedge tool because the repurchase price is locked in
at the time of the sale itself.
 IMPORTANCE OF REPOS
• Repos are safer than pure call money and inter-corporate deposit markets
which are non-collteralised.
• Repos are backed by securities and are fully collateralised. Thus the counter-
party risks are minimum.
• Since repos are market-based instruments, they can be utilised by central
banks as an indirect instrument of monetary control for absorbing or injecting
short-term liquidity.
• Repos help maintain an equilibrium between demand & supply of short-term
funds. The repos market serves as an equilibrium between the money market
and securities market and provides liquidity and depth to both the markets.
• Monetary authorities can transmit policy signals through repos to the money
market which has a significant influence on the government securities market
and foreign exchange market.
• Internationally it is a versatile and the most popular money market instrument.
 LOAN PRICING
• Interest earned by banks on loans, advances and investments is the
equivalent of revenues earned by a non-financial firm.
• The variable costs for financial product- the loan- are the cost of the
bank’s liabilities. The fixed costs include the transaction servicing costs
plus a portion of the overheads utilised for maintaining and monitoring
the account. The bank’s desired profit margin corresponds to the profit
margin inbuilt into the selling price of a good or service.
• Therefore, Loan price= Cost of funds + servicing costs + desired
profit margin.
LOAN PRICING MODEL
• Step-I : Arrive at Cost of Funds - The objective here is to ensure that
the loan price covers variable costs. The cost of funds depends on
bank’s sources of funds- deposits or borrowings.
• Step – II : Determine Servicing Costs for the Customer :-
• Identify the full list of services used by the customer. This list would
include services related to the credit and non-credit facilities availed by
the customer. E.g. activity in the demand deposit account maintained
by the customer, usage of security custodial services, payment related
services such as transfers or letters of credit.
• Assess the cost of providing each service.
 •Cost of credit services depends on the loan size and forms a major
portion of the servicing costs. They include loan administration
expenses, of which a large share is contributed by personnel,
processing or delivery costs. Most banks calculate these costs as a %
of the loan size.
• Step-III Assess Default Risk & Enforceability of Securities :-
• Based on the risk value assigned to the borrower, banks build models
to assess the probability of default, arising out of the bank’s prior
experience with borrowers having similar risk profiles. The bank then
puts a value to the enforceability and strength of the securities the
bank holds or proposes to hold for the loan.
• Assigning these probabiliities to the loan amount and interest
recoverable, the bank computes the risk premium that will fit the
borrower.
• With probability of default the expected rate would be the aggregate of-
E(r) = P(R) x r + P (D) x {R(P + P r)/P) – 1}
E(r) = Expected rate, P(R) = Probability of recovery, r = Contracted rate of
interest, P(D) = Probability of default, P = Principal amount, R =
Recovery rate in the event of default.
 Step-IV Fixing the Profit Margin :-
The approach used to set the profit margin for loan transactions is to
use the ROE which is based on market expectations & shareholders’
required returns. Thus,
ROE = ROA x Equity/Assets.
FIXED VS FLOATING RATES
• When the interest rates are relatively stable and the yield curve slopes
upward, banks would be willing to lend at fixed interest rates, which are the
rates above that is paid for shorter term liabilities.
• In an environment where rates are volatile, and banks have to source
funds from the market at varying interest rates, they would prefer to lend
on floating rates and for shorter maturities. In effect, floating rate loans
transfer the interest rate risk from the bank to the borrower. Though this
appears desirable, it may result in heightened credit risk for the bank as
the rising interest rates increase the borrower’s interest expense. If it is not
met out of operating cash flows or the borrower’s own funds, may lead to a
shortfall in debt service.
• It is evident that most borrowers would prefer fixed rate loans, due to the
predictable cash flows for debt service, and allow the banks to bear interest
rate risk. If the banks want to encourage borrowers to agree for floating
rate pricing, they offer two alternatives.
• In the first alternative,banks may set the floating rate at a level below the
corresponding fixed rate. The bank charges a ‘term premium’ to cover the
risk on fixed rate loans. The size of the discount and the premium will have
to depend on the bank’s cost of funds and required rate of premium.

• In the second, banks set an interest rate cap on the floating rate loans to
limit the possible increase in interest payments. The cap may be
applicable for any interval, or for the entire maturity of the loan. The
borrower pays the negotiated floating rate till the cap is reached. The
inherent risk to banks lies in the market interest rates breaching this cap.
The floating rate structure works well when linked to a reliable benchmark
reference rate, representing the rate structure in the economy. The most
widely used reference rates are the LIBOR and the prime rate in US
markets.