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Vasant Desai






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Introd uction



Financial Market Evolution and Globalization



Structure and the Growth of Financial Markets in India



Money Market



Call Money Market



The Bill Market



105 -111


The New Issue Market

112 -127


Government Securities Market

128 -146


The Debt Market

147 -171


The Futures Market

172 -183


The Capital Market



Recent Trends in the Capital Market



Integration of Money and Capital Markets



Foreign Exchange Market

241 -268


Stock Exchange Transactions

269- 308



97 -104






Financial Services



Merchant Baking








21 .

Venture Capital



Mutual Funds



Money Market Mutual Funds

471 -476








Securitisation of Debt






Credit Rating



Credit Cards



Depository and Custodial Services



The Brokerage Services

574 - 588


Securities and Exchange Board of India







Chapter A well-functioning financial system is a sine quo non for the pursuit of economic growth with stability. The core function of a well-developed financial system is to facilitate smooth and efficient allocation of resources from savers to the ultimate users. That an efficient financial system is a key to development is not new in the economic literature. In fact, in his classic, Lombard Street: A Description a/the Money Market (1873), Walter Bagehot had argued that it was England's efficient capital market that made the industrial revolution possible. Bagehot was the first to define the two primary roles of financial markets. One, they facilitate the accumulation of capital. Two, they manage risk inherent in particular investment projects and industries.


Financial markets in India have existed for a long time. However, they remained relatively underdeveloped for a variety of reasons. India introduced financial sector reforms as a part of structural reforms in the early 1990s. Since then, momentous changes have taken place in the Indian financial sector, including financial markets. Reforms in the financial markets encompassed all segments- the money market, the credit market, the government securities market, the foreign exchange market, the equity market and the private corporate debt market. The development of financial markets in India has been pursued to bring about a transformation in the structure, efficiency and stability of markets has also to facilitate integration of markets. The emphasis has been on strengthening price discovery, easing of restrictions on flows or transactions, lowering of transaction costs, and enhancing liquidity. During the post-reform period, the structure of financial markets has witnessed a remarkable change in terms of the financial market and market participants. Development of these markets has been done in a calibrated sequenced and careful manner in step with those in other markets in the real economy. The sequencing has also been informed by the need to develop market infrastructure, technology and capabilities of market participants and financial institutions in a consistent manner. In a low income economy like India, the cost of downside risk is very high, so the objective of maintaining financial stability has to be constantly kept in view while developing financial markets. Developed financial markets are required not only to enable corporates to raise resources from the market, but also to enable banks to raise resources to sustain their growth. Banks need to raise capital from the market on an ongoing basis in order to sustain their operations. Their requirements of capital are also expected to increase on implementation of Basel II. Thus, banks inability to raise resources from the capital market could stunt their growth with attendant implications for economic growth. In India, pension and provident funds hold a large corpus of funds. These funds, however, generate low returns as they have limited avenues to deploy their funds in highly rated corporate bonds. Developed private corporate debt market may enable these pension and provident funds to deploy their funds in corporate bonds and generate higher returns. Global developments, particularly those in international financial markets, have the most direct and serious impact on the financing conditions in emerging markets. Volatility in financial markets could adversely affect



the EMEs in many ways, and also in a complex and interrelated fashion. For convenience of analysis, the impact may be classified broadly into: (i)

The impact on the financing conditions in which EMEs operate;


Impairment of the balance sheets of the banking sector;


Hampering of the growth prospects in the real sector.

Extensive reforms have been undertaken in the Indian capital markets, since 1990, encompassing reforms in the Legislative framework, trading mechanisms, institutional support etc. These reforms were desirable because the Indian capital markets were plagued by relative inefficiency in the trading mechanisms and regulatory gaps. In particular, the capital markets were characterized by excessive Government controls, inefficient trading mechanism through open out-cry, settlement of transactions by physical movement of paper, instances of manipulation on the secondary market price of the shares of a target company and non-existence of a derivative market for hedging and speculation. Over the decade of 90s significant changes have been made in various elements of the market design in the Indian securities market. Reforms in each of the spheres of regulator, intermediaries, access to market, pricing of securities, trading mechanism, settlement cycles, risk management, derivatives trading etc., have been carried out. A comparison of the market structure as in 1992 with that in 2007 is at Annexure-I. Over the past decade (1996-2006), many emerging market economies have, therefore, made significant efforts to strengthen their domestic financial systems, including financial markets - the money market, the government securities market, the foreign exchange market and the equity market. Local bond markets are now the dominant source of funding for the government in several countries. Main Market Parameters of the securities market are indicated in Table 1.1.

Table 1.1: Main Market Parameters Parameter

(Rs. crore) 2007-08 (till Aug 07)



Capital Raised -Public Issues




Amount Raised by Mutual Funds










Turnover in Cash Segment of BSE




Turnover in Cash Segment of NSE




Turnover in F&O Segment of NSE




Return on Sensex (%)




Net FII inflows (US$ millions)




AUM of Mutual Funds Market Capitalization (BSE)

Institutions and Markets Commercial banks are likely to remain the dominant institutions for some time. Banks can be made more efficient by improving their management systems and increasing the competition they face. Better management requires new lending policies. better loan recovery procedures. more sophisticated information systems. and better-trained staff. The entry of new banks, domestic or foreign. can stimulate competition. Countries also need to develop other financial institutions. whose services compete with and complement those of commercial banks. Nonbank financial intermediaries. such as development finance institutions, insurance companies. and pension funds. are potentially important sources of long-term finance. Most of the existing



development banks are insolvent, however. Where they are to be restructured, rather than closed or merged with commercial banks, thought must be given to their future role and viability. Any diversification should build on the experience of their staffs and on their existing client relationships. As more of the population becomes able to and desires to make provision for retirement, contractual savings institutions will grow in size. Permitting pension funds and insurance companies to invest in financial instruments other than low-interest government bonds can greatly increase the supply of long-term finance to the private sector. Many developing countries have benefited from the creation of money and capital markets. Money markets can provide competition for banks, a flexible means for managing liquidity, a benchmark for market-based interest rates, and an instrument of monetary policy. Capital markets can be a source of long-term finance both debt and equity - and can help to foster sounder corporate capital structures.

Table 1.2: Market Participants (Numbers as on 31 March, 2007) Depositories Depository Participants Stock Exchanges Brokers-Cash segment Sub-brokers FIls Portfolio Managers Custodians Registrars/Share Transfer Agents Merchant Bankers Bankers to an Issue Debenture Trustees U nderwri ters Venture Capital Funds Foreign Venture Capital Investors Mutual Funds

2 583 23 9,444 27,894 996 158 11

82 152 47 30 45 90 78 40

Most developing countries have a long-established informal financial sector that provides services to the non-corporate sector - households, small farmers, and small businesses. Although family and friends are usually the most important source of credit, pawnbrokers provide a substantial amount of credit to those with marketable collateral, and moneylenders to those without. Merchants provide financing to their customers, and purchasing agents advance funds to their suppliers. Rotating savings and credit associations are ubiquitous in the developing world. Financial institutions have often been weakened by being forced to channel credit to small-scale borrowers. Because such borrowers do not maintain financial accounts, formal lenders find it difficult to predict who is likely to repay. Moreover, if the borrower is in a group favoured by government, formal intermediaries may find it difficult to collect. The informal sector, in contrast, has been able to serve such borrowers. Informal lending has severe drawbacks, however. The scale of lending is small, the range of services is limited, markets are fragmented, and interest rates are sometimes usurious. Nevertheless, these institutions help clients that formal institutions often find too costly or risky to serve. Some countries have recognized this and have established programs to link informal markets more closely with formal markets. The most successful formal programs for the non-corporate sector utilize rather than suppress indigenous systems, take deposits as well as lend, and levy charges that cover costs.



Objectives of Financial Market From the view point of an emerging economy like India, the key objectives of financial market development are: (i)

to aid economic growth and development,


to raise adequate resources,


to intermediate resources from savers to investors,


to allocate funds in an efficient manner among competing users in the economy,


to increase investment, and


to enhance efficiency in resource use.

FINANCIAL INTEGRATION AND FINANCIAL MARKETS The need for developed financial markets also arises in the context of increasing integration of domestic financial markets with international financial markets. The concept of globalization today is no longer restricted to its traditional sense, i.e., variety of cross-border transactions in goods and services, but also extends to international capital flows, dri ven by rapid and widespread diffusion of technology. In fact, most of the literature in recent years on globalization has centred around financial integration due to the emergence of worldwide financial markets and the possibility of better access to external financing for a varif"ty of domestic entities. Integration of the domestic economy with the global economy can also provide the benefits of diversification to the residents. During the 1980s, capital account liberalistion came to be seen as an essential and even inevitable step on the path to economic development, analogous to the earlier reductions in barriers to international trade in goods and services. However, capital account liberalisation also exposes the domestic economy to certain risks. Large capital flows cause volatility, i.e., tendency of financial markets to go through boom and bust cycles in which capital flows grow and then contract. Financial integration minimises risks. Thus, with greater financial integration, a developed, vibrant, effective and stable financial system assumes considerable significance.

To maximise the benefits from financial integration, it is imperative to pursue efforts towards a greater sophistication of financial markets and develop innovative instruments that allow appropriate pricing, sharing and transfer of risks.

Management's Vision The management's effectiveness lies in channelling these distinct qualities and obtaining the best results from each employee to help create an organisation that is always energised, profitable and enthusiastic. Banks are witnessing a gradual improvement in utilisation of their human resource rates, as they battle declining price realisations and the consequent impact on profitability. In order to fuel growth, banks are aggressively hiring

Menu of Policy Option in Responding to Rapid Credit Growth Policy Options


I Macroeconomic Policy Measures

Prudenti al Measure s







- Fiscal tightening


- Avoiding fiscal/ quasifiscal

- Reserve

that may encourage certain lending.

Exchange rate policy response

Monetary Measures

Fiscal Measures



Interest rate tightening requirements

- Liquid asset requirements - Sterilization operations.

- Increase exchange rate flexibility


In general maintain a consistent mix ofa monetary and exchange rate policy

Supervisory/ Monitoring Measures



Higher differentiated capital requirements Tighter differentiated loan classification and provising rules - Tighter eligibility criteria for certain loans - Dynamic provisioning - Tighter collateral rules - Rules on credit concentration - Tightening net open foreign exchange position limits

Source: Hilbers et al? 2005.

- Maturity mismatch regulations and guidance to avoid excessi ve reliance on short-term borrowing.

Market Development Measures


I - Increasing disclosure requireents for banks on risk management and internal control policies and practices - Closer onsite/offsite inspections! surveillance of potentially problem banks - Periodic stress testing - Periodic monitoring/survey of banks and customer exposure. - Increasing supervisory co-ordination of banks and non-bank financial institutions - Improved dialo-gue and exchange of information between domestic and home supervisors of foreign banks.

Administrati ve Measures

Promotion of better Understaning of Risks

I 1 - Encouraging development of hedging instruments to manage risk requirements - Developing asset management instruments to deal with distressed assets - Developing securities markets to reduce dependence on bank credit and improve diversification of banks credit risks - Improving credit culture (establishment of credit bureaus, credit registry, stronger legal system, creditors rights, etc.) - Improving banks and corporations accounting standard

I - Over all or bank -by bank credi t limits - Cont rols on capit al flows e.g., - Cont rolon foreig n borro wing by bank sand/or bankc ustomers - Diffe rent reserv e requi rements on do mestic andfo reign curre ncy - Taxes on financ ial intermediation

~ - Strengthening banks ability to monitor, assess and manage - Public risk awareness campaigns, press statements etc. - Discussions/ meetings with banks ("moral suasion") to warn or persuade banks to slow down credit extension.




0 0




0 z



new professionals. Strong leadership which is about getting others to believe in, become confident and perform miracles, is the key for effective and efficient utilisation of human resource. Successful management offers a strong vision of where they want their organisations to go in the future. They are capable of getting their people to trust them and harness their energies towards the attainment of that vision. Against this backdrop, the management's vision like human visual system has two pathways - efficiency and effectiveness (E2). Peter Drucker, the management expert, has pointed out that performance achieved through management is actually made up of two important dimensions: •

Effectiveness is essentially doing the right things. It is the ability .to choose appropriate goals and achieve them, and

Efficiency is doing things in a right manner. It is the ability to make best use of available resources in the process of achieving goals. Management

Taking care of Resources

Utilisation of resources

Fig. 1.1 The Management's Vision

Thus, management needs to develop the ability to keep two conflicting ideas in mind at the same time and retain the ability to function. The functions of management's vision can be split into two as explicitly shown in the above figure; . •

To take care of ~esources to enhance efficiency and to sustain it in the activities or environment; and

To utilise them effectively at optimum level which, in turn, produces desired outcome.

Effectiveness comes from utilisation of human resource, the most crucial input for an organisation's success, through planned and systematic approach in an effective manner. For effective management the following five tools are suggested:

Succession Planning A tight fit between business strategy and HR policy through succession planning is considered to be essential for effective utilisation of human resource.



Strength Building It is the art of recogmsmg where an emplQyee's areas of natural talent lie and to develop the necessary skills to turn those talents to effective performance. Perforr:nance~anager:nent

Performance management involves constantly rewarding superior performance and weeding out the nonperformers to keep employees motivated enough to develop their talent and give their best.

Difficult Goals Individuals are likely to put in more efforts when goals are difficult and challenging than when they are easy. So making job challenging by setting up high targets and difficult goals is the way of effective utilisation of human resource. .

Training Continuously improving the skills to keep pace with the changes and increasing the potential for higher productivity and effectiveness is the ~ssence of training. It is important that organisations hire individuals who have ability to do what is required. Then the management challenge is providing working conditions that nurtures and supports individual motivation to work towards organisational effectiveness. Efficiency, which in fact comes from taking care of resources, is a vital part of management. The human related factors, which directly contribute to the efficiency and overall success of the organisation, have great significance for management's vision. These factors constitute: The organisational philosophy basically gets reflected through the thinking, perception and vision of the management which exerts on various factors contributing to the organisational success. The actual performance of any organisation is influenced by a function of ability, motivation, and working conditions. Efficiency and effectiveness (E2) are the two eye-pieces of management's vision which take the organisation on the path of realising and ensuring that the team contributes at its optimal level. A management's vision, which aims at MANAGING FOR EFFECTIVENESS ARTICULATE STRATEGY The organisation strategy sets the direction for performance management

~ ENABUNGINFRASTRUCTURE LINK STRATEGY TO VALUE Leverages process and technology Translates direction to tangible for improved performance organisational goals management




~ REWARD & REINFORCE Provides incentives/disincentives to evoke desired behaviour and performance


ENABUNG PERFORMANCE CULTURE Fosters a culture driven by a desire to exceed expectations

SETTING GOALS & OBJECTIVES Translates the organisational goal into performance targets PERFORMANCE MANAGEMENT CYCLE

REVIEW & EVALUATE Reviews and evaluates the reported performance vis-a-vis the targets to determine compliance with expectations



MEASUREMENT & MONITORING Measures and reports the actual performance

Fig. 1.2 Performance Management Cycle



effective and efficient utilisation of Human Resource (HR) to get desired outcome, has the power to be able to infuse all levels of an organisation with positive energy and motivate employees towards its successful execution. Banks therefore need to exhibit both efficiency and effectiveness (E2) in order to stay on their vision to grow as energised and profitable organisations.

Deep and liquid financial markets play a key role in allocating resources in an efficient manner among competing uses in an economy, thereby contributing to productivity gains and higher economic growth. Absence of well-developed domestic financial markets can lead to mispricing of risks, misallocation of resources and higher intermediation costs. This could in turn, lead to a preference for physical assets over financial assets, preference for foreign currency denominated assets, vis-a-vis domestic currency denominated assets, credit and investment booms, maturity mismatches, and excessive external debt culminating in periodic crises. In the view of critical role played by the financial markets in financing the growing needs of various sector of the economy. It is important that financial markets are fully developed and well-integrated. The financial system is in the process of liberalisation. A search is underway for policies as well as reforms that will strengthen the financial sector, so that it can make its full contribution to the efficient use of resources, while keeping its tendency towards instability and volatility in check. In the new millennium, we see the global economy undergoing a transition from the 'old' to the 'new' fostered by rapid advances in information technology and telecommunications, and the emergence of the Internet as a mainstream medium for conducting business.

Users of Financial Services Financial institutions sell their services to households, businesses and government. The household sector includes small mainly unregulated firms and individuals. Their main financial needs are for payment of services, saving and small credit. They seek convenience, liquidity and security. Businesses have more complicated financial needs. It needs short-term credit to finance inventories and long-term funds to finance capital expansion. All governments use payment services. In most developing countries, governments, like businesses, are net borrowers, and they use the financial system as a source of funding for current and capital spending. In industrial countries, government deficits are financed mainly by selling securities to the public. In developing countries they are usually financed by borrowing from banks. Governments have also used the financial system to serve development or other goals.

Providers of Financial Services Different financial institutions provide services that are both complementary to and competitive with each other. Deposit institutions offer payment and liquid deposit facilities, and contractual savings institutions provide illiquid savings opportunities that cater to the longer-term needs of customers. Collective investment institutions offer small investors the benefits of professional management and low-cost risk diversification, encouraging them to diversify their savings into marketable securities. On the lending side, commercial banks have traditionally provided working capital and trade finance, but longer-term lending is gaining with the spread of universal banking. Factoring companies provide long-term investment finance. Money and capital markets provide investment instruments appropriate for contractual savings and collective investment institutions, whose services to the saving public are thereby improved. The efficient functioning of financial markets also depends on institutions that lend and borrow little on their own account: investment banks, securities brokers, and credit rating agencies. Commercial banks also improve the working of financial markets by providing credit and payment facilities to market markers and other market participants. Different financial institutions and markets compete for a limited pool of savings by offering different instruments. Money and capital markets increase competition between suppliers. Money markets give merchant banks, or commercial banks with limited branch networks, greater access to funds. Because such banks specialize in lending to larger corporations, the corporate loan market may be highly competitive, even though


few large domestic banks may continue to dominate the retail deposit market. Money markets also provide large corporations and nonbank financial institutions with efficient shortterm instruments for investing their liquid funds and thus compete directly with commercial banks' traditional deposit facilities. They also enable large corporation to issue short-term securities in the form of commercial paper and thus further reduce the market power that large banks may have in the domestic banking sector. Finally, capital markets enable contractual savings and collective investment institutions to playa more active role in the financial system. The complementary and competitive interaction of financial institutions has policy implications. To promote an efficient financial system there must be competition, but the system must also offer an array of services. Rather than restrict the growth and diversification of the main banking groups, governments in the greater competition by encouraging money and capital markets, specialized credit institutions (such as leasing and factoring companies), and contractual savings and collective investment institutions. Economies too small to support such specialized institutions can spur competition by allowing economic agents to buy.

Outline of the Study As a result of several reforms initiated in the last 17 years, various segments of the financial markets are now better developed and integrated. However, financial markets need to develop further in line with the evolving conditions and economic needs. This students need to understand the structure of the Indian Financial Markets and to identify the substantive issues that need to be addressed. Towards meeting this objective, the theme of this book has been "Financial Markets and Financial Services". The study undertakes an indepth analysis of various segments of the financial markets in India in terms of development, major issues, reform process and the policy initiatives. To provide students with conceptual framework within which the banks and the other financial institutions operate. The book makes a sincere attempt to familiarise students with the various management and operational aspects of markets and financial intermediaries. The study consists of thirty-five chapters grouped into two distinctive modules, i.e., financial markets and financial services. Part ONE of the study, including this chapter, is organised into nineteen chapters. As a prelude to the substantive theme based discussion, chapter Two and Three presents an analytical account of financial market evolution and globalisation and the structure of the financial markets in India.

The theme based study begins with chapter Four on "Money Market". The money market is a key segment of the financial market as it provides the fulcrum of monetary operations conducted by the Reserve Bank of India. The working of other key segments of financial markets are discussed in the remaining fifteen chapters in a lucid manner. PART TWO dwells on financial services. Financial markets are mainly dominated by institutions. Each of these institution offer varied and distinctive financial services. Part two comprises of sixteen chapters and presents an indepth study of important selected financial services available in the financial markets.

The variety of financial services now provided by the All India Financial Institutions have widened into a broad spectrum of activities. In addition to normal project financing, loan syndication, they operate equipment leasing, equipment procurement, equipment credit, instalment credit, supplier's credit, buyer's credit, finance to leasing and hire-purchase schemes etc. The IDBI's Bills Rediscounting Scheme also helps in financing the indigenous manufacturers of machinery and capital equipment by getting the money through discounting the bills with his banker, while the banker in turn gets rediscounting facility from lOBI. The purchaser is enabled to repay the cost over a number of years. This helps the growth of sales of manufacturers and also the users of capital equipment, machinery, plant etc.




Forfaiting is another source of finance developed by banks for exports and import trade and to cover credit risk. Under this, for consideration of having received the full payment immediately by the exporter, he surrenders to the forfaiter all his rights to receive the consideration price from the buyer at a future date. The period of finance may be for three to seven years. The political and transfer risks in addition to credit risks are borne by the forfaiter. Factoring is another service of non-bank financial nature. Banks like SBI, Canara Bank etc., have set up subsidiaries for such services. Such services are available since 1991 to business concerns through purchase of their book debts and receivables. The services include administration of clients' sales ledger, collection ofdebts, covering of credit risk etc. This helps the cash generation against receivables and helps the process of production and distribution of goods.

Types of Non-Bank Financial Services 1.

Merchant Banking and New Issue Marketing.


Underwriting and Loan Syndication.


Bill Discounting and Money Market Operations.


Housing Finance.


Lease and Hire Purchase Financing.


Venture Capital Funds.


Investment Financing.


Investment Consultancy and Advise.


Mergers, Acquisitions, Amalgamations.


Capital Restructuring, Revaluations and Designing Capital Structure.


Portfolio Management Services.


Corporate Asset Management Services.


Technical Consultancy and Project Preparation.


Project Appraisal and Feasibility Studies.


New Issue House Services.


Guarantees and Underwriting including Registrar's Services.

Management of financial services calls of professional approach and needs to develop specialised skills. The objectives of management of financial services are efficiency in service quality, cost effectiveness and profitability. This is a service industry where quality counts more than quantity. In this process, costs and profitabi!.ity cannot be sacrificed. In the name of social obligations, banks have sacrificed the productivity and profitability which should not happen for non-bank finance companies.


Men are the best assets. The manager has to manage them effectively. 1.

Encourage capable and committed men.


Train the less capable ones and motivate uncommitted men.


Develop self-management ideas and help them to be cultivated by delegation of authority and responsibility.

Time is another valuable asset. Time is money. Develop a sense of timeliness. Good management has time sense and plans all activities in a time bound fashion. Quality counts in any activity and counts more in services. Competition in services takes the form of quality differences, in addition to pricing and charges.

CONCLUSION In the post liberalisation era, the banking and the finance sector is witnessing a complete metamorphosis. Deregulation measures have included the freeing up of direct controls over ownership, liberalizing interest rates and credit allocation, deregulating foreign exchange transaction controls, freeing up the entry of new firms, and expanding and broadening the base of the banking system, both for nationals and international business ventures. At the same time, non-banking financial institutions, securities markets and money markets have developed to mobilize and allocate savings. Experience suggests that financialliberalisation needs to be undertaken along-side macro-economic reforms. With the gradual liberalization of the Indian economy, there has been substantial inflow of foreign capital into India, much in excess of the prevailing current account deficit. Whereas the opening of the economy has brought about gains in terms of inflows of foreign investments with positive implications for output and employment, it has also posed new challenges for managing the macroeconomy amidst large and volatile capital flows. The market stabilization scheme (MSS) was introduced to absorb inflows of the more enduring part of the liquidity overhang induced by excess capital flows. Suitable changes were also made in the liquidity adjustment facility (LAP) scheme, However, going forward, there will be a continuous need to adopt and appropriate strategy of active liquidity management and short-term interest rate smoothening for effective monetary management and financial stability. Consequently, traditional businesses are being forced to innovate and re-think the way they conduct business. With the volume of on-line business transactions increasing at an exponential rate, the momentum of this transition is only getting stronger and traditional players are being forced to realign organization structures to meet the changing needs of the new economy. Development of financial markets is an ongoing process. Initiatives to further deepen and widen the various segments of the financial market will, therefore need to be pursued in the period ahead. Financial markets will have to play an even more important role in future to sustain the current growth momentum being experienced by the Indian economy. Large investment needs of the growing economy will depend heavily upon the ability of the financial markets to raise resources from savers and allocate them efficiently for the most productive uses. Further development and integration of various segments is also important in the context of envisaged move towards fuller capital account convertibility. Initiatives taken by the Reserve Bank and other regulatory authorities have brought about a significant transformation in the working of various segments of the financial market. Domestic financial markets transited from highly administered system - marked by administered interest rates, credit controls and exchange control - to a system dominated by market-determined interest rates and exchange rate and price-based instruments of monetary policy. These developments, by improving the depth and liquidity in the domestic financial markets, have contributed to better price discovery of interest rates and exchange rates, which, in tum, have led to greater efficiency in resource allocation in the economy. The increase in size and depth of financial markets has paved the way for flexible use of indirect instruments. Greater depth and liquidity and freedom to market participants have also increased integration of the various segments of the financial market. Increased integration




not only leads to more efficient dispersal of risks across the spectrum but also increases the efficacy of monetary policy impulses. In a world of integrated financial markets, monetary policy operates not only through the conventional interest rate channel but also through the exchange rate and other asset prices, channels, thereby strengthening the impact of monetary policy on the real economy and inflation. Evidence suggests that growing integration of various financial market segments in India has been accompanied by lower volatility of interest rates. Concomitantly, with growing liberalisation, deregulation and integration with global financial markets, policy initiatives have ensured that domestic financial markets and market participants in are in a position to absorb unanticipated and large shocks that can emanated from global developments so that financial stability is maintained in the country while supporting the growth. The Indian experience demonstrates that development of markets is an arduous and time-consuming task that requires conscious policy actions and effective implementation. Financial markets have to be created, nurtured and monitored on a continuous basis, before they start functioning autonomously. While the Internet revolution has far reaching implications for all businesses, its most dramatic impact has been on the services sector and in particular the financial services and banking industry. Internet banking or ebanking has emerged as a mainstream service delivery channel, which is providing customers unmatched convenience in terms of a location-and-time-independent service offering. E-banking presents lower transaction costs for banks, unrivalled opportunities for customization and encourages a greater degree of interactivity. At the pace and degree of technological innovation being witnessed today, customers are able to or will soon be able to carry out all their banking through electronic devices like personal computers, palmtops, laptops, mobile phones and other hand-held devices. Once this trend gains acceptance, banks with large physical branch networks will gradually lose their competitive edge. Though the leadership' status of the Indian software industry has come to be acknowledged the world over, the Internet has not impacted the Indian economy to the same extent as in the West. However, this situation is expected to be remedied shortly with the growing popularity of cyber-cafes and the emergence of set-top boxes, both of which are expected to provide Internet access at affordable rates. Further, an enabling regulator framework for e-commerce is expected shortly, with the passing of cyber-Iaws by Parliament. As a result, India has an opportunity to make the transition towards a knowledge-based society, which in tum promises an overall improvement in the quality of life. There is every evidence that this improvement will take place across a broad spectrum of the society including the semi-urban and rural areas. The globalization of the economy has pushed competition in the Indian financial sector to unprecedented heights. Against this backdrop the study of "Financial Markets and Financial Services" becomes quite unique and meaningful.






Corporate Securities Market Regulator

No specific regulator, Central Government A specialized regulator for securities market oversight (SEBI) vested with the powers to protect investors' interest and to develop and regulate securities market. SROs strengthened


Limited number of traditional instruments Expanded to cover government securities, units of CISs and MFs, derivatives of securities, security receipts, etc.

Form of Securities



Regulatory Approach

Merit based regulation

Disclosure based regulation


Some of the intermediaries (stock brokers, A variety of specialized intermediaries authorized clerks and remisiers) regulated emerged. They are registered and regulated by SEBI (also by SROs in some instances). They by the SROs as well as their employees are required to follow a code of conduct and are subject to a number of compliances. All participants are identified by a unique identification number

Access to Market

Granted by the Central Government


Voluntary, vague, scanty and non- Standardised, systematic and at par with the standardised international standards. A dedicated web site for corporate disclosures, EDIFAR, operationalised

Pricing of Securities

Determined by the Central Government

Eligible issuers access the market after complying with the issue requirements

Determined by market, either by the issuer through fixed price or by the investors through book building

Access to International Market

No access

Corporates allowed to issue ADRs/GDRs and raise ECBs. ADRs/GDRs have two way fungibilty. FIls allowed to trade in Indian market. MFs also allowed to invest overseas

Corporate Compliance

Very little emphasis

Emphasis on disclosures, accounting standards and corporate governance

Mutual Funds

Restricted to public sector

Open to private sector and emergence of a variety of funds and. schemes

Exchange Structure

Mutual not-for- profit exchanges

For profit corporate, demutualised exchanges

Trading Mechanism

Open outcry, available at the trading rings Screen based trading system; orders are of the exchanges; opaque,auctionl matched on price-time priority; transparent, negotiated deals trading platform accessible from allover the country



Aggregation of Order of Flow

Market fragmented by geographical distance. Order flow observed.

Order flow observed. The exchanges have open electronic consolidated limit order book (OECLOB) Complete

Anonymity in Trading Absent Settlement Cycle

14-days account period settlement, not adhered to always

Rolling settlement on T+2 basis

Counterparty Risk



Form of Settlement


Mostly electronic

Basis of Settlement

Bilateral netting

Multilateral netting

Transfer of Securities

Cumbersome. Transfer by endorsement security and registration by issuer

Securities are freely transferable. Transfers are recorded electronically in book entry form by depositories

Risk Management

No focus on risk management

Comprehensive risk management system encompassing capital adequacy, limits on exposure and turnover, VaR based margining, client level gross margining, on-line position monitoring, business continuity plans, etc.

Derivatives Trading



Very little


A wide array of exchange traded derivatives such as Futures and Options on indices and select securities and Futures on interest rate available Many market participants have full fledged research departments. Some of them have schemes/initiatives to promote research

Government Securities Market Expanded to include zero coupon bonds, floating securities rate bonds, capital indexed bonds, bonds with embedded derivatives, interest rate futures etc.


Plain vanilla securities

Form of Securities


Demat holding by RBI regulated entities

Pricing of Securities

Administered interest rates

Issue at market related rates (auction)


Captive investors(mostly banks)

Trading Mechanism

Through telephone

Expanded to allow primary dealers, FIls, retail investors Negotiated Dealing System which provides negotiation and screen based trading

Counterparty Risk


Mode of Settlement

Clearing Corporation provides novation and guarantees settlement


Delivery-versus-payment (DVP-ITI)




Financial Markets Financal markets are never perfect. In allocating credit, they can make two mistakes: funding low-yielding projects and failing to fund high-yielding ones. In the early stages of development, the governments of developing countries fearing that the costs of failing to fund good projects were likely to be high, intervened to direct cedit. Perhaps that assessment was sound at the time, but experience has since revealed too many errors of the first kind - funding low-yielding projects. With time, economies have become more complex, information flows have improved, and financial managers have become more skilled. In most countries, errors can be minimized by leaving more decisions to a diverse and competitive financial system that responds to market signals. The primary role of the government then shifts to making market signals more meaningful and, in particular, to preventing its own actions from distorting them. On occasions, the government may have a role to playas a promoter of financial institutions and markets in order to create a diversified and competitive financial system. Many high-income and developing countries have used fiscal incentives to favour particular institutions and markets. Such incentives may be justified to encourage financial diversity, particularly if the existing markets are dominated by large banks and are uncompetitive. Fiscal incentives, however, should be used only moderately, should have clear objectives, and should be withdrawn once those objectives are achieved. In the long-term, countries should opt for regimes that do not favour one type of instrument or institution over others. To improve competition and efficiency, some small countries have opened their markets to foreign banks or have encouraged joint ventures between foreign and domestic institutions. Many small and countries could buy the specialised financial services they need (such as reinsurance, swaps, and forward contracts) from abroad. Small, specialised institutions and foreign competition can force even big oligopolistic banks to behave competitively - although not necessarily across the full range of financial services.

The stockmarket in India is more than a century old. Going forward into its 125th year, the BSE has drawn up plans to make itself an attractive destination both for investors and companies. A gist of the plan includes exclusive market-making in poorly traded scrips. High on the agenda is the expansion of BOLT to 2000 centres (including overseas) over the next two years. Strengthening the vigilance cells on the exchanges and setting. up strong scrutinising cells (for new companies seeking listing) are urgent requirements, as is the introduction of derivatives trading in indexed futures. The roadmap for the next five years - Vision 2005 - factors in developments in technology including the use of the internet, one component of which is e-broking. The concept of taking the stock exchange to the investors' doorsteps is soon to become a reality.

Financial Markets -

Reform Measures

Since the early 1990s, various measures were initiated in all segments of financial markets aimed at improving depth and liquidity in the markets. The reforms also emphasised on improving the transparency and


efficiency of the markets. The key reform measures undertaken in different market segments are briefly presented below: Money Market •

A ceiling of 10 per cent on call money rates imposed by the Indian Banks Association was withdrawn in 1989.

Initially, the participation in the call market was gradually widened by including non-banks, such as, financial institutions, non-banking finance companies, primary/satellite dealers, mutual funds, corporates (through primary dealers), etc. The process of transformation of call money market to a pure inter-bank market commenced effective May 2001.

The 182-day treasury bills were introduced effective November 1986, followed subsequently by phasing out of on-tap treasury bills, introduction of auctioning system in 91-day treasury bills since January 1993, and introduction of 14-day and 364-day treasury bills. The system of ad hoc treasury bills (with a fixed 4.6 per cent interest rate since July 1974), which were issued by the Central Government to the Reserve Bank, was abolished effective April 1997. Currently only the 91-day and 364-day treasury bills exist.

The Discount and Finance House of India (DFHI) was set up in April 1988, and was allowed to participate in the call notice money market both as a borrower and lender commencing from July 1988.

Several new financial instruments were introduced, such as inter-bank participation certificates (1988), certificates of deposit (June 1989), commercial paper (January 1990) and repos (December 1992).

Derivative products like forward rate agreements and interest rate swaps were introduced in July 1999 to enable banks, FIs and PDs to hedge interest rate risks.

A full-fledged Liquidity Adjustment Facility was introduced on June 5, 2000 with a view to modulating short-term liquidity under diverse market conditions.

With a view to adopting the sound risk management procedures and eliminating counter-party risk, the Clearing Corporation of India Ltd. was set up on February 15,2002. The CCIL acts as a central counterparty to all trades involving foreign exchange, government securities and other debt instruments routed through it and guarantees their settlement.

The segment refinance facility for banks is gradually being phased out.

Govemment Securities Market •

New auction-based instruments were introduced with varying maturities such as 364-day, 182-day, 91-dayand 14-day treasury bills and the zero coupon bond. The auction system was also introduced for Government of India dated securities. An innovative feature of 'part payment' was added to the auction of Government of India dated securities.

In the long-term segment, Floating Rate Bonds (FRBs) benchmarked to the 364-day treasury bill yields and a 10-year loan with embedded call and put options exercisable on or after 5 years from the date of issue were introduced.

A system of Primary Dealers (PDs) was made operational in March 1996.

Foreign Institutional Investors (FIls) were allowed to set up 100 per cent debt funds to invest in Government (Central and State) dated securities in both primary and secondary markets.

The system of automatic monetisation of budget deficit through ad hoc treasury bills which hampered the development of the market was phased out over a period of three years from 1993-94 to 199697 and was replaced by the system of Ways and Means Advances (WMA) with effect from April 1, 1997.

The Delivery-versus-Payment system (DvP) was introduced in 1995 for the settlement of transactions in Government securities. A screen-based trade reporting system with the use ofVSAT communication




network complemented by a centralised Subsidiary General Ledger (SGL) accounting system was put in place. •

The Negotiated Dealing System (NDS) (Phase 1) was operationalised in February 2002 to enable online electronic bidding facility in the primary auctions of Central/State Government securities. OMOI LAF auctions. screen-based electronic dealing and reporting of transactions in money market instruments. including repo and to facilitate information on trades with minimal time lag.

Since timely flow of information is a critical factor in evolving the efficient price discovery mechanism. improvements were brought in transparency of operations and data dissemination.

A practice of pre-announcing a calendar of treasury bills and government securities auctions to the market was introduced.

Retail trading in Government securities at select stock exchanges commenced in January 2003.

Foreign Exchange Market

The current account was gradually made convertible leading to the acceptance of obligations under Article VIII of the IMF. The exchange rate. which was pegged to a basket of currencies. was made market-determined in a phased manner. Several transactions in the capital account were also gradually liberalised over the years.

In line with the liberal policy environment of the 19908. the Foreign Exchanee Regulation Act. 1973 (FERA) was replaced by the Foreign Exchange Management Act (FEMA) in 1999.

Banks were given increased freedom for operating in the forex market. These related to the following: (a) freedom to fix overnight position limit and gap limits approved by RBI. replacing the sy~tem of across-the-board or RBI-prescribed limits; (b) freedom to initiate trading position in the overseas market; freedom to borrow (up to 25 per cent of Tier I capital or up to US $ 250 million. whichever is higher) or freely invest funds in the overseas market; (c) freedom to determine the interest rates (subject to a ceiling) and maturity period of Foreign Currency Non-Resident (FCNR) deposits (not exceeding three years); (d) freedom to use derivative products for asset-liability management.

Corporates were allowed to undertake active hedging operations by resorting to cancellation and rebooking of forward contracts. book forward contracts based on past performance without having to produce documents endorsing a forex exposure. use foreign currency options and variations thereof like range forwards and ratio range forwards. They can access a range of products including Foreign Currency - Rupee Swap to manage longer-term exposures arising out of External Commen;ial Borrowings.

Capital Market

With the repeal of the Capital Issues (Control) Act. 1947. companies were given freedom to price their issues. The book-building process in the new issue of capital was introduced with a view to further strengthen the price discovery process.

In the secondary market. the floor-based open outcry trading system was replaced by electronic trading system in all the stock exchanges.

The account period settlement system was replaced by rolling settlement. thUS. reducing the scope for speCUlation. The rolling settlement cycle was shortened from T+5 to T+3 with effect from April 1. 2002. This process was enabled by a shift to electronic book entry transfer system through depository mechanism.

The risk management system was made more comprehensive with trading members being subject to margins based on trading volumes and some other parameters and exposure norms based on the capital deposited with the exchange. The mark-to-market margins based on 99 per cent value at risk were introduced to capture the risk profile of trading members.

The Indian companies were allowed to raise funds from abroad. through American/Global Depository Receipts (ADRs/GORs). foreign currency convertible bonds (FCCBs) and external commercial


borrowings (ECBs). The Reserve Bank allowed two-way fungibility of ADRs/GDRs in February 2002. •

Foreign institutional investors (FIls) were allowed to participate in the capital market.

For strengthening the process of information flows from the listed companies, several measures were introduced: (i) while sufficient disclosures are mandatory for the companies at the stage of public issue, the listed companies are also required under the listing agreement to make disclosures on a continuing basis; (ii) for ensuring quick flow of information to the public, the decision pertaining to dividend, bonus and right announcements or any material event are now required to be disclosed to the public within 15 minutes of the conclusion of the board meeting in which the decisions are taken; (iii) the accounting practices were streamlined with norms introduced for segment reporting, related party transactions and consolidated balance sheets.

Insider trading was made a criminal offence. The regulations governing substantial acquisition of shares and takeovers of companies were also introduced aimed at protecting the interests of minority shareholders by making the takeover process more transparent.

For providing market participants instruments for hedging and risk management, several types of derivative products on equities were introduced. Non-transparent products like 'badIa' were banned.

AN ASSESSMENT OF REFORMS While financial institutions and financial markets are two generic mechanisms for transferring resources from the surplus sectors to deficit sectors, their relative significance varies from country to country. In the context of the underdeveloped capital market in India, financial intermediaries or institutions have traditionally played a predominant role in meeting the fund requirements of various sectors in the form of credit and investment. The major institutional purveyors of credit in India are banks (commercial banks and co-operative banks), DFls and NBFCs. Traditionally, banks and MBPCs predominantly extended short-term credit and DFls mainly provided medium and long-term loans. Insurance companies and mutual funds provided medium to long-term funds mainly in the form of investments. This distinction has got somewhat blurred in recent years. While financial intermediaries play an important role in the growth process by encouraging saving and investment and by improving the allocative efficiency of resources, this role is performed well only when financial intermediaries are sound, stable and efficient. The key objective of reforms in the financial sector in India has been to enhance the stability and efficiency of financial institutions. To achieve this objective, various reform measures were initiated that could be categorised broadly into three main groups: enabling measures, strengthening measures and institutional measures. The enabling measures were designed to create an environment where financial intermediaries could respond optimally to market signals on the basis of commercial considerations. Salient among these included reduction in statutory pre-emptions so as to release greater funds for commercial lending, interest rate deregulation to enable price discovery, granting of operational autonomy to banks and liberalisation of the entry norms for financial intermediaries. The strengthening measures aimed at reducing the vulnerability of financial institutions in the face of fluctuations in the economic environment. These included, inter alia, capital adequacy, income recognition, asset classification and provisioning norms, exposure norms, improved levels of transparency and disclosure standards. Institutional measures were aimed at creating an appropriate institutional framework conducive to development of markets and functioning of financial institutions. Financial sector reforms have been successful in bringing significant improvements in various market segments by effecting regulatory and legal changes building up of institutional infrastructure, constant finetuning in market microstructure and substantial upgradation of technological infrastructure. Efficient stable and healthy financial markets constitute the bedrock for successful.conduct of monetary policy; hence, improving the effectiveness of the transmission channel of monetary policy necessitated significant reforms in the money and government securities markets. Facilitating integration of domestic financial markets was the other major objective of financial market reforms.




Financial market reforms have helped in improving the price discovery in the primary market, while the secondary markets have attained greater depth and liquidity. The number of instruments and participants has also increased. The capital market has become a safer place for investors as various risks involved at various stages of trading and settlement have been either completely eliminated or reduced considerably. Liquidity in the stock market has improved considerably. The government securities market has witnessed a transformation from a captive bank-dominated market to an active debt market operating at market related/determined interest rates. Among the financial market segments, the linkages among the money, government securities and foreign exchange markets have been established and are growing. The presence of foreign institutional investigators strengthened the integration between the domestic and international capital markets. The Reserve Bank's short-term liquidity management is centred around the LAF operations through repo/ reverse repo transactions. However, certain impediments need to be overcome for the smooth operation of LAF. These include the presence of non-bank players in the call market and skewed distribution of liquidity among market players. Further development of the term money market would help in removing the segmentation in the yield curve. This is crucial for effectiveness of monetary policy transmission. Placing limits on banks' exposure to call money market, making call money market a purely inter-bank market, encouraging development of the collateralised repo market, adherence to prudential asset-liability and risk management guidelines, and on-line connectivity between major bank branches are expected to preserve the integrity of financial markets and facilitate emergence of term money/repo markets in the near future. Significant achievements have been made through the operationalisation of the Clearing Corporation of India Ltd. (CCIL) and the Negotiated Dealing System (NOS). The wider accessibility of NOS to facilitate the development of a repo market in a risk free environment for settlement would need to be expedited. Future developments in the Government securities market hinge on legislative changes consistent with modem technology and market practices. Other measures include the introduction of an RTCS system, integration of the payment and settlement systems for government securities, standardisation of practices with regard to manner of quotes, conclusion of deals and code of best practices for repo transactions and retailing of government securities. The recently proposed introduction of trading in government securities through a nationwide, anonymous, order-driven, screen-based trading system of the stock exchanges, in the same manner in which trading takes place in equities, would further enhance the operational and informational efficiency of the market as well as its transparency, depth and liquidity, thereby providing for a country-wide retail investor base. . Derivatives can play an important role in risk mitigation. There has been a substantial increase in Interest Rate Swaps (IRS)lForward Rate Agreements (FRA) transactions in 2002. With the increased popularity of the derivatives, a range of possibilities for efficient pricing, hedging and managing of interest rate risks will open up. These would raise new issues like counterparty risks and liquidity risks. For optimising the capital charges, the clearing and settlement of contracts could increasingly be through a centralised counterparty. It may, however, be noted that derivatives market is in an evolving stage in India. A cautious, gradual and sequenced approach to introduction of derivatives instruments to avoid pitfalls is in order. Like derivatives, introduction of floating rate bonds can promote effective management of balance sheet risks when interest rate outlook is uncertain. Depth and liquidity in the spot as well as forward segments in the foreign exchange markets need to be enhanced further. A way to address these concerns lies in the further development of the money market as well as in assumption of the role of 'market makers' by large public sector banks who handle the major portion of the export-import transactions. The preconditions for the pick-up of activity in forex derivatives include sequentially, the development of (i) a deep and liquid inter-bank term money market, (ii) a liquid forward dollar-rupee market, and (iii) rupee-based derivatives. Expeditious development of these market segments would remove the irritants in the healthy development of the foreign exchange market. In the light of the experience of the East Asian crisis, the movement would need to be 'gradual' as the 'big- bang' approach could have adverse repercussions for the exchange rate regime, foreign exchange reserves, BoP situation and the overall growth prospects of the economy.



Although the capital market has made significant strides in information acquisition, processing and dissemination, there is little evidence that it is now processing the information more efficiently than before reforms. Both, the primary market for private debt (with preponderance of privately placed debt issues) and the secondary market are tagging behind the equity markets in terms of transparency, thus adversely affecting the process of price discovery. Preponderance of the private placement market can potentially strip the market of its ability to discipline issuers and thereby enhance systemic risk. Not all privately placed issues are listed. As a result, investors cannot signal their changing evaluation of the business prospects of the issuers. Some recent regulatory initiatives have been taken to contain risks. In addition norms for corporate disclosure would also require to be strengthened that would enable investors to take informed decisions as well as to promote transparency. Measures to revive the public issues segment of the primary market could also be contemplated. BENEFITING FROM REFORMS The private management of provident fund marks another step on the road to reforming the country's financial system. The following study puts a figure to the entire set of indirect and direct financial reforms: $ 47.3 billion. IMPACT OF INDIA'S FINANCIAL SYSTEM REFORMS, 2004-05 INDIRECT IMPACT



More saving captured

Improved allocation of capital

DIRECT IMPACT Improve banking _ efficiency to best practices Fully implement electronics payment system

7.8 _


Migrate informal lending to formal banks Reduce corporate bond deafault rates to benchmark


Create shift in financing mix from bank loans to bonds Direct impact of financial system reforms

Indirect + direct impact of financial reforms =$47.3b So"",.: CSO. RBI, McKim.ey Glohal lnsti.ute analysis


SF. Private Players No.

Share %

Incremental Corpus Rs. crore 2008-2009 w.ef. 01-09-2008

Existing Corpus . Rs.crpre

Fund Management Fee Quoted

As on 31-08-2008








ICICI Prudential AMC






Reliance Capital






State Bank of India








Total Source: EPFO.




APPENDIX SOME RECENT POLICY MEASURES Monetary policy would continue to enhance the integration of various segments of the financial market, improve credit delivery, nurture credit culture and enhance the quality of financial services. Given the volatility in the inflation rate during '04-05, there is also a need to consolidate the gains obtained in recent years from reining in inflationary expectations. It is important to appreciate that; while sustained efforts over time have helped to build confidence in price stability. Inflationary expectations can turn adverse in a relatively short time if noticeable adverse movements in prices take place. In the world economy, after a prolonged period of low inflation, there are signs that inflation may be edging up. The global oil markets continue to remain tight with higher prices and increased volatility. Credible commitment of policy to fight inflation is critical to stop translation of higher oil prices into wage-price spirals. In addition, the international prices of non-oil primary commodities may continue to remain firm. On the domestic front, the manoeuverability on oil prices is getting limited and corporates have a higher probability of gaining their pricing power with a better industrial outlook. The pricing pressure, if it were to occur from the supply side, could get complicated by continuing overhang of excess domestic liquidity. While the economy has the resilience to withstand supply shocks, the upside risks do exist. As such, the inflationary situation needs to be watched closely and there could be no room for complacency on this count. In the context of current inflation scenario, an issue of policy interest for financial management by banks and other market participants is, whether the interest rate cycle has turned from the low Observed during '03-04. As is well known, the outcome for interest rates depends mainly on the outlook for inflation, growth prospects and investment demand and it is not possible to predict short-run movements in interest rates, either up or down, without taking cognizance of possible movements in all other macroeconomic variables. These variables are also subject to unanticipated changes because of unforeseen domestic or external developments. However, the system has to recognise interest rate cycles and strengthen risk management processes to cope with eventualities so that financial stability could be maintained and interest rate movements could be transited in a non-disruptive manner. In this regard, it is instructive to observe global trends as the Indian economy is progressively getting linked to the world economy. While there is an overhang of domestic liquidity, partly mirroring abundant global liquidity, the trends in global interest rates, inflation expectations and investment demand would also have some relevance in the evolution of the domestic interest rates. It will, therefore, be desirable to contain inflationary pressures to stabilise domestic financing conditions both for the governments and the private sector. The Reserve Bank will continue to ensure that appropriate liquidity is maintained in the system so that all legitimate requirements of credit are met, consistent with the objective of price stability. Towards this end, RBI will continue with its policy of active demand management of liquidity through OMO including MSS, LAP and CRR, and using the policy instruments at Its disposal flexibly, as and when the situation warrants. In sum, barring the emergence of any adverse and unexpected developments in various sectors of the economy and keeping in view of the inflationary situation, the overall stance of monetary policy for the year '05-06 will continue to be as set out in the mid-term Review of October 2004, namely: •

Provision of appropriate liquidity to meet credit growth and support investment and export demand in the economy white placing equal emphasis on price stability.

Consistent with the above, to pursue an Interest rate environment that is conducive to macro-economic and price stability, and maintaining the momentum of growth.

To consider measures in a calibrated manner, in response to evolving circumstances with a view to stabilising inflationary expectations.

Bank Rate, Repo Rate and eRR In the mid-term Review of October '08, the Bank Rate was kept unchanged at 6%. On a review of the macroeconomic developments, it is considered desirable to leave the Bank Rate stable (at 6%) at present. Reserve repo rate also at 6 per cent, Repo rate at 9 per cent and CRR at 9 per cent.


Reverse Repo Rate In view of the current macroeconomic and overall monetary conditions, it has been decided: •

To increase the fixed reverse repo rate by 25 basis points under the liquidity adjustment facility (LAP) of the RBI effective from April 29, '05 to 5% from 4.75%.

The repo rate will continue to be linked to the reverse repo rate, as at present. However, the spread between the reverse repo rate and the repo rate is reduced by 25 basis points from 125 basis points to 100 basis points with effect from April 29, '05. Accordingly, the fixed repo rate under LAF will continue to remain at 6%.

Cash Reserve Ratio The cash reserve ratio (CRR) of scheduled banks is currently at 5%. While the RBI continues to pursue its medium-term objective of reducing the GRR to the statutory minimum level of 3%, on a review of the current liquidity situation, it is felt desirable to keep the present level of GRR (5%) unchanged. I. Financial Markets Money Market Framework for Development of Money Market: Money market provides a focal point for the central bank's operations in influencing system liquidity and thereby transmitting the monetary policy impulses. The broad policy objectives that are being pursued for the development of money market include ensuring stability in short-term interest rates, minimising default risk and achieving a balanced development of various segments of the money market. In order to review the recent developments and current status of money market in the context of evolving monetary policy framework, fiscal scenario, regulatory regime and extent of financial integration, both domestic and external, a Technical Group on Money Market was constituted. The report of the Group was discussed in the Technical Advisory Committee on Money, Foreign Exchange and Government Securities Markets (TAC) and certain recommendations have been accepted for implementation. Accordingly, the following measures are proposed:

(i) CalVNotice Money Market •

With effect from the fortnight beginning June 11, 'OS, non-bank participants, except PDs, would be allowed to lend, on average in a reporting fortnight, upto 10% of their average daily lending in calVnotice money market during '00-01.

With effect from August 6, 'OS, non-bank participants, except PDs, would be completely phased out from the calVnotice money market.

With effect from the fortnight beginning April 30, '05, the benchmark for fixing prudential limits on exposures to calVnotice money market in the case of scheduled commercial banks would be linked to their capital funds (sum of Tier I and Tier II capital).

From April, 30, 'OS, all NOS members are required to report their term money deals on NOS platform.

A screen-based negotiated quote-driven system for all dealings in calVnotice and term money market transactions is proposed.

(ii) Market Repo

An electronic trading platform for conduct of market repo operations in government securities, in addition to the existing voice based system, to be facilitated. •

Participation in market repo facility in government securities, for non-scheduled urban co-operative banks (UCBs) and listed companies having gilt accounts with scheduled commercial banks will be allowed subject to eligibility criteria and safeguards.

(iii) Certificates of Deposit

The minimum maturity period of certificates of deposit (CDs) reduced from 15 days to 7 days with immediate effect.




The Report of the Group is being placed on RBI website for wider dissemination. The recommendations of the Group on introduction of asset-backed commercial paper (ABCP) to further deepen the CP market and additional intraday LAF to stabilise short-term interest rates would be considered in future in consultation with market participants. In addition, optionalities in OTC rupee derivatives would be considered, once legal clarity to OTC derivatives is provided and appropriate accounting standards are put in place. Government Securities Market (a) Central Government Securities Market: Medium-term Framework In terms of the stipulation of FRBM Act, RBI will not be participating in primary issuance of government securities with effect from April 1, '06. In this context, the mid-term Review of October '04 emphasised that open market operations (OMO) would become a more active policy instrument necessitating review of processes and technological infrastructure consistent with market advancement. In order to address these emerging needs and equip RBI as well as the market participants appropriately, a Technical Group on Central Government Securities Market was constituted. Earlier, another Group (Chairman: R.H. Patil) had examined the role of primary dealers (PDs) in the government securities market. The Reports were discussed in TAC and certain recommendations have been accepted for implementation. Accordingly, the following measures are proposed: •

The number of actively traded securities need to be enlarged to enhance liquidity and improve pricing in the market. It is proposed to consolidate debt and build up large liquid securities in consultation with the Government while continuing the programme of reissuances.

Post-FRBM, RBI will reorient government debts management operations while simultaneously strengthening monetary operations. This will entail functional separation between debt management and monetary operations within RBI. For this purpose, RBI will have discussions with market players on the modalities and procedures of market operations.

The settlement system for transactions in government securities will be standardised to T+ 1 basis.

The Reserve Bank would continue to resort to mUltiple and uniform price methods flexibly in the auction of government securities.

Permitted structures of PD business will be expanded to include banks which fulfil certain minimum criteria subject to safeguards and in consultation with banks, PDs and the Government.

The recommendations of the technical Group on restructuring the underwriting obligations of PDs, allowing PDs exclusively in primary auctions, introduction of 'When Issued Market' and limited short selling in government securities would be considered in consultation with the Government. (b) Sale of Government Securities: Relaxation At present, sale of government securities allotted in primary issues can be entered into on the same day only between entities maintaining SGL account with RBI. In order to facilitate further deepening of the government securities market, it is proposed: To permit sale of government securities allotted in primary issues with and between CSGL account holders also on the same day. (c) Market Borrowings of State Governments The Twelth Finance Commission (TWFC) recommended that the Centre should not act as a financial intermediary for future lending to the States. The Centre would release only the grant portion of central assistance of state plan to States and allow them to approach the market directly to raise the loan portion of the funds. In case some fiscally weak States are unable to raise funds from the market, the Centre could borrow for on-lending to such States. The Centre has accepted in principle the recommendations and has proposed to implement it in phases, in consultation with RBI. As the implementation of the recommendations of TWFC would have major implications for the market borrowing programmes, RBI would facilitate smooth transition of the process in consultation with the Central and the State governments. As a first step, consultations, were held with State Finance Secretaries on April 8, '05.


n. Foreign Exchange Market (a) Forex Market Group: Medium-term Framework Since the onset of reforms in the early 1990s, significant liberalisation of the foreign exchange market has taken place and the process gained momentum after Sodhani Committee recommendations were accepted for implementation by RBI. The foreign exchange market is now deeper and wider as gauged in terms of parameters such as the range of products, participation, liquidity and turnover. As indicated in the mid-term Review of October '04, an internal Group was set up to review comprehensively the initiatives taken by RBI in the foreign exchange market and identify areas for further improvements. The Group reviewed forex market liberalisation in select emerging markets and examined the current regulatory regime in the light of liberalisation in related sectors to identify areas for further liberalisation. The Report of the Group was discussed in TAC as recommended by the Group, the following measures are proposed: •

Cancellation and rebooking of all eligible forward contracts booked by residents, irrespective of tenor to be allowed.

Banks to be allowed to approve proposals for commodity hedging in international exchanges from their corporate customers.

The closing time for inter-bank foreign exchange market in India to be extended by one hour up to 5.00 pm.

Dissemination of additional information including traded volumes for derivates such as foreign currencyrupee options to the market.

The other recommendations of the Group pertaining to writing of covered options by corporates and hedging of economic risk of corporates in respect of their domestic operations arising out of changes in the landed cost of the imported substitutes of the commodities they consume/produce would be considered. The sequencing with regard to implementation of these measures will take into account the enabling conditions for further progress towards capital account convertibility, liberalisation in other sectors of the economy and the trend in overall balance of payments.

(b) Overseas Investment: Liberalisation At present, under the automatic route, Indian entities are permitted to invest in overseas joint ventures and/or wholly owned subsidiaries up to 100% of their net worth. With a view to promoting Indian .investments overseas, it is pro~~d: ' •

To raise the ceiling of overseas investment by Indian entities in overseas joint ventures and/or wholly owned subsidiaries from 100% to 200% of their net worth under the automatic route.

(c) Foreign Cu"ency Accounts by Foreign Companies in India: Liberalisation At present, authorised dealers (ADs) are required to obtain RBI approval for opening of foreign currency accounts of the project offices set up in India by foreign companies. In order to further liberalise the procedure, it is proposed: •

To accord general permission to ADs to open foreign currency accounts of the project offices set up in India by foreign companies and operate the accounts flexibly.

Interest Rate Prescriptions The deregulation of financial markets in the recent years has improved the competitive environment in the financial system and strengthened the transmission mechanism of monetary policy. Sequencing of interest rate deregulation has been an important component of the reform process which has imparted greater efficiency in resource allocation. The process has been gradual and predicated upon institution of prudential regulation of the banking system, market behaviour, financial opening and, above all, the underlying macro-economic conditions. The interest rates have been largely deregulated except for (i) savings deposit accounts, (ii) non-resident, Indian (NRJ) deposits, (iii) small loans up to Rs. 2 lakh and (iv) export credit. The annual policy Statement of '02 had weighed the option of deregulation of interest rate on savings accounts but the time was not considered opportune considering that bulk of such deposits are held by households in semiurban and rural areas. It has, however, been argued that deregulation will facilitate better asset-liability management for




banks and competitive pricing to benefit the holders of savings accounts. As regards NRI deposits, interest rate ceilings on FCNR(B) deposits are linked to LIBOR/SWAP rates of corresponding foreign currencies, while NRB deposit rates are linked to US dollar LIB OR/SWAP rates. These stipulations have been put in place taking into account their implications for the banking system and the management of the capital account. As regards lending rates, given the limited ability of small borrowers to manage interest rate risk and for ensuring availability of credit at reasonable rates, interest rate ceiling on small loans up to Rs. 2 lakh is linked to BPLR. The contrary view is that given the competitiveness in the credit market, high share of sub-BPLR lending and increasingly broad-based credit structure, availability of credit to all segments of the economy at a price consistent with their risk profiles becomes important. Further, it is argued that lending rate regulation has dampened larger flow of credit to small borrowers. In addition, the current regulation seems to have imparted an element of downward rigidity to BPLR. It may be noted that RRBs and co-operative banks are free to determine their lending rates and there are no restrictions on lending rates of micro finance institutions (MFIs). Interest rate regulation on export credit has been favoured for making available credit to exporters at internationally competitive rates. The annual policy Statement of April '02 had indicated that "linking of domestic interest rates on export credit to PLR has become redundant in the present circumstances as effective interest rates on export credit in rupee terms is substantially lower than the PLR." The mid-term Review of October '02 had mooted deregulation of interest rate on rupee export credit in phases to encolU"age greater competition in the interest of exports. One view is that in the light of competitive lending rates in the economy, it is important to ensure that regulated interest rates should not restrict credit flow to all segments of exporters with different risk profiles. While there is merit in moving forward to impart greater competitiveness and depth to the activities of the financial system by further deregulating interest rates in some segments which have hitherto remained regulated for various reasons found relevant at different stages, it is proposed to continue with status quo as various issues pertaining to above regulations on interest rates are being debated.

Recent Capital Account Liberalisation Measures in India •

Resident individuals and listed Indian companies have been permitted to invest in overseas companies listed on a recognised stock exchange and which have the shareholding of at least 10 per cent in an Indian company listed on a recognised stock exchange in India (as on 1st January of the year of the investment). Such investmep.ts by corporates shall not exceed 25 per cent of the Indian company's net worth, as on the date of latest audited balance sheet. Investment by resident individuals is without any monetary limit.

Limit on banks' investment fromlin overseas markets has been raised. In case of resident banks, ADs have been given freedom to undertake investments in overseas markets, subject to the limits approved by the banks' Board of Directors. Banks in India have the freedom to invest the undeployed FCNR(B) funds in overseas market; in long-term fixed income securities rated at least AA(-) by-Standard and Poor, or Aa3 by Moody's or AA by Fitch IBCA.

Banks are allowed to invest their unimpaired Tier I capital in overseas money market of debt instruments without any percentage or absolute limit subject to approval by their Board of Directors.

Indian companies are allowed to access ADR/GDR markets through an automatic route without prior approval subject to specified norms and reporting requirements. They can invest abroad funds raised through ADRs/GDRs in bank deposits/certificates of deposit (CDs), Treasury Bills and other monetary instruments pending repatriation/utilisation of such funds.

Indian companies with a proven track record were eligible to invest upto 100 per cent of their net worth within the overall limit of US $100 million for investment in a foreign entity engaged in any bonafide business activity. The overall limit of US $100 million has been done away with.

Exporters are permitted to extend trade related loans/advances to overseas importers out of their exchange earners' foreign currency (EEFC) balances without any ceiling.

A unit in domestic tariff area (DTA) can receive foreign exchange out of the foreign currency account of a unit in Special Economic Zones (SEZs) which is permitted to be treated as eligible for credit to its EEFC account.


Foreign investment by non-resident corporateslNRIs under the Reserve Bank's automatic route has been substantially expanded to include almost all items/activities, for investment under FDI (excepting 6 prohibited items and 12 items included in the negative list).

With the new External Commercial Borrowings (ECBs) policy announced in January 2004, ECBs have been allowed under an automatic route up to US $ 500 million (for ECBs with average maturity of more than five years) and up to US $20 million (for ECBs between three to five years of average maturity). Borrowings which fall outside purview of the automatic route will be subject to a transparent process and will be decided by an Empowered Committee of the Reserve Bank.

Indian companies have been permitted to prepay existing FCCBs subject to certain conditions.

Residents have been allowed to open Resident.Foreign Currency (RFC) (Domestic) Accounts without any ceiling.

Resident individuals are permitted to remit foreign exchange for acquisition of foreign securities under employees' stock option plan (ESOP) scheme without any monetary limit.

Resident shareholders of Indian companies are permitted to offer their shares for conversion to ADRs/ GDRs and to receive the sale proceeds either in foreign currency or by way of credit to their EEFC/ RFC(Domestic) accounts or to their rupee accounts in India at their option.

Non-resident Indians (NRIs)lPersons of Indian origin (PIOs) and foreign nationals are permitted to remit up to US $1 million per calendar year out of balances held in non-resident ordinary (NRO) accounts/sale proceeds of assets.

The lock-in period for repatriation of sale proceeds to the extent of funds brought in or paid by debit to NRElFCNR(B) account for acquisition of immovable property (other than agricultural land/farm house/ plantation property) purchased in India by NRIslPIOs has been removed.

ADs are permitted to issue international credit cards (ICCs) to NRIslPIOs and to remit refund of funds received for purchase of shares.

Any non-resident Indian is permitted to purchase/sell shares and/or convertible debentures of an Indian company through a registered broker on a recognised stock exchange, provided the NRI routes all his transactions through designated branch of an authorised dealer in India.

NRlslPIOs have been permitted to repatriate assets in India acquired by way of inheritance/legacy, in addition to other facilities. Full repatriation of current income like rent, dividend, pension and interests of NRIs even without holding an NRO account in India has also been permitted.


2 Chapter


INTRODUCTION The importance of developing appropriate financial institutions and financial markets in promoting economic growth can be hardly overemphasized. Central banks in emerging markets have made conscious efforts towards developing efficient markets and institutions in recent years, especially after some weaknesses in the system were revealed during 1990s in different parts of the world. There is a growing recognition among central bankers around the world that a well functioning financial markets enables efficient use of market-based instruments of monetary policy by improving interest rate signals in the economy. Apart from enhancing the efficiency of monetary policy, deep and well functioning financial markets promote mobilisation of domestic savings and improve the allocative efficiency of financial intermediation, and foster the necessary conditions to emerge as an international or a regional financial centre (Turner and t'dack 1996). Strong domestic financial markets also act as a buffer against external disturbances and help in absorbing shocks to the domestic banking system during crises. Further, they provide incentives for development of hedging instruments, and lower macroeconomic volatility and financial instability. Efficient financial markets also have several indirect benefits such as rapid accumulation of physical and human capital, more stable investment financing, and faster technological progress. Financial market development is a complex and time-consuming process. There are no short cuts for developing well-functioning markets with depth and liquidity (Tarapore, 2000). Some of the pre-conditions for financial market reform are macroeconomic stability, sound and efficient financial institutions and structure, prudential regulation and supervision, strong creditor rights and contract enforcement. Measures to improve market infrastructure must be implemented at an early stage of reform alongside appropriate legal framework. These conditions facilitate growth of financial transactions including inter-bank transactions and active liquidity management. At the same time, there are at least three major macroeconomic features which can inhibit reform of domestic financial markets. First, large government deficits can crowd out financing of the private sector thereby inhibiting the growth of corporate debt markets. Second, high and variable inflation rates and unrealistic exchange rates also stifle the financial markets by raising uncertainties about the risks and returns to financial activity. Third, financial repression policies such as high inflation taxation high required reserve ratios, subsidized or directed credit programmes, credit rationing and ceilings on deposit and loan interest rates also hinder financial market development. The objective of this chapter is to trace the changing role of Reserve Bank in financial market evolution and development in India, particularly in the context of increasing globalization and liberalization. Section I deals with the structure and development of financial markets in India with particular focus on the money, Government securities and foreign exchange (Forex) markets which are regulated by the Reserve bank. The evolution of these markets over time and their current are reviewed. Section II delineates the changing role of the Reserve Bank in the financial markets in the context of liberalization and globalisation of the economy and highlights the importance of appropriate institutional and legal reforms.



The role of financial markets assumes greater importance in the modern economy. Financial markets perform an important function of channelling surplus funds from savers to those who are short of funds, thereby contributing to higher production and efficiency in the economy. In the wake of increased degree of globalization, financial markets facilitate across border movements of funds the countries lacking profitable avenues for investments to countries providing higher returns. Another crucial role of financial markets is the pricing and management of economic and financial risks. Financial markets also playa crucial role in the transmission of monetary policy impulses. Developed and stable financial markets also enable central banks to use market-based instruments of monetary policy to target monetary variables more effectively. Thus, the financial markets through their Linkages with the real economy enhance the level of output and employment. Therefore, efficient functioning of the financial market is important. FINANCIAL MARKET DEVEWPMENT: THE INDIAN EXPERIENCE

India has a long and chequered history of financial intermediation. By the turn of the twentieth century, India had insurance companies (both life and general) and a functional stock exchange. Even before the setting up of the Reserve Bank of India in 1935, the country had money, Government securities and foreign exchange markets. The markets were, however, characterized by paucity of instruments, limited number of player financial system was primarily a bank-based system. The course of development of financial institutions and markets during the post-independence period was largely guided by the process of planned development pursued in India with emphasis on mobilization of savings and channelising investment to meet Plan priorities. At the time of independence in 1947, India had a fairly welldeveloped banking system. The adoption of bank dominated financial development strategy was aimed at meeting the sectoral credit needs, particularly of agriculture and industry. Towards this end, the Reserve Bank concentrated on regulating and developing mechanisms for institution building. The commercial banking network was expanded to cater to the requirements of general banking and for meeting the short-term working capital requirements of industry institutions (DFIs) such as the IDB!, NABARD, NHB and SIDBI, etc., with majority ownership of the Reserve Bank were set up to meet the long-term financing requirements of industry and agriculture. To facilitate the growth of these institutions, a mechanism to provide concessional finance to these institutions was also put in place by the Reserve Bank. Thus, while characterized by significant institutional development, the environment in the financial sector up to the 1990s was not particularly conducive for the development of deep and wide financial markets. In fact, it had resulted in segmented and under-developed markets characterized by paucity of instruments, and limited number of participants. Banks and financial institutions functioned in a highly regulated environment, characterized by an administered interest rate structure, quantitative restrictions on credit flows, fairly high reserve requirements and pre-emption of significant proportion of lendable resources for the priority and the Government sectors. While the quantitative restrictions resulted in credit rationing for the private sector, interest rate controls led to sub-optimal use of credit reSUlting in low levels of investment and growth. These, coupled with other factors such as the absence of proper accounting, transparency and prudential norms, resulted in a large build-up of non-performing asset in the banking system. The resultant 'financial repression', led to erosion of profitability in the banking sector, besides decline in productivity and efficiency. The bank-based and highly controlled regime turned out to be inimical to financial market development. In the context of the balance of payments crisis of 1991, a comprehensive structural and financial sector reform process was initiated in India as recommended by the Committee on the Financial System (Chairman: M. Narasirnham, 1991) which became the starting point for gradual deregulation of the financial sector and development and integration of various segments of the financial market. Measures were initiated to streamline functioning of the financial system to create a sound, competitive and efficient banking system capable of meeting the increasing challenges of liberalization and globalization. Some of the major structural changes in the




Call Money Year Month


Govt. Securities

Average Daily Turn-over

Average Average 100Year Call YIeld@ Rates (Rs. crore) (per cent) (per cent)

Foreign Exchange

Average Daily Turn-over in Govt. Securities (Rs. crore)+

Average Daily Inter-bank Tum-over (US $ million)

Average Exchange Rate (Rs.per

US $)

Liquidity Management


RBI's net Average Average Average Foreign Daily Forward MiN Currency Premia 3 OutstaReverse Sales(-)f month ding Repo(LAF) Purchase (per cent) (Rs. crore) (Outstan(+)(US$ inding million) (Rs. crore)

Average Daily BSE Turnover (Rs. crore)

Average Daily NSE Turnover

Average BSE Sensex"

Average SSP

CNX Nifty"















17,213 15,269 20,134 20,046 16,158 16,292 17,164 22,620 21,149 17,911 13,497 18,290

4.77 4.99 5.10 5.02 5.02 5.05 5.12 5.79 6.00 6.83 6.95 6.58

7.02 7.11 6.88 7.13 704 7.04 7.14 7.10 7.13 7.15 7.32 7.40

3.001 3.805 6,807 3,698 4,239 5,207 2,815 3,314 2,948 3,094 2,584 2,203

9,880 10,083 10,871 11,003 11,749 11,040 13,087 11,228 13,808 16,713 15,798 17,600

43.74 43.49 43.58 43.54 43.62 43.92 44.82 45.73 45.64 44.40 44.33 44.48


1.96 1.57 1.40 1.56 0.69 0.62 0.69 0.67 1.51 2.60 2.85 3.11

65,638 68,539 70,651 70,758 71,346 67,617 68,602 67,041 52,040 40,219 33,405 29,652

30,675 22,754 13,915 10,754 34,832 30,815 18,608 3,268 1,452 -15,386 -13,532 -6,319

1,890 1,971 2,543 3,095 3,451 3,871 2,955 2,635 3,516 3,966 3,688 5,398

4,136 3,916 4,843 6,150 6,624 6,923 6,040 5,480 5,814 7,472 7,125 9,518



6,926 7,337 7,726 8,272 8,220 8,552 9,162 9,540 10,090 10,857

2,134 2,237 2,358 2,512 2,487 2,575 2,773 2,893 3,019 3,236

16,909 18,074 17,425 18,254 21,294 23,685 26,429 25,649 24,168 22,360 23,254 23,217

5.62 5.54 5.73 5.86 6.06 6.33 6.75 6.69 8.63 8.18 7.16 14.07

7.45 758 786 8.26 8.09 7.76 7.65 7.52 7.55 7.71 7.90 8.00

3,685 3,550 2,258 2,243 5,786 8,306 4,313 10,654 5,362 4,822 4,386 2,991

17,712 18,420 15,310 14,325 15,934 18,107 16,924 20,475 19,932 21,065P 20,050P 24,231P

44.95 45.41 46.06 46.46 46.54 46.12 45.47 44.85 44.64 44.33 44.16 44.03

1.31 0.87 0.73 0.83 1.22 1.31 1.67 2.07 3.20 4.22 3.71 4.51

25,709 26,457 31,845 36,936 40,305 40,018 41,537 31,099 38,148 39,553 40,827 52,944

46,088 59,505 48,610 48,027 36,326 25,862 12,983 9,937 -1,713 -10,738 648 -11,858

4,860 4,355 3,261 2,605 2,869 3,411 3,481 4,629 4,276 4,380 4,680 3,716

9,854 9,155 6,828 5,652 5,945 9,873 6,919 8,630 8,505 8,757 9,483 7,998

11,742 11,599 9,935 10,557 11,305 12,036 12,637 13,416 13,647 13,984 14,143 12,850

3,494 3,437 2,915 3,092 3,306 3,492 3,649 3,869 3,918 4,037 4,079 3,731

2005-06 April May June July August September October November December January February March

-104 2,473 1,552





2,614 8,149



2006-07 April May June July August September October November December January Fabruary March

-Average of daily weighted call money borrowing rates


4,305 504


3,198 1,818 2,830 11,862

Average daily closing rates

4# Average of weekly outstanding MSS --Average daily closing indices Source: REPORT ON CURRENCY AND FINANCE-2005-06.


+Outright turnover Central Government dated securities - Nil P: Provisional

18ble 2.1 Domestic Financial Markets-Select Indicators


BOX 2.1




Countries intending to move towards fuller capital account convertibility (FCAC) need to ensure that different market segments, besides being well developed in terms of physical infrastructure, skill and competency levels are also well integrated. If different markets remain segmented, any policy shock to influence market behaviour would not get transmitted to the various segments, thus, leading to inefficiency of policy outcome. Moreover, segmentation also impedes the development of a term structure of interest rates which facilitates the conduct of monetary policy. The Committee on FCAC made several recommendations to further the development of financial markets along sound lines as detailed below:

(a) Money Market • Prudential regulations be strengthened to encourage capital inflows . • Necessary co-ordination be ensured by the lead regulator. • More players be allowed to access the repo market. • The CBLO and the repo markets be allowed to cover corporate debt instruments. • Skills be upgraded to develop the inter-bank term money market. • Prudential limits for CP and CD be fixed since any unlimited opening up could have implications for short-term flows . • A dedicated cell within the Reserve Bank be set up for closer monitoring of all derivative products. • Banks should frame 'appropriate policy' before marketing complex derivatives. • The market in interest rate futures be activated and interest rate options be allowed. Initially, options could be introduced as OTC derivatives and subsequently they could be exchange traded. • Provision for netting of derivative transactions be made, before opening up the swap market. • Internationally aligned accounting standards for derivatives be developed. • Fixed Income Money Market and Derivatives Association (FIMMDA) be suitably empowered to act as a self-regulatory organization to develop market ethics, trading standards and also undertake regulation of participants, besides disseminating information. (b) Government Securities Market

• The share of mark-to-market category be progressively increased. • Short-selling across settlement cycles with adequate safeguards be permitted. • Gilt funds be exempted from the divided distribution tax and income up to a limit from investment in gilts could be exempted from tax to stimulate retail investments in gilts. • STRIPS in Government securities should be expeditiously introduced. • Non-resident investors, especially longer term investors, could be permitted entry to expand investor base. • Repo facility in government securities be widened by allowing all market players without any restrictions. • Rapid debt consolidation process be initiated that is tax-neutral. • The limit for FII investment in Government securities could be fixed at 6 per cent of total gross issuances by the Centre and States during 2006-07 and gradually raised to 8 per cent gross issuance between 2007-08 and 2008-09, and to 10 per cent between 2009Oland 2010-11 . The limits could be linked to the gross issuance in the previous year to which the limit relates. The allocation by SEBI of the limits between 100 per cent debt funds and other FIls should be discontinued.

(c) Forex Market • The spot and forward markets should be liberalized and extended to all participants, removing the constraint on past performance/ underlying exposures. • Separate forex business from lending transactions and introduce an electronic trading platform on which forex transactions for small and medium customers could take place. For very large trades, the Committee proposed a screen-based negotiated dealing system. • Reserve Bank's intervention in the forex market be through the anonymous order matching system. • Increase in limits for banks on short-term and long-term borrowing/lending overseas to promote more interest parity with international markets. • FIls be proyided with the facility of cancelling and rebooking forward contracts and other derivatives booked to hedge rupee exposures. • Currency futures be introduced, subject to risks being contained through proper trading mechanism, structure of contracts and regulatory environment. • The existing guaranteed settlement platform of CCIL be extended ,to the forwards market. • Banking sector be allowed to hedge currency swaps by buying and selling without any monetary limits.



financial sector comprised removal of barriers to entry, introduction of free pricing of financial assets in most of the segments, relaxation of quantitative restrictions, new methods of floatation lissuance of securities, increase in the number of instruments, enlarged participation, improvement in trading, clearing and settlement practices, improvement in the informational flows, transparency and disclosure practices. Simultaneously, measures were initiated since 1992-93 to strengthen the banking system by putting in place capital adequacy requirements, asset classification and provisioning norms, asset-liability management systems and risk management systems. Such measures contributed towards growing competition in the banking sector and integration of the money, foreign exchange and Government securities markets and they have been integrated into the overall deregulation process of financial sector. THE ROLE OF REsERVE BANK OF INDIA

The role of the Reserve Bank in the financial markets assumed significance due to the following factors: First, the primary interest of the Reserve Bank in financial markets is because of its criticality in the transmission of monetary policy. From an operational perspective, reliance on indirect instruments and money market operations for conducting monetary policy necessitated development of the money, Government securities and foreign exchange markets. Second, financial stability has emerged as one of the increasingly important concerns for the Reserve Bank resulting in increased attention to financial market development. The money market is the focal point for Reserve Bank intervention for equilibrating short-term liquidity flows on account of its linkages with the foreign exchange market. The Government securities market has become the focal point for the entire debt market due to several considerations: First, the fiscal deficit of the Government, both Centre and the States, continues to be fairly high, resulting in large market borrowings by the Central and State Governments. With the corporate debt market still in its nascent stage of development, the Government securities market is the largest component of the debt market. Second, it serves as a benchmark for pricing of other debt market instruments. Third, it provides an efficient transmission channel for monetary policy. The Reserves Bank's attention to the foreign exchange market development is primarily directed towards imparting stability to the exchange rate. The stake of the Reserve Bank in the financial markets arises on account of several reasons: First, the Reserve Bank as a monetary authority is most concerned with the transmission of monetary policy. Second, it must be recognized that India is neither a closed economy nor an open economy. In reality, India is an opening economy and a careful management of the process of opening is critical for growth and stability (Reddy, 2005). Third, since the markets were repressed in several ways in the past by law, regulation and policies, the Reserve Bank has, therefore, been facilitating the development of markets by creating an enabling environment through legal changes, technological and institutional development and dynamic improvements in market micro-structure. Fourth, the regulation of some of the financial markets is warranted by virtue of the Reserve Bank's Charter. This relates to the money market, which is central to monetary policy, the Government securities market which


is significant from the point of view of developing a yield curve, and the forex market which is integral to external sector management. The amendments to the Securities Contract Regulations Act and Government notifications there under giving jurisdiction to the Reserve Bank has helped in formalizing this aspect. Fifth, technological infrastructure has become an indispensable part of the reform of the financial markets, with the gradual development of sophisticated instruments and innovations in market practices. The Reserve Bank has, therefore, taken active interest in developing appropriate technological infrastructure to facilitate market development in areas such as payment and settlement systems, Delivery versus Payment (DvP) and Electronic Funds Transfer (EFT). Last though not the least, modern financial markets are complex. The Reserve Bank, therefore, needs to equip and continuously update itself to perform its developmental and regulatory roles effectively. The process involves constant interaction with the global counter-parts in order to identify best practices, benchmark existing practices in the Indian markets, identify gaps and take measures to move towards international standards, within the framework of India's unique country circumstances. CHANGING ROLE OF THE REsERVE BANK IN FINANCIAL MARKETS IN THE CONTEXT OF LIBERALISATION AND GWBALISATION

A significant feature during the past century has been the rapid evolution in the role of central banks globally. This was brought about by several factors like the liberalization of the domestic economy and the financial system; and globalization and technological advances. While during most of the last century, central banks had made their decisions largely in a domestic context, this situation changed markedly for many countries from the early 1990s (Greenspan, 1997). In the context of the volatile capital flows and a series of crises, central banks in several countries were forced to re-examine their roles, particularly with regard to financial market development and expend considerable efforts and resources in developing strong domestic financial markets. The experience of countries such as India has shown that with a move from plan-based and regulated structure to a market-based system, central bank's role have also undergone significant changes. Though the central bank 'continues to have regulatory and developmental roles, the nature of such role has changed. As a regulator of financial markets, the primary concern of the central bank is financial stability and maintenance of orderly conditions in the markets. Towards this end, it strives to create a congenial regulatory environment to support orderly market development by putting in place appropriate systems, procedures, standards and codes, risk management systems and accounting standards on par with global standards. Similarly, the developmental role of the central banks in markets involves removing irritants to market development (creating new institutions, instruments, and providing necessary infrastructural and technological support by way of modern payment and settlement systems). The integration of domestic financial markets with the global markets calls for closer coordination among central banks and international standard setting agencies to bring greater transparency and uniformity in standards across world markets to prevent crises and contagion. The changes in the structure of the economy and the financial markets, together with globalization, have necessitated changes in the monetary policy framework and operating procedures in several countries, including India. Globalisation and liberalisation have also created various dilemmas in c~ntral bank's operations. All central banks are fundamentally concerned about the flow of credit in their economies, whether this credit flows from banks, non-bank financial institutions, or institutional investors. In the new financial landscape, institutional investors and other non-bank financial institutions hold a larger share of assets and credit risk than ever before. A large proportion of the financing needs are intermediated through securities markets which is very much in keeping with their traditional responsibilities (McDonough, 1998). Accordingly, the two important responsibilities of central banks in respect of global fixed income and debt markets are :(i) to enhance the price discovery process by promoting transparency in their own actions ; (ii) to ensure that the banks, as providers of liquidity, perform their proper role in supporting the trading process by making sound credit decisions. Globalisation and integration of financial markets have posed new challenges and dilemmas for central banks in monetary, financial and external sector management. In the context of the integration of the Indian financial markets with the global markets, the regulatory and supervisory role of the Reserve Bank has become




critical for maintenance of the financial stability. Accordingly, the Reserve Bank refined its monetary policy operating procedures and instruments as also it regulatory mechanism to match global standards. Various aspects of financial institutions, markets and financial infrastructure such as risk management systems, income recognition and provisioning norms, disclosure norms and accounting standards have been introduced in line with international best practices. INTERNATIONAL FINANCIAL SERVICES (IFS) AND CENTRES (IFCs) IN PERSPECTIVE Historically, finance has always been 'international' in character; capital has rarely beed immobile. Money has moved freely across borders for all of civilisation with gold and silver (in various weights and measures) being global currencies for millennia. But, the freedom of capital was dramatically curtailed during the 'Bretton Woods' regime, created in 1945, when capital controls were imposed on war-ravaged, capital-starved economies. With post-war recovery, that regime broke down in 1971. World finance has since been reverting to its natural state with the removal of capital controls and the gradual re-integration of national capital and banking markets; but this time on a global scale. OECD countries opened their capital accounts between 1974 and 1990. A number of emerging markets did so in the 1990s - often at the IMF's urging. In 1996, the 1M F contemplated making an open capital account a condition of membership. But the idea was shelved when the Asian financial crisis erupted in 1997. That was precisely when India first contemplated re-opening its capital account. A series of similar ulini-crises occurred elsewhere in 1998 engulfing Russia and Latin America. By 2002, all these crises were contained. Capital account opening resumed but with reduced momentum as the IMF and others began to reconsider its benefits and costs. The question of capital account convertibility now weighs heavily on China and India, where financial systems with structural weaknesses, legacy constraints and varying degrees of State domination now confront the irresistible forces of globalisation. Even with an open capital account, some financial services (e.g., deposit banking) remain local and nontradable. But most financial services are now tradable across borders: i.e., they are international financial services (lFS). A cross-border market for IF S has existed over millennia, but it has been transformed in the 19th and 20th centuries and grown quite differently and more dramatically sincel980. It has also become extremely competitive, with buyers and sellers around the world now having a choice of procuring IFS from competing international financial centres (IFCS). A concrete example of procuring IFS from an IFC would be the raising of debt. If Mumbai became an IFC, a South African railway project could issue a bond there in the primary market. It would wish to do so because of Mumbai's sophisticated securities markets, along with a number of asset managers in Mumbai running global portfolios. If the INR bond market was developed, the South African bond issue could be INR denominated. Global investors would buy these bonds and trade them on the secondary market in Mumbai. Each of these three steps-primary market bond issuance by the South African entity, primary bond purchases by global and Indian investors, and secondary bond market trading by global players-would generate revenues from the export of financial services from Mumbai. Creating an IFC in India requires that Mumbai must be viewed as competitive in the eyes of the South African railway and in the eyes of global bond investors, when compared with alternatives like Singapore or London. The global IFS market in the 21st century is one in which competition is driven by rapid innovation in financial products, services, instruments, structures, and arrangements to accommodate and manage myriad requirements, risks, and a ceaseless quest for cost reduction. Competitive advantage in IFS provision depends on seven key factors: 1.

An extensive national, regional, global network of corporate and government (supranational, sovereign, sub-sovereign and local) client connections possessed by financial firms participating in an international financial centre (IFC).


High level human capital specialised in finance, particularly quantitative finance, supported by a numerate labour force providing lower level paraprofessional accounting, book-keeping, compliance and other skills.



World-class telecommunications infrastructure with connectivity around the clock, and around the world.


State-of-the art IT systems, capability to help develop, maintain and manage the highly sophisticated and expensive IT infrastructure of global financial firms, trading platforms and regulators; systems that are evolving continuously to help firms retain their competitive edge.


A well-developed, sophisticated, open financial system characterised by: (i) a complete array of proficient, liquid markets in all segments, i.e., equities, bonds, commodities, currencies and derivatives; (ii) extensive participation by financial firms from around the world, (iii) full integration of market segments, i.e., an absence of artificially compartmentalized, isolated financial markets that are barred from having operational linkages with one another; and (iv) absence of protectionist barriers and discriminatory policies favouring domestic over foreign financial firms in providing financial services.


A system of financial regime governance (i.e., embracing legislation, policies, rules, regulations, regulatory agencies, etc.,) that is amenable to operating on global 'best practice' lines and standards; and finally,


A 'hinterland advantage' in terms of either a national or regional economy (preferably both) whose growth is generating rapid growth in demand for IFS.

Advances in information and communication s technologies (lCT) have eased interactions over a distance and reduced their cost dramatically. However, activities involving complex judgement and intellectualization continue to be clustered at a few physical locations, where key individuals meet face-to-face. This is characteristic of R&D in computer technology - clustered in Silicon Valley and the Cambridge Corridor - despite extensive use of email, voice telephony and video conferencing. India has achieved a minor miracle with the explosion of export revenues from IT services; yet, these revenues are a fraction of Silicon Valley's. Similarly, routine production of financial services takes place everywhere. But, the most important and high value decisionmaking functions are concentrated in a handful of IFCs that have effectively (and consequently) become global cities. At present, London, New York and Singapore are the only globalfinancial centres (GFCs). Many emerging IFCs around the world are aspiring to playa global role in the years to come: e.g., Shanghai and Dubai. Other IFCs in Europe and Asia, like Paris, Frankfurt or Tokyo, connect their financial systems to the world. But they have lost market share and importance in competing for global IFS for reasons explained in the report. The world market for IFS is represented mainly by the EU, US and Asia which together account for over 80% of global GDP. Correspondingly, the global IFS market is concentrated in the three GFCs located in each of these regions. CONCLUSION In the context of integration of the Indian financial markets with the global markets, the Reserve Bank has been constantly refining and fine-tuning its regulatory mechanism to match global standards. To safeguard financial stability, central banks, including the Reserve Bank, have to closely monitor the current and evolving global developments. Global financial imbalances, coupled with other developments such as abundant liquidity and generally low interest rates in the global financial markets, growing sophistication of financial market participants and the proliferation of complex and highly leveraged financial instruments including credit derivatives and structured products such as Collateralised Debt Obligations could cause liquidity and interest rate risks and heighten volatility in the financial markets, if there is an abrupt and sharp readjustment. This issue has gained more relevance in the context of the recent trend of consolidation in the financial sector. The single most important risk factor for financial markets in good times is complacency (Global Financial Stability Report, 2005). This coupled with factors such as low risk premiums and untested elements of risk management systems dealing with complex financial instruments could ultimately become hazardous to financial markets. These developments pose a challenge to the Reserve Bank and other central banks, as they have to factor these in while designing monetary policy responses, devise strategies to mitigate systematic liquidity risks to stave off crises and keep a close watch on financial market innovations.




Central banks, including the Reserve bank, have to be vigilant about the risk profile of financial intermediaries, particularly concentration risk and their vulnerability to abrupt market price shocks. The current global financial scenario highlights the need for appropriate risk management strategies as also for greater co-ordination and information sharing among central banks to prevent transmission of adverse developments abroad to the domestic economy and markets. Notwithstanding the significant changes in the financial markets, there are several imponderables which may have a bearing on monetary policy, Some of the developments which are likely to have a bearing on the size and evolution of the money and Government securities markets in the coming years are implementation of the FRBM Act, 2003 (which would put an end to the Reserve Bank's participation in primary auctions of Central Government securities from April 1, 2006). While this would lead to functional separation of debt management fmm monetary operations, thereby enabling the Reserve bank to have greater control over the composition of its balance-sheet and flexibility in monetary operations, it would also call for greater co-ordination between the Reserve Bank and the Government for ensuring stability in the financial markets. In the context of the changed monetary and debt management scenario, the Reserve Bank has to take steps to fine-tune its open market operations and LAF. Greater accuracy in forecasting market liquidity over the short-to-medium-term has also become very crucial. The issue of broad-basing the pool of securities to act as collateral for the Reserve Bank repo may also have to be examined. Liberalised and integrated financial system and markets pose fresh challenges to cent:al banks as they tend to amplify existing distortions in macroeconomics management. It often generates excessive optimism and under-pricing of financial assets, which coupled with capital account convertibility and high fiscal deficits lead to crises. In a liberalized financial system, it is no longer regulation, but market discipline, which maintains financial stability. This necessitates greater transparency, fostering strong institutions and developing better risk analysis systems. Improvements in market discipline also call for greater co-ordination between banks, major players in the financial markets and regulators. Over the years, the changes in monetary and financial regime globally have changed the dynamics of the financial markets. In the area of monetary policy the low and stable inflation coupled with very strong central banks have changed the monetary dynamics. Consequently, while rising inflation is no longer a major concern, excessive increase in asset prices and credit have emerged as major challenges facing the central banks as this could lead to financial instability. As economies have become more pro-cyclical, inflation is no longer the major indicator of financial stability because strong swings in asset prices could lead to financial instability. In the context of financial stability, besides improved transparency, better analysis of trends in major sectors of the economy and banks to detect signs of stress, policies which better affect inflation expectations and cautious liberalization of international capital movements have assumed significance. The Reserve Bank and other central banks have to pursue market driven strategies and policies that are stable and forward looking to anchor expectations. Fiscal discipline and deep and well functioning financial markets are necessary for the success of central bank's policy strategy. Overall, 250 banks, covering 55 countries, have been represented. Here are the highlights: •

Banks have a more international footprint; markets and products have become more complex; there is greater investment in emerging markets; the amount of privately held wealth has vastly increased, and all alternative asset classes have undergone significant growth. These structural changes have deep implications on how banks tackle the challenges of anti-money laundering (AML) and counterterrorist financing (CTF).

Now, senior managements are more engaged in AML issues than three years ago.

71 per cent of banks have reported that their most senior levels of management, including their Board of Directors, take an active interest in AML compliance.

Over 40 per cent of respondents said their main Board of Directors formally discussed AML issues at least once a quarter, with an additional 25 per cent saying they did so at least once a month.



Global Money laundering: How Banks Are Facing Up to the Challenge Estimated money laundering flows are reported to be in excess of $ 1 trillion every year. A recent KPMG survey shows how banks have responded to this challenge - by increased investment, senior management focus, and co-operation with governments, regulators and law enforcement. Profile of AML'" Measures at Senior Management Level 95 _



CIS Amt:ricwCarib




North America


Ru ssia/C IS


Asia Pacific

West Asia! Africa

Figures in per cent of rt!spondents

HIGH PROFILE: The most senior level of management, including the Board of Directors, takes an active interest

MODERATE PROFILE: The most senior level of management. including the Board of Directors, takes some interest

LOW PROFII~E: Little senior management interest or involvement "Anti-Money Laundering



ANNEXURE FINANCIAL MARKETS Most world class International Financial Centres (IFCs) provide financial institutions which provide trading in various asset classes such as currency, equity, bonds, commodities and derivatives. We look at the legaVregulatory system from the point of view of banks, asset managers and funds, and securities markets in terms of their access to various asset classes in India.

Financial Markets and Banks At present, Indian banks have limited access to currency markets. Commercial and private banks need to be enabled to do the following: 1.


Full fledged participation in speculation, market-making, hedging and arbitrage for all currency pairs out of INR, USD, CNY, EUR and JPY futures, options, swaps and exotics. Participation out of Mumbai in Chicago, New York and London markets.

Private banks also need to be enabled to give HNI clients global currency management and currency trading services along with multi-currency checking, savings and deposit accounts. Investment banks should be able to offer clients multi-currency facilities with conversion rights across currencies through swaps and swaptions. They should also be in a position to do OTC and tailored multi-currency facilities. In terms of equity trading, commercial banks need to be enabled to do the following: 2.

Invest in equities for proprietary in-house trading, with full access to leverage and/or short selling. Offer equity trading and portfolio management facilities to individuals, trusts and HNIs.

3. 4. 5. 6. 7.

Finance equity trades through collateralised leverage. Market making on equity spot and derivatives markets. Equity derivatives arbitrage. Accept listed equities as collateral subject to risk-based limits. Engage in all the above without concern for the location of the exchange.


Private banks should be permitted to do the following: 1. 2. 3.

Have in-house proprietary trading account. Create in-house funds for private clients. Operate in domestic and foreign equity markets, including access to borrowed shares, short selling, and derivatives.

Investment banks should be enabled access to equity trading and be able to do all the above from an investment banking perspective. Commercial and private banks need to be allowed access to the entire spectrum of bond market products enabling them to do the following: 1.

2. 3. 4. 5.

Take longlshortlleveraged/repo positions on government bonds, sub-sovereign, 001- guaranteed, municipal, corporate 'bonds' and other fixed-coupon instruments, junk bonds, workout bonds, ARC bonds. Do market making for exchange-traded bonds. Originate and trade stripped/securitised assets based on a full range of underlying cash flows. Have neutrality between Indian and offshore assets in all the above. Not be under financial repression that forces purchases of Indian government paper or requires high credit ratings on corporate bonds.

Investment banking should have access to the bond market and be able to do all the above from an investment banking perspective. Commercial banks should have access to derivatives markets which would enable them to avaiVoffer a range of products and services as follows: 1.

Build arbitrage businesses in all kinds of derivatives trading as a robust fixed-income business.

2. 3.

Do market making on derivatives exchanges. Hedge in-house proprietary trading accounts.



Risk-manage corporate or individual client portfolios.


Risk-manage internal bond portfolio based on risk considerations, without limitations on long or short positions, or a bias against options.


Risk-manage commodity exposure.


Offer full-service contracts to securities firms and hedge funds, involving financing, record keeping, information feeds, order routing, sales support etc.


Have neutrality between Indian and offshore exchanges.

Private banks must be enabled to risk-manage client or proprietary portfolios, provide liquidity and have open speculative positions and trade in equity, currency, interest-rate and credit risk. In terms of commodities trading, commercial banks should be enabled the following: 1.

Market making and arbitrage on commodity futures markets.


Take open or hedged positions.

3. 4. 5.

Finance commodity traders on a collateralised basis. Hedge exposure owing to collateral. Have neutrality between Indian and offshore exchanges.

Private banks must be enabled to do the following: 1.

Diversify and enhance private client portfolios.


Participate in a full range of commodities, well beyond bullion.


Provide liquidity to clients against commodity portfolios as collateral.

Besides being able to do all the above in an investment banking context, investment banks must be able to develop innovative new commodity contracts and be able to trade on established CBOT' LMFiNCDEX contracts.

Financial Markets and Asset Managers We look at the regulatory/legal framework as it applies to mutual funds, insurance firms, pension funds and hedge funds in an Indian context. Mutual funds in India are not allowed access to the currency markets. In an IFS setting, mutual funds as well as hedge funds would be allowed to do the following: 1.

Currency conversions associated with a global portfolio.


Trading in currencies as assets.


Hedging currency exposure of a global portfolio.

In terms of equity trading by mutual funds, we have some regulations in place. For instance the transparency and disclosure requirements, NAY and customer redemption rules and rules about fund liquidation and distribution of proceeds are fairly clearly laid out. However, mutual funds are not permitted the following: 1.

Access to the market for global funds.


Investments all over the world.


Full range of fund types (sector, risk, geography).


Access to borrowed shares, borrowed money, derivatives trading and short selling.

On the bond trading aspect, mutual funds can do a lot more. We have rules in place on NAY and mark to market, holding to maturity, trading the yield curve and so on. Regulations provide the following: 1.

Ability to create debt funds (government securities, corporate bonds, etc.)


Access to trading the corporate bond market.

However, mutual funds still face financial repression where rules require purchase of Indian government bonds or require corporate bonds to have high credit ratings. Funds do not have access to trading the government bond market or debt securities all over the world. As far as derivatives trading by mutual funds is concerned, some activity is permitted. Mutual funds are allowed to hold open positions on derivatives on index or single stocks. They are allowed to do arbitrage using derivatives and these arbitrage positions are treated as being a fixed income position.




However, the following is still not permitted: 1.

2. 3.

Risk-managing the portfolio including specific derivatives positions associated with specific risks. (e.g., A yen futures position when there is an investment in a firm which imports raw materials from Japan). Holding positions on markets across the world, which flow from the core portfolio which is internationally diversified. Participation in credit derivatives.

On the commodities trading front, there isn't much that mutual funds are permitted to do at the moment. They cannot establish commodity funds, undertake commodity trading in general or take speculative positions on commodities in India or across the world. Much of the issues discussed above that apply to mutual funds are also applicable to hedge funds. Insurance companies have no access to currency trading. To be able to compete in a global market, these companies should be in a position to offer a range of forex denominated insurance products and engage in activities such as: 1. 2. 3. 4.

Produce products with premia or payouts in foreign exchange. Take asset positions in foreign securities and currency markets. Manage currency exposure on assets or liabilities. Provide insurance to companies on their foreign assets or liabilities.

While insurance funds are allowed to invest and trade in local equities, investments into offshore equities are not permitted. Also, sound rules need to be formed about extent of asset allocation into equities, matching equity holding to long-term liabilities and reserve requirements on equity assets. In terms of bond trading, insurance companies face financial repression, where rules require purchase of Indian government bonds or require corporate bonds to have high credit ratings. Investment and trading in government bonds across all rating categories is not permitted. Neither is insurance companies allowed to invest in bonds in all countries. There is a need to have sound rules about matching of bond cash flows and liabilities as well as reserve requirements on bond holdings. In terms of derivatives trading, insurance companies face issues similar to those faced by mutual funds. So also in terms of trading on the commodity markets. Investments in commodities such as gold or oil either through direct holdings or indirect paths such as ETFs are not permitted. Neither is trading and taking proprietary positions on commodity markets. Even hedging of commodity positions on derivatives markets is not permitted. Pension funds should be able to take exposures in currency markets and design pension products which cope with foreign contributions or .benefits, sell pensions to individuals or firms outside the country, globally diversify their assets and be able to manage currency exposure on foreign assets or liabilities. At the moment, none of this is permitted. While pension funds are allowed to invest in equity to a limited extent, they cannot hold equity indexes and individual stocks across countries. There are no clear rules about NAV computation of equity portfolios nor is there clarity about transparency and disclosure requirement. As far as trading in bond funds, derivatives and commodities markets is concerned, the same issues that apply for insurance companies also apply to pension funds.

Securities Markets We look at the regulatory framework for financial exchanges that do currency trading, trading of equity and debt, derivatives trading and commodity trading. The only market in currency trading that exists in India at the moment is the interbank currency forward market. There is a need for an exchange that would offer spot or derivatives trading facilities on any currency pair. Similarly, partnerships with global exchanges on transfer of currency derivatives positions need to be put in place. To enable entities to arbitrage and exploit price differentials across markets, there is need to enable direct market access. As far as equity trading is concerned, we have a fair degree of success in terms of the following regulations already in place: 1. 2.


Listing of ETFs including ETFs on closed-end funds, investment trusts, etc. Disclosure and transparency rules governing all trades. Required minimum publicly traded stock that has to be issued.



Rules about proportions that can be owned by certain kinds of institutional investors.


Support for diverse array of market participants.

6. 7.

Flexible framework permitting multiple listing by a given issuer. Sound rules about circuit breakers.


On-line realtime surveillance by exchange that is world respected.

What we are lacking in terms of regulations on the equity markets is the following: 2.

Listing rules that enable listing of a diverse array of international issuers. Listing of ETFs on commodities.



Neutrality between local and offshore issuers.


Support for borrowed shares and margin trading.

5. 6.

Consistency with global FATF approved AML-CFf regulations for members, dealers and customers. Direct market access.

As concerns the bond markets, we have rules in place for listing of fixed income funds and ETFs. There are no restrictions on multiple listing. However, the following still needs to be enabled: 1.

Listing and trading of government bonds, sub-sovereign bonds, corporate bonds, with issuers from across the world.


Sound procedures for disclosure, transparency and surveillance.

3. 4.

Support for borrowed bonds, margin trading and short selling. Direct market access.

On the derivatives trading front, a lot needs to happen. We need regulations in place that will permit the following: 1.


Ability to innovate and create derivatives contracts on all underJyings in equity, currency, fixed income and commodities. Global exchanges to trade local underlyings.


Placement of terminals by global exchanges in India and placement of terminals by Indian exchanges abroad.


Margin requirements based on overall portfolio risk, where there is an incorporating maximal information into the definition of the position, including OTC positions, asset holdings, etc.


International-style position limits.


Direct market access.

As far as commodity exchanges are concerned, there is a need for listing of all manner of futures and options on all types of commodities and providing fungibility of local contracts against those prevalent globally. All issues of market design and operations as seen with securities exchanges need to be implemented on the commodity exchanges. As far as brokerage/securities firms are concerned, all issues that apply to banks in terms of trading on the various markets discussed above also apply to these firms.


3 Chapter



The financial markets are in the forefront in developing economics. Efficient financial markets are a sine qua non for speedy economic development. The vibrant financial market enhances the efficiency of capital formation. This market facilitates the flow of savings into investment vis-a-vis capital formation. Dr. Khan has opined that, a variegated financial market can appeal to the security, moti vation and other such aspects of savers and attracts more savings by the creation of an array of attractive financial assets. It also tends to promote the development financial structure. The role of financial markets in the financial system is quite unique. The relevance of the financial markets in the financial is not merely quantitative but also supportive. Thus, the financial markets bridge one set of financial intermediaries with another set of players. The money market is the main conduit for transmitting the monetary policy impulses to the real sector of the economy. The broad policy objectives that are being persued for the development of the money market are ensuring stability in short-term interest rates maximising default risk and achieving a balanced development of various segments of the market. The Reserve Bank has been encouraging the growth of the collateralised segment, developing the rupee yield curve, improving transparency and better price discovery and providing avenues for better risk management. Well-developed financial markets enlarge the range of financial services. More importantly, under appropriate conditions, financial (capital) markets can provide long-term finance to government and large business firms. The development of securities markets usually starts with trading in a short-term money market instrument, often a government security. Other money market instruments are interbank deposits, bankers' acceptances, certificates of deposit, and commercial paper issued by non financial corporations. Money markets provide a non inflationary way to finance government deficits. They also allow governments to implement monetary policy through open market operations and provide a market-based reference point for setting other interest rates. Furthermore, money markets are a source of funds for commercial banks and other institutions with limited branch networks. including foreign banks and leasing and factoring companies. By enabling large corporations to issue short-term securities in the form of commercial paper. money markets make the corporate loan market more competitive and reduce the market power of large commercial banks.


India has benefited from the creation of money and capital markets. Money markets can provide competition for banks, a flexible means for managing liquidity, a benchmark for market-based interest rates, and an instrument of monetary policy. Capital market can be a source of long-term finance - both debt and equity - and can help to foster sounder corporate capital structures.

DEVEWPMENT OF FlNANCIALMARIffiT The importance of developing appropriate financial institutions and financial markets in promoting economic growth can be hardly overemphasized. Central banks in emerging markets have made conscious efforts towards developing efficient markets and institutions in recent years, especially after some e weaknesses in the system were revealed during several financial crises that occurred in the 1990s in different parts of the world. There is a growing recognition among central bankers around the world that a well functioning financial market enables efficient use of market-based instruments of monetary policy by improving interest rate signal in the economy. Apart from enhancing the efficiency if monetary policy, deep and well functioning financial markets promote mobilization of domestic savings and improve the allocative efficiency of financial intermediation, and foster the necessary conditions to emerge as an international of a regional financial centre (Turner and t'dack 1996). Strong domestic financial markets also act as a buffer against external disturbances and help in observing shocks to the domestic banking system during crises, Further, they provide incentives for development of hedging instruments, and lower macroeconomic volatility and financial instability. Efficient financial markets also have several indirect benefits such as rapid accumulation of physical and human capital, more stable investment financing, and faster technological progress. Financial market development is a complex and time-consuming process. There are no short cuts for developing well-functioning markets with depth and liquidity (Tarapore, 2000). Some of the pre-conditions for financial market reforms are macroeconomic stability sound and efficient financial institutions and structure, prudential regulation and supervision, strong creditor rights, and contract enforcement. Measures to improve market infrastructure must be implemented at an early stage of reform alongside appropriate legal framework. These conditions facilitate growth of financial transactions including inter-bank transactions and active liquidity management. At the same time, there are at least three major macroeconomic features which can inhabit reform of domestic financial markets. First, large Government deficits can crowd out financing of the private sector thereby inhibiting the growth of corporate debt markets. Second, high and variable inflation rates and unrealistic exchange rates also stifle the financial markets by raising uncertainties about the risks and returns to financial activity. Third financial repression policies such as high inflation taxation, high required reserve ratios, subsidized or directed credit programmes, credit rationing, and ceilings on deposit and loan interest rates also hinder financial market development.

CLASSIFICATION OF FINANCIAL MARKET The classification of financial markets in India is shown in Fig. 3.2

Unorganised Markets In these markets there are a number of money lenders, indigenous bankers, traders etc., who lend money to the public. Indigenous bankers also collect deposits from the public. There are also private finance companies, chit funds etc., whose activities are not controlled by the RBI. Recently, the RBI has taken steps to bring private finance companies and chit funds under its strict control by issuing non-banking financial companies (Reserve Bank) Directions, 1998. The RBI has already taken some steps to bring the unorganised sector under the organised fold. They have not been successful. The regulations concerning their financial dealings are still inadequate and their financial instruments have not been standardised.

Organised Markets In the organised markets, there are standardised rules and regulations governing their financial dealings. There is also a high degree of institutionalisation and instrumentalisation. These markets are subject to strict supervision and control by the RBI or other regulatory bodies.





Organised Sector

Unorganised Sector

I :::!!

Pawn Brokers

Money Indigenous Lenders Bankers

Traders & Landlords




I Develop-

I Insurance


Cos. (LIC& GIC)


I Agl. Financing Institutions


Govt. (p.p., NSCetc.)


Govt (Treasury Bills)

» z c



»z o









Purchase Coys.

Fig. 3.1

Com. Banks Co-op. Banks

I EximBank



»r» ::tJ

Money Market Intermediaries

Capital Market Intermediaries


» z


Leasing Coys


Investment Coys


Finance Coys

< c=;



These organised markets can be further classified into two. They are: (i)

Capital market


Money market.

Capital Market The capital market is a market for financial assets which have a long or indefinite maturity. Generally, it deals with long term securities which have a maturity period of above one year. Capital market may be further divided into three namely: (i)

Industrial securities market


Government securities market and


Long-term loans market.

(i) Industrial Securities Market As the very name implies, it is a market for industrial securities namely: (i) Equity shares or ordinary shares, (ii) Preference shares, and (iii) Debentures or bonds. It is a market where industrial concerns raise their capital or debt by issuing appropriate instruments. It can be further sub-divided into two. They are: (i)

Primary market or New issue market


Secondary market or Stock exchange.

Primary Market Primary market is a market for new issues or new financial claims. Hence, it is also called New Issue market. The primary market deals with those securities which are issued to the public for the first time. In the primary market, borrowers exchange new financial securities for long-term funds. Thus, primary market facilitates capital formation. There are three ways by which a company may raise capital in a primary market. They are: (i)

Public issue


Rights issue


Private placement.

The most common method of raising capital by new companies is through sale of securities to the public. It is called public issue. When an existing company wants to raise additional capital, securities are first offered to the existing shareholders on a pre-emptive basis. It is called rights issue. Private placement is a way of selling securities privately to a small group of investors.

Secondary Market Secondary market is a market for secondary sale of securities. In other words, securities which have already passed through the new issue market are traded in this market. Generally, such securities are quoted in the Stock Exchange and it provides a continuous and regular market for buying and selling of securities. This market consists of all stock exchanges recognised by the Government of India. The stock exchanges in India are regulated under the Securities Contracts (Regulation) Act, 1956. The Bombay Stock Exchange is the principal stock exchange in India which sets the tone of the other stock markets.

(ii) Government Securities Market It is otherwise called Gilt-edged securities market. It is a market where Government securities are traded. In India, there are many kinds of Government securities - short-term and long-term. Long-term securities are traded in this market while short-term securities are traded in the money market. Securities issued by the Central Government, State Governments, Semi-Government authorities like City Corporations, Port Trusts etc. Improvement Trusts, State Electricity Boards, all India and State level financial institutions and public sector enterprises are dealt in this market.






Unorganised Market

Organised Market




I Market

Govt. Securities Market


Money Market

Capital Market

Industrial Securities

» z

Long-term Loans Market

Call Money Market

Commercial Bill Market

:; r-



Treasury Bill Market

» :::tJ



ShortTerm Market


» z c



» z n :; r-





Secondary Market

Term Loan Market

Market for Mortgages

Market for Financial Guarantees

Fig. 3.2

Money Lenders Indigenous Bankers etc.


< c; m



Government securities are issued in denominations of Rs.100. Interest is payable half-yearly and they carry tax exemptions also. The role of brokers in marketing these securities is practically very limited and the major participant in this market·is the "commercial banks" because they hold a very substantial portion of these securities to satisfy their S.L.R. requirements. The secondary market for these securities is very narrow, since most of the institutional investors tend to retain these securities until maturity. The Government securities are in many forms. These are generally: (i)

Stock certificates or inscribed stock


Promissory Notes


Bearer Bonds which can be discounted.

Government securities are sold through the Public Debt Office of the RBI while Treasury Bills (shortterm securities) are sold through auctions. Government securities offer a good source of raising inexpensive finance for the Government exchequer and the interest on these securities influences the prices and yields in this market. Hence, this market also plays a vital role in monetary management.

(iii) Long-term Loans Market Development banks and commercial banks playa significant role in this market by supplying long-term loans to corporate customers. Long term loans market may further be classified into: (i)

Term loans market


Mortgages market


Financial guarantees market.

Term Loans Market In India, many industrial financing institutions have been created by the Government both at the national and regional levels to supply long-term and medium term loans to corporate customers directly as well as indirectly. These development banks dominate the industrial finance in India. Institutions like lOBI, IFCI, ICICI, and other state financial corporations come under this category. These institutions meet the growing and varied long-term financial requirements of industries by supplying long-term loans. They also help in identifying investment opportunities, encourage new entrepreneurs and support modernisation efforts.

Mortgages Market The mortgages market refers to those centres which supply mortgage loan mainly to individual customers. A mortgage loan is a loan against the security of immovable property like real estate. The transfer of interest in a specific immovable property to secure a loan is called mortgage. This mortgage may be equitable mortgage or legal one. Again it may be a first charge or second charge. Equitable mortgage is created by a mere deposit of title deeds to properties as security, whereas in the case of a legal mortgage, the title in the property is legally transferred to the lender by the borrower. Legal mortgage is less risky. Similarly, in the first charge, the mortgager transfers his interest in the specific property to the mortgagee as security. When the property in question is already mortgaged once to another creditor, it becomes a second charge when it is subsequently mortgaged to somebody else. The mortgagee can also further transfer his interest in the mortgaged property to another. In such a case, it is called a sub-mortgage. The mortgage market may have primary market as well secondary market. The primary market consists of original extension of credit and secondary market has sales and re-sales of existing mortgages at prevailing prices. In India, residential mortgages are the most common ones. The Housing and Urban Development Corporation (HUDCO) and the LIC playa dominant role in financing residential projects. Besides, the Land Development




Banks provide cheap mortgage loans for the development oflands, purchase of equipment etc. These development banks raise finance through the sale of debentures which are treated as trustee securities.

Financial Guarantees Market A Guarantee market is a centre where finance is provided against the guarantee of a reputed person in the financial circle. Guarantee is a contract to discharge the liability of a third party in case of his default. Guarantee acts as a security from the creditor's point of view. In case the borrower fails to repay the loan, the liability falls on the shoulders of the guarantor. Hence, the guarantor must be known to both the borrower and the lender and he must have the means to discharge his liability. Though there are many types of guarantees, the common forms are: (i) Performance Guarantee, and (ii) Financial Guarantee. Performance guarantees cover the payment of earnest money, retention money, advance payments, non-completion of contracts etc. On the other hand, financial guarantees cover only financial contracts. In India, the market for financial guarantees is well organised. The financial guarantees in India relate to: (i)

Deferred payments for imports and exports.


Medium and long-term loans raised abroad.


Loans advanced by banks and other financial institutions.

These guarantees are provided mainly by commercial banks, development banks, Governments both central and states and other specialised guarantee institutions like ECGC (Export Credit.Guarantee Corporation) and DICGC ( Deposit Insurance Credit Guarantee Corporation). This guarantee financial service is available to both individual and corporate customers. For a smooth functioning of any financial system, this guarantee service is absolutely essential. MONETARY POllCY

Monetary policy in any country is largely determined by the institutional framework and environment in which it is expected to operate. It is necessarily moulded by the world in which it takes shape. The structure of the money market is the base on which depends the operation of the monetary policy. Monetary management is largely governed by such institutional factors as the use of credit, credit consciousness of the people and their preferences, the general banking structure and the development of the banking habit among the people as a whole. Any effective organisation and the response of financial institutions in general and banks in particular depend upon the nature of the organisation of the money market and the degree of co-operation between its various components. The structure of the money market is, therefore, a base for introducing monetary discipline and for implementing monetary policies in any economic system. One of the most remarkable features in all discussions on central banking is the unanimity with which all writers regard a developed money market as essential for the effective functioning of the central bank. An attempt has been made here to examine the effectiveness of the monetary policy in India in the context of the money market in this country. MONETARY MANAGEMENT

The monetary policy in India is a case study of monetary management in a developing economy with an unorganised money market. The study is, therefore, valuable for the undeveloped and underdeveloped countries as well as for developed countries. Since the monetary policy in India operates in the organised and unorganised sectors of money markets, the structural changes have to be analysed first.

State of the Financial Markets in India The financial sector in India currently comprises financial institutions, financial markets and financial instruments. The various segments of the financial market in India are the credit market, the money market, the Government securities market, the foreign exchange market, the capital market and the insurance market. While the money, Government securities and foreign exchange markets are regulated by the Reserve Bank, the capital market falls within the purview of Securities and Exchange Board of India (SEBI) and the insurance



market is regulated by the Insurance Regulatory and Development Authority (IRDA). Several measures have been taken by the Reserve Bank over the years and by the SEBI (during the 1990s) for developing these markets. The evolution of the financial markets in India has been a gradual process and is broadly categorized into pre-reform period (i.e., before 1990s when markets were in a state of inertia/transition) and reform/post-reform period (since the early 1990s when markets were characterized by large scale and rapid reform).


Financial Markets




Foreign Exchange

Financial Services







Money Market

I ~

Call Money Market

T-Bill Market

l Bills Rediscounting Market




Repos Market

Other Markets

Government Market


... Share Market


Merchant Banking Services










Credit Rating Service

Factoring Forfaiting Services

Custodial & Depository Services

Provision of Financial Guarantees


1Industrial Securities Market

... Debt Market


... Venture Capital


Fig. 3.3

MoNEY MARKET Money market is the most important segment of the financial system as it provides the fulcrum for equilibrating short-term demand for the supply of funds, thereby facilitating the conduct of monetary policy. It is a market for short-term funds with a maturity of up to one year and includes financial instruments that are close substitutes for money. The money market is generally expected to perform three broad functions: (i) it provides an equilibrating mechanism to even out demand for and supply of short-term funds. (ii) it also presents a focal point for central bank intervention for influencing liquidity and general level of interest rates in the economy; and (iii) it provides reasonable access to providers and users of short-term funds to fulfil their borrowing and investment requirements at an efficient market clearing price (Vaghul, 1987). There is no demarcated distinction between the short-term money market and the long-term capital market, and in fact there are integral links between the two markets, as the array of instruments in the two markets invariably form a continuum (Vaghul, 1987). The Reserve Bank is the most important constituent of the money market policy, the money market falls under the direct purview of regulation of the Reserve Bank. The primary objective of the Reserve Bank's operations in the money market has been to ensure that short-term interest rates and liquidity are maintained at levels which are consistent with the overall monetary policy objectives, viz., maintaining price stability, ensuring adequate flow of credit to the productive sectors of the economy and maintain orderly conditions in the financial markets. Liquidity and interest rates in the system are influenced by the Reserve Bank through the use of various instruments at its disposal such as cash reserve ratio, standing facilities/refinance schemes, repo and reverse repo transactions, changes in the Bank Rate, open market operations, and some times through foreign exchange swap operations. Recognising the important role of the market in the monetary policy process, the Reserve Bank has taken active interest in continuously refining the money market instruments in order to have greater control over the liquidity in the system and for creating an efficient mechanism to impart interest rate signals.



The Indian Money Market during the pre-reform period was characterized by paucity of instruments, lack of depth and dichotomy in the market structure. The inter-bank call money market was the core of the Indian money market. The money market during the 1970s and 1980s was also characterized by poor liquidity, the paucity of instruments and limited number of participants. The volume of business was low. However, in the late 80s, new instruments like treasury bills, bill rediscounting, certificate of deposits (CDs), Commercial paper (CP), interbank participation certificates were introduced. The money market in India witnessed significant progress since the post-reform period. Following the various initiatives taken by the Reserve Bank of India over the years, the depth and liquidity in the money market has increased significantly.

Government Securities Market The Government securities market in India forms an overwhelming part of the overall debt market. The impetus for development of the Government securities market in India has come from the large Government borrowing requirements, the increased capital flows and the need for sterilization. The RBI actively operates in the gift-edged market in order to create orderly conditions in the market by influencing the prices and yields of securities. In the post-reform, wide ranging reforms have been introduced in the Governme~t securities market towards institutional strengthening, introduction of an auction system, development or the secondary market for Government securities etc. Over the years, as the market reached progressively high stages of development, the RBI divested its holdings in the institution. The system of primary dealers in government securities was introduced in March, 1996 to provide two-way quotes and develop the market. The investor-base has widened since the early 1990s which now includes commercial banks, co-operative banks, insurance companies, provident funds, mutual funds, gift funds, primary dealers, NBFC's and corporate entities. The Government securities market witnessed significant growth in terms of volume and liquidity following the various measures taken by the RBI. The increasing secondary market activity in the Government securities market has been more than seventeen fold in the volume of transactions between 1996-97 to 2005-06. Trading in the Government securities market had exceeded the combined trading in equity segments of all exchanges in the country.

Foreign Exchange Market During the past seven decades, the foreign exchange market in India has witnessed a significant transformation from a highly controlled to a liberal regime. The forex market basically comprises Authorised Dealers (ADs) which are mostly banks, exporters and importers, individuals and the RBI. The forex market in India has acquired increasing depth with the transition to a market determined exchange rate system in March, 1993 and the gradual liberalization of restrictions on various external transactions. INTEGRATING FINANCIAL MARKETS

A segmented financial system complicates the conduct of monetary policy and adversely affects resource allocation and growth. To illustrate, suppose that interest rate ceilings are set at higher levels for non-bank financial institutions than for banks. A policy of credit restraint would then encourage the outflow of funds from the banking system. The income velocity (that is, ratio of GNP to money) of broad money (currency and demand deposits plus savings and time deposits) may increase, while that of narrow money (currency and demand deposits), which is used as reserve asset of non-bank financial institutions, may fall. A redefinition of monetary and credit targets for purposes of financial management cannot sufficiently counteract the possible negative impact on the intermediation capability of a financial system that is segmented by excessive and inappropriate regulations. A long-term solution is to reform the domestic regulatory framework to eliminate the major causes of segmentation, such as inadequate licensing regulations, burden some reserve requirements and portfolio restrictions, unrealistic interest rate ceilings, and the operating inefficiencies of the regulated markets.



Globalization - the process through which an increasingly free flow of ideas, people, goods, services, and capital leads to the integration of economies and societies - has brought rising prosperity to the countries that have participated. It has boosted incomes and helped raise living standards in many parts of the world, partly by making sophisticated technologies available to less advanced countries. The globalization ofnational economies has advanced significantly as real economic activity - production, consumption, and physical investment - has been dispersed over different countries or refines. Today, the components of a television set may be manufactured in one country and assembled in another , and the final product sold to consumers around the world. New multinational companies have been created, each producing and distributing its goods and services through networks that span the globe, while established multinationals have expanded internationally by merging with or acquiring foreign companies. Many countries have lowered barriers to international trade, and cross-border flows in goods and services have increased significantly. The liberalization of national financial and capital markets, coupled with the rapid improvements in information technology and the globalization of national economies, has catalyzed financial innovation and spurred the growth of cross-border capital movements. The globalization of financial intermediation is partly a response to the demand for mechanisms to intermediate cross-border flows and partly a response to declining barriers to trade-in financial services and liberalized rules governing the entry of foreign financial institutions into domestic capital markets. Competition among the providers of intermediary services has increased because of technological advance and financial liberalization. The regulatory authorities in many countries have altered rules governing financial intermediation to allow a broader range of institutions to provide financial services, and new classes of nonbank financial institutions, including institutional investors, have emerged. Investment banks, securities firms, asset managers, mutual funds, insurance companies, specialty and trade finance companies, hedge funds,and even telecommunications, software, and food companies are starting to provide services similar to those traditionally provided by banks.

During the past two decades, financial markets around the world have become increasingly interconnected. Financial globalization has brought considerable benefits to national economies and to investors and savers, but it has also changed the structure of markets, creating new risks and challenges for market participants and policymakers. BENEFITS VERSUS RIsKS

All in all, the radical change in the nature of capital markets has offered unprecedented benefits. But it has also changed market dynamics in ways that are not yet fully understood. One of the main benefits of the growing diversity of funding sources is that it reduces the risk of a "credit crunch". When banks in their own country are under strain, borrowers can now raise funds by issuing stocks or bonds in domestic securities markets or by seeking other financing sources in international capital markets. Securitization makes the pricing and allocation of capital more efficient because change in financial risks are reflected much more quickly in asset prices and flows then on bank balance sheets, the downside is that markets have become more volatile, and this volatility could pose a threat to financial stability. For example, the OTC derivatives markets, which accounted for nearly $ 100 trillion in national principal and $3 trillion in offbalance-sheet credit exposures in June 2001, can be unpredictable and, at times, turbulent. Accordingly, those in charge of preserving financial stability need to better understand how the globalization of finance has changed the balance of risks in international capital markets and ensure that private risk-management practices guard against these risks. Another benefit of financial globalization is that, with more choice open to them, borrowers and investor can obtain better terms on their financing. Corporations can finance physical investments more cheaply, and investors can more easily diversify internationally and tailor portfolio risk to their preferences, this encourages investment and saving, which facilitate real economic activity and growth and improve economic welfare.




However, asset prices may over- shoot fundamentals during booms and busts, causing excessive volatility and distorting the allocation of capital. For example, real estate prices in Asia soared and then dropped precipitously before the crises of 1997-98, leaving many banks with non-performing loans backed by collateral that had lost mush of its value. Also, as financial risk becomes actively traded among institutions, investors, and countries, it becomes harder to identify potential weaknesses and to gauge the magnitude of risk. Enhanced transparency about economic and financial market fundamentals, along with a better understanding of why asset market booms and busts occur, can help markets better manage these risks. Finally, creditworthy banks and firms in emerging market countries can reduce their borrowing costs, now that they are able to tap a broader pool of capital from a more diverse and competitive array of providers. However, as we saw during the Mexican crisis of 1994-95 and the Asian and Russian crises of 1997-98, the risks involved can be considerable - including sharp reversals of capital flows, international spillovers, and contagion. (Even though the extent of contagion seems to have decreased, for reasons that are still unclear, since the 1997-98 crises, the risk of contagion cannot be ruled out). Emerging market countries with weak or poorly regulated banks are particularly vulnerable, but such crises can threaten the stability of the international financial system as well.

CONCLUSION The prerequisite of any effective implementation of the monetary policy is to have a developed, organised, coordinated and integrated money market. In India, there are a number of unorganised, undeveloped and parallel money markets. With the assumption that the Government in this country has the responsibility for the overall direction of the economy, and given the increasing role assigned to the public sector, fiscal policy clearly is a major determinant of economic activity; but to proceed from this to the conclusion that an appropriate fiscal policy is all that matters would be unwarranted. The relationship between fiscal and monetary policy is best regarded as being complementary, for they constitute, together with trade and exchange policies, the essential ingredients of economic policy. The decision as to which policy should be implemented and when it should be implemented is largely a matter to be decided on the basis of the particular circumstances of a given situation and the appropriateness or otherwise of a particular set of instruments. A fiscal policy would obviously commence itself where the object is to effect a structural transformation in the economy, while for effective quick changes and to retain flexibility of approach, an effective monetary policy would be more appropriate. To suggest that they are in conflict is to argue that there is an inconsistency in the objectives of economic policy.

R. S. Sayers has observed: "In countries like India and China, the Central Bank must be prepared to open numerous branches in order to provide assistance quickly and easily to new local banks. A single Central Banking institution may be suited to small countries like England, Belgium or Holland."


In the final analysis, the operation of a monetary policy of the central bank depends on the intentions of the regulating authorities and the degree of co-operation extended by commercial banks, which must respond appropriately in carrying out the gigantic work of planned economic development. Since it is an aspect of the State's intervention in the economic process, a monetary policy must naturally be attuned to the larger economic objectives of the State. Even within a system of planning, its role could be conceived as a substitute for administrative decisions, as a technique of intervention rather than as an ideological alternati ve. The authorities must pursue a positive policy to integrate the organised, parallel and unorganised markets. The organised monetary market must be consolidated and strengthened. The parallel market should be brought within the regulation of the monetary authority. This apart, there must be the closest possible link and coordination between the policies of the Reserve Bank and the Government. Economic development is a joint venture of the Government, the Reserve Bank and the varied institutions of the money market. Each and every agency must play its part to make the tconomic programme a success. For this purpose, a developed, coordinated and integrated money market is an asset to the economy of the country, both in respect of economic development and in pursuing a sound monetary management policy that is conducive to development. A review of the financial market development in India during the past seven decades reveals that the Reserve Bank has been successful in creating deep and vibrant money, Government securities and foreign exchange markets, though they still need to be strengthened further. The success of the reform process has so far depended on several factors like macroeconomic stability, sound financial institutions, a favourable legal framework, technological support and congenial policy environment. Further, financial market reform was calibrated with reforms in other areas, in particular with fiscal reforms, and reforms in the external sector. Financial market development in India has, apart from improving monetary policy transmission mechanism facilitated changes in monetary policy strategies; from emphasis on credit allocation to monetary targeting and the subsequent multiple indicator approach. These changes would not have been possible without finan€ial market development. The success of deregulation of interest rate regime in India owes significantly to the simultaneous development of financial markets. Financial markets have enabled banks and institutions to better manage their affairs, liquidity and treasury operations and thereby strengthened their fund-based income and profitability. Further, the growth of financial markets in the 1990s contributed towards improved asset and liability management by banks and other financial entities. At the same time, there was a significant shift in the financing pattern of larger companies, which moved away from the banking system to raise resources from the financial markets. Though the various initiatives taken by the Reserve Bank have resulted in deep and wide, money, Government securities and forex markets, the reforms process is far from over.





INTRODUCTION The money market is a key component of the financial system. It is a market for short-term funds with maturity ranging from overnight to one year. It includes instruments that are deemed to the close substitutes of money or near money like trade bills, promissory notes and Government papers drawn for a short period not exceeding one year. These short-term instruments can be converted into cash readily without any loss and at low transaction cost. Money market is the centre for dealing mainly in short-term money assets. It meets the short-term requirements of borrowers and provides liquidity or cash to lenders. It is the place where short-term surplus funds at the disposal of financial institutions and individuals are borrowed by individuals and also the Government. The money market does not refer to a particular place where short-term funds are dealt with. It includes all individuals, institutions and intermediaries dealing with short-term funds. The transactions between borrowers, lenders and middlemen take place through telephone, telegraph, mail and agents. No personal contact or presence of the two parties is essential for negotiations in a money market. However, a geographical name may be given to a money market according to its location. For example, the London money market operates from Wall Street. But, they attract funds from all over the world to be lent to borrowers from all over the globe. Similarly, the Mumbai money market is the centre for short-term loanable funds of not only Mumbai, but also the whole of India. Money market is the fulcrum of monetary operations conducted by the central bank (RBI) in its pursuit of monetary policy objectives. An objective analysis of the structure of the Indian Money Market, therefore assumes great importance in the study of monetary policy and central banking activities. In this chapter the concept, structure and management are discussed in brief.

ThE CONCEPT At ihe outset, it is necessary to examine what we mean by the term money market, which has sometimes been defined as an organisation for dealings in loan money or borrowed funds. This is a very broad definition and has been adopted by a number of writers. It is also defined as follows:

A money market is a mechanism through which short-term funds are loaned and borrowed and through which a large part of the financial transactions of a particular country or of the world are cleared. Broadly conceived, it includes the entire mechanism employed in financial business of all types. In the narrower sense, in which the term is generally used, however, a money market includes only dealings in more or less standardised types of loans, such as call loans and in credit instruments, such as acceptance and treasury bills, in which personal relations between lender and borrower are of negligible importance. In this sense, a money market is distinct from, but supplementary to the commercial banking system. 1 1. Madan, J.T. and Nadler, M.: The International Money Markets, 1935, p. 108. See also Wilson, J.S.G.: 'The Business in India', in Banking in the British Commonwealth, edited by R.S. Sayers, 1952, p. 102, where Wilson writes: "In essence, a money market is a place where the borrowers and lenders of short-term funds are brought together."


Money Market has no geographical constraints and relates to all dealings in money or monetary assets. J.S.U Wilson defined the money market as a "centre in which financial institutions congregate for the purpose of dealing impersonally in monetary assets." This is giving too literal an interpretation of money market. In fact, 'money market' is a wide term and encompasses a variety of transactions, instruments and institutions. Money market is a centre where borrowers and lenders of money and near money assets are put together. It may comprise a group of such markets for various types of money assets characterised by relative liquidity or nearness to money. Such assets may be called call money, treasury bills or bills of exchange etc. Secondly, although there are various centres of money market such as Mumbai, Kolkata, Chennai, etc., they are not separate independent markets but are interlinked and related. Thirdly, in a true sense of free and perfect competition, there should be only one price for each category of money assets, which would result from dealing of purchase and sale made on a purely impersonal basis and through blind economic forces. The financial institutions dealing in these assets may be spread over so wide a geographical area that it would be impossible to specify the geographical limits of the market. The fact that there are some geographical centres does not limit the operations to these centres. According to Geottery Crowther, "The money market is the collective name given to the various firms and institutions that deal in the various grades of near money." The RBI defines the money market as, a 'market for short term financial assets that are close substitutes for money, facilitates the exchange of money for new financial claims in the primary market as also for financial claims, already issued, in the secondary market'. Traditionally, the money market in India comprised mainly the call money market. Although other money market segments, viz., commercial bills market and inter-corporate deposits market have been in existence for a long time, there has not been much activity in these segments. Therefore, for assessing the impact of reforms on the money market the focus is mainly on the call money market. The impact of reforms on the money market the focus is mainly on the call money market. The impact of reforms is assessed in terms of behaviour of the call money market and the market growth related paraIl.leters, including those instruments, which were introduc~d in the 1990s. The development of securities markets usually starts with trading in a short-term money market instrument, often a government security. Other money market instruments are interbank deposits, bankers' acceptances, certificates of deposit and commercial paper issued by non-financial corporations. Money markets provide a non-inflationary way to finance government deficits. They also allow governments to implement monetary policy through open market operations and provide a market-based reference point for setting other interest rates. Furthermore, money markets are a source of funds for commercial banks and other institutions with limited branch networks, including foreign banks and leasing and factoring companies. By enabling large corporations to issue short-term securities in the form of commercial paper, money markets make the corporate loan market more competitive and reduce the market power of large commercial banks. ROLEOFTHE~ONEY~RKET

The money market forms an important part of the financial system by providing an avenue for equilibrating the surplus funds of lenders and the requirements of borrowers for short periods ranging from overnight up to a year. It also provides a focal point for central bank's intervention for influencing the liquidity in the financial system and thereby transmitting the monetary policy impulses. The money market performs three broad functions. One, it provides an equilibrating mechanism for demand and supply of short-term funds. Two, it enables borrowers and lenders of short-term funds to fulfill their borrowing and investment requirements at an efficient market clearing price. Three, it provides an avenue for Central Bank (RBI) intervention in influencing both quantum and cost of liquidity in the financial system.




From the point of view of monetary and financial stability, an effective functioning of the money market is very important.

IMPoRTANCEOF~ONEY~RKET A developed money market plays an important role in the financial system of a country by supplying shortterm funds adequately and quickly to trade and ~ndustry. The money market is an integral part of a country's economy. Therefore, a developed money market is highly indispensable for the rapid development of the economy. A developed money market helps the smooth functioning of the financial system in an economy in the following ways:

(i) Development of Trade and Industry Money market is an important source of financing trade and industry. The money market is an integral part of country's economy. The money market, through discounting operations and commercial papers, finances the short-term working capital requirements of trade and industry and facilitates the development of industry and trade both - national and international.

(ii) Development of Capital Market The short-term rates of interest and conditions that prevail in the money market influence the long-term interest as well as the resource mobilization in capital market. Hence, the development of capital market depends upon the existence of a developed money market.

(iii) Smooth Functioning of Commercial Banks The money market provides the commercial banks with facilities for temporarily employing their surplus funds in easily realisable assets. The banks can get back the funds quickly, in times of need, by resorting to the money market. The commercial banks gain immensely by economising on their cash balances in hand and at the same time meeting the demand for large withdrawal of their depositors. It also enables commercial banks to meet their statutory requirements of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) by utilizing the money market mechanism.

(iv) ERective Central Bank Control A developed money market helps the effective functioning of a central bank. It facilitates effective implementation of the monetary policy of a central bank. The central bank, through the money market, pumps new money into the economy in slump and siphons it off in boom. The central bank, thus, regulates the flow of money so as to promote economic growth with stability.

( v) Formulation of Suitable Monetary Policy Conditions prevailing in a money market serve as a true indicator of the monetary state of an economy. Hence, it serves as a guide to the Government in formulating and revising the monetary policy then and there depending upon the monetary conditions prevailing in the market.

(vi) Non-Inflationary source of Finance to Government A developed money market helps the Government to raise short-term funds through the treasury bills floated in the market. In the absence of a developed money market, the Government would be forced to print and issue more money or borrow from the central bank. Both ways would lead to an increase in prices and the consequent inflationary trend in the economy. SUB-MARKETS

However, with the development of the economy and techniques, the money market is composed of money sub-markets of a sort in almost every country in the form of institutions that lend and borrow money for short periods. Some of these markets, for example, the call money market, short-term market, capital market, stock


market or bond market, commercial bill market, treasury bill market, discount market, etc., are highly developed and well organised. The larger the number of sub-markets, the broader and more developed is the structure of the money market. In developed money markets, large varieties of sub-markets have been organised for specialised dealings in almost all sources of loanable funds. Money markets that are undeveloped generally lack such of a variety of sub-markets. 2 The Indian money market has generally been divided into two watertight compartments: that which concerns itself with modem commercial banking and that which derives from indigenous practice with a tradition going back many hundred years. 3 The "black market money" or "unaccounted money" is made up of accumulated gains, largely of illegal transactions which cannot be brought into account books or into bank accounts. 4


Fig. 4.1 The Institutionalisation of Money Market.


The organised sector of the money market consists of the Reserve Bank of India, commercial banks, large-sized joint stock companies lending money, financial intermediaries such as the Life Insurance, Credit and Investments Corporation ofIndia, the Unit Trust ofIndia, the Agricultural Refinance and Development Corporation, Land Mortgage Banks, Co-operative Banks, Insurance Companies, etc. and call-loan brokers, general finance brokers and stock brokers. The unorganised sector of the money market is largely made up of indigenous bankers, moneylenders, traders, commission agents, etc., some of whom combine money lending with trade and other activities. Then there are the co-operative credit institutions set up mainly with a view to supplanting the indigenous sources of rural credit, particularly the money lenders. These co-operative institutions are liberally assisted by the Reserve Bank and are being brought into closer contact with the commercial banks. Generally speaking, these two sectors in the Indian money market - those institutions which come directly or indirectly under the broad regulations of the Reserve Bank constitute the organised sector, while the others, which fall completely outside the purview of the central banking regulations, make up the unorganised sector.

Call Money Market The call money market is a market for extremely short period loans say one day to fourteen days. So, it is highly liquid. The loans are repayable on demand at the option of either the lender or the borrower. In India, call money markets are associated with the presence of stock exchanges and hence, they are located in major industrial towns like Mumbai, Kolkata, Chennai, Delhi, Ahmedabad, etc. The special feature of this market is 2. Sen, S.N.: Central Banking in Undeveloped Money Markets, 1961, p. 17. 3. See Gupta, G.P.: Reserve Bank of India and Monetary Management, 1962, p. 234. 4. Gadgil, D.R.: MEffectiveness of Credit Regulation by the Reserve Bank of India/ Artha-Vijnana, March 1963, p.2.








Call Money Market

Gift Edge

Capital Market



Collateral Loans Market

Acceptance Market

, Bill Market

Fig. 4.2 The Classification of Money Market.

that the interest rate varies from day-to-day and even from hour-to-hour and centre-to-centre. It is very sensitive to changes in demand and supply of call loans.

Commercial Bills Market It is a market for Bills of Exchange arising out of genuine trade transactions. In the case of credit sale, the seller may draw a bill of exchange on the buyer. The buyer accepts such a bill promising to pay at a later date the amount specified in the bill. The seller need not wait until the due date of the bill. Instead, he can get immediate payment by discounting the bill. In India the bill market is under-developed. The RBI has taken many steps to develop a sound bill market. The RBI has enlarged the list of participants in the bill market. The Discount and Finance House of India was set up in 1988 to promote secondary market in bills. In spite of all these, the growth of the bill market is slow in India. There are no specialised agencies for discounting bills. The commercial banks playa significant role in this market.

Treasury Bills Market It is a market for treasury bills which have 'short-term' maturity. A treasury bill is a promissory note or a finance bill issued by the Government. It is highly liquid because its repayment is guaranteed by the Government. It is an important instrument for short-term borrowing of the Government. There are two types of treasury bills namely (i) ordinary or regular and (ii) ad hoc treasury bills popularly known as 'ad hocs'. Ordinary treasury bills are issued to the public, banks and other financial institutions with a view to raising resources for the Central Government to meet its short-term financial needs. Ad hoc treasury bills are issued in favour of the RBI only. They are not sold through tender or auction. They can be purchased by the RBI only. Ad hocs are not marketable in India but holders of these bills can sell them back to RBI. Treasury bills have a maturity period of 91 days or 182 days or 364 days only. Financial intermediaries can park their temporary surpluses in these instruments and earn income.

Short-term Loan Market It is a market where short-term loans are given to corporate customers for meeting their working capital requirements. Commercial banks provide short-term loans in the form of cash credit and overdraft. Overdraft facility is mainly given to business people whereas cash credit is given to industrialists. Overdraft is purely a temporary accommodation and it is given in the current account itself. But cash credit is for a period of one year and it is sanctioned in a separate account. The organised sector of the Indian money market is comparatively well-developed in terms of organised relationships and specialisation of functions. It more or less centres round the Reserve Bank of India; and the State Bank, commercial banks and co-operative banks are associated with it. The policies and operations of the State Bank and the co-operative banks are governed by the Reserve Bank and are also dependent on it for direct financial assistance. In fact, a substantial portion of the funds which co-operative credit agencies lend out is provided by the Reserve Bank. Financial intermediaries, such as the Industrial Financial Corporation, the Industrial Development Bank of India, State Financial Corporation, the Agricultural Refinance Corporation, etc., derive most of their resources from the Reserve Bank. The policies of these financial intermediaries are enunciated


Financial Institutions

Lie, UTI General

Fig. 4.3 Institutions in the Organised Sector under the Control of the Reserve Bank of India.

with the approvals of the Reserve Bank; even the personnel of some of them are supplied by the Reserve Bank. More important than all the above-mentioned institutions, is the inter-bank call-money market, which is regarded as the core of the Indian money market. "Although the magnitude offunds dealt in this market is not large in relation to the deposit resources of banks, perhaps this is the most sensitive sector of the money market." Then there are the treasury bills and bills of exchange, which absorb the surplus liquidity of the institutions in the organised sector.

FEATURES OF A MONEY MARKET The following are the general features of a money market: (i)

It is a market purely for short-term funds or financial assets called near money.


It deals with financial assets having a maturity period upto one year only.


It deals with only those assets which can be converted into cash readily without loss and with minimum transaction cost.


Generally transactions take place through phone i.e., oral communication. Relevant document and written communications can be exchanged subsequently. There is no formal place like stock exchange as in the case of a capital market.


Transactions have to be conducted without the help of brokers.


It is not a single homogeneous market. It comprises of several sub-markets, e~ch specializing in a particular type of financing e.g., Call money market, Acceptance market, Bill market and so on.


The components of a money market are the Central Bank, Commercial Banks, Non-banking financial companies, discount houses and acceptance houses. Commercial banks generally playa dominant role in this market.

Other features of the money market are: (i)

It is a market for short-term loanable funds for a period of not exceeding one year.


This market supplies funds for financing current business operations, working capital requirements of industries and short period requirements of the Government.


The instruments that are dealt in a money market are bills of exchange, treasury bills, commercial papers, certificate of deposit etc.


Each single money market instrument is of large amount. A TB is of minimum forone lakh. Each CD or CP is for a minimum of Rs. 25 lakhs.


The Central bank and Commercial banks are the major institutions in the money market.


Money market instruments generally do not have secondary markets.


Transactions mostly take place over-the-phone and there is no formal place.


Transactions have to be conducted without the help of brokers.




Oblectlves The following are the important objectives of a money market: (i)

To provide a parking place to employ short-term surplus funds.


To provide room for overcoming short-term deficits.


To enable the Central Bank to influence and regulate liquidity in the economy through its intervention in this market.


To provide a reasonable access to user of short-term funds to meet their requirements quickly, adequately and at reasonable costs.

Characteristic Features of A Developed Money Market In order to fulfill the above objectives, the money market should be fully developed and efficient. In every country of the world, some type of money market exists. Some of them are highly developed while others are not well developed. Prof. S. N. Sen has described certain essential features of a developed money market. They are as follows:

(I) Highly Organised Banking System: The commercial banks are the nerve centre of the whole money market. They are the principal suppliers of short-term funds. Their policies regarding loans and advances have impact on the entire money market. The commercial banks serve as a vital link between the central bank and the various segments of the money market. Consequently, a well developed money market and a highly organized banking system co-exist. In an underdeveloped money market, the commercial banking system is not fully developed. FuNCTIONS OF MONEY MARKET As the Reserve Bank of India observes, "A well-developed money market is the basis for an effective monetary policy. It is in the money market that the central bank comes into contact with the financial sectors of the economy as a whole and it is through varying the liquidity in the market and thereby influencing the cost and availability of credit that the Bank achieves its economic objectives." The important functions of a well developed money market may be listed down in more precise terms as follows:


By providing various kinds of credit instruments suitable and attractive for different sections, a money market augments the supply of funds.


Efficient working of a money market helps to minimize the gluts and stringencies in the money market due to the seasonal variations in the flow of and demand for funds.


A money market helps to avoid wide seasonal fluctuations in the interest rates.


A money market, by augmenting the supply of funds and making them readily available to the legitimate borrowers, help in making funds available at cheaper rates.


A well organized money market, through quick transfer of funds from one place to another, helps to avoid the regional gluts and stringencies of funds.


It enhances the amount of liquidity available to the entire country.


A money market, by providing profitable investment opportunities for short-term surplus funds, helps to enhance the profit of financial institutions and individuals.

MONEY MARKET INSTRUMENTS A variety of instruments are available in a developed money market. In India, till 1986, only a few instruments were available. They were: (i) (ii)

Treasury bills in the treasury market. Money at call and short notice in the call loan market.



Commercial bill, promissory notes in the bill market. Now, in addition to the above, the following new instruments are available:


Commercial papers (CPs)


Certificate of deposit (CD)


Inter-bank participation certificates


Repo instruments.


A major characteristic of the Indian money market each year is the pronounced swing from 'busy' to 'slack' times and vice versa. s The Reserve Bank provides accommodation to the commercial banks, especially during the busy season; and the treasury bills issued by the Reserve Bank provide an important outlet for the surplus funds of the commercial banks during the slack season. In the same way, other financial institutions, such as hire-purchase companies, insurance companies, etc., place their surplus funds with commercial banks or co-operative banks in short-term deposits; and they borrow from the commercial banks in case of need. The noteworthy feature is that one does not find a clear-cut demarcation of functions among the institutions comprising of the organised money market in India, as one finds, for example, among the financial institutions in the U.K., where the commercial banks, discount houses, acceptance houses, etc., perform a highly specialised set of functions, and their spheres of operations are well defined and co-ordinated. But in India, the Reserve Bank is not only the lender of the last resort, but provides capital to co-operative banks, refinance facilities for export and special accommodation to banks financing small industries. Commercial banks in India directly undertake the discounting of commercial bills. In the U.K., however. such bills are initially taken up by the discount houses. Therefore, in India, there is a considerable overlapping of functions among the institutions comprising the organised money market, which perhaps is the outcome of the peculiar circumstances under which they have developed. The Indian banking structure possesses a heterogeneous mass of indigenous banks, joint stock banks and co-operative banks as its base layers; the highly organised, developed and nationalised banks, State Bank as its middle layer and a state-owned central bank, namely, the Reserve Bank of India, as its apex. 6 The organised sector is principally composed of the commercial banks, the co-operative banks and the land mortgage banks. Considering the continental character of the country, the banking development is most inadequate for the needs of trade and industry, largely because of the hoarding habit among the people. J.S.G Wilson remarks: "The hoarding habit appears to provide an almost bottomless pitfor the absorption of gold and silver."7 With a view to strengthening the organised money market in India, new institutions have been established and consolidated to either lend on long-term basis or regulate credit in a prescribed manner. The new institutions which have come up after independence are the Industrial Finance Corporation (1948); the National Industrial Development Corporation (1954); the Industrial Credit and Investment Corporation of India, Ltd. (1955); State Financial Corporations (1951); the National Small-scale Industries Corporations (1955); the Agricultural Refinance and Development Corporation; the Unit Trust of India (1964) and the Industrial Development Bank of India (1964), which incorporates the Refinance Corporation and the Industrial Reconstruction Corporation (1971).

5. Tata Quarterly, April/July, 1964, p. 43. 6. Ghosh, Alak: Indian Economy, 1963, p. 468. 7. Op. cit., p. 151. Wilson also gives some of the reasons for the strength of the hoarding habit in India.




GROWTII OF MONEY MARKET: POST REFORM The money market in India witnessed significant progress particularly from the mid-1990s in terms of refinements in money market instruments, introduction of new instruments and supplementary measures to add depth and liquidity to the market. The money market instruments in India during the period mainly consisted of: (i) Call1Notice Money, (ii) Term Money, (iii) Certificates of Deposit, (iv) Commercial Paper, (v) Treasury Bills, (vi) Repurchase Agreements (Repos), (vii) Interest Rate Swaps/Forward Rate Agreements, and (viii) Rediscounting of commercial bills scheme. During the 1990s, the participation in the call money market was widened to cover primary and satellite dealers and corporates (through primary dealers) besides other participants. While banks and primary dealers are permitted to lend and borrow in the market, other entities could participate only as lenders. Following the recommendations of the Narasirnham Committee (1998) and the Reserve Bank's Internal Working Group-1997, steps were initiated to reform the call money market and make it a pure inter-bank market, in a phased manner starting in 1999. With the development of the repo market since the late 1990s, the call money market has gradually been transformed into a pure inter-bank market including primary dealers. This process which was initiated in 1999, was completed in August 2005. A significant development in the Indian money market has been the introduction of Rupee derivatives, i.e., Interest Rate Swaps (IRS) !Forward Rate Agreements (FRA) in 1999 to further deepen the money market and enable market paFticipants to hedge their risks. In addition to several other measures taken since its introduction, with effect from May 20,2005, market participants were advised to use only domestic rupee benchmarks for interest rate derivatives. Market participants were however, given a transition period of six months for using Mumbai Inter-bank Forward Offered Rate (MIFOR) as a benchmark, subject to review. However, on request from the Fixed Income Money Market and Derivatives Association (FIMMDA), market participants have been allowed to use MIFOR swaps in respect of transactions having underlying permissible forex exposures, for market making purpose, subject to appropriate limit as may be approved by the Reserve Bank. UNORGANISEDSECTOR As regards the agencies constituting the unorganised money market, it is necessary at the outset to clarify one important point regarding the nomenclature used to designate them. The term unorganised money market conveys the impression that indigenous agencies providing credit have neither any system nor any organisation among themselves, nor any definite procedure regulating their lending practices. In fact, these agencies have been functioning for ages in almost all parts of this country, and have a time-tested organisation. They follow well-set patterns, both as regards their lending policies and their interest rates. Their native origin is mainly responsible for some of their unique features, which have few parallels among similar agencies in Europe. INDIGENOUS BANKING The system of indigenous banking in India is of ancient growth and dates back to Vedic times, which may be taken to range between 2000 B.C. and 1400 B.C. Money lending was regarded as an ancient practice. That it was practised even in the early Aryan days is evident from the references to money lending as one of the four honest callings, the other three being tillage, trading and harvesting. The researches of MacDonnell and Keith provide the main source of information regarding money lending during the Vedic and Pre-Vedic periods. Rina (debt) is often mentioned in the Rig Veda and in late Vedas, and indicates a normal condition in the Vedic society. On the subject of interest, the available information is sketchy. That interest was charged may be inferred from the fact that the usurer (kusidin) is referred to in the Shatapatha Brahmana and the Sutras. However, little is known about the rate of interest prevailing in Vedic times or the terms and conditions on which loans were advanced. The available evidence shows that rather low rates were generally prevalent and usurious rates were frowned upon. The money market in India is dominated by the unorganised sector. The only link that exists between the organised and unorganised sectors is through the commercial banks. Indigenous shroffs carry on their activities through the media of tltese commercial banks. In rural areas, they do so through co-operative credit societies.






Unorganised Sector I Indigenous Bankers

Money Lenders


Organised Sector


Co-operative Sector


Chit Funds I Reserve Bank of India






Sector Banks

Sector Banks

Development Banks and other Financial Institutions

I Non-Scheduled Banks







Scheduled Banks


Foreign Banks


Indian Banks


Fig. 4.4 The Indian Money Market.

However, a number of credit societies are under the control of moneylenders. In fact, the Rural Credit Survey Report gives instances of moneylenders who are actively associated with co-operative credit agencies either as members or as office-bearers. Recently, more instances of their active interest have come to light. It seems that a growing number of spurious co-operative societies have been organised solely to enable these moneylenders to take advantage of the concessions they offer. The indigenous bankers use banks as intermediate agencies of their transactions and yet remain outside the orbit of central bank control. The unorganised market has of late been strengthened with the addition of unaccounted money, variously known as black money or unaccounted gains or untaxed assets. A conservative estimate places this amount at between Rs. 2,500 crore and Rs. 4,000 crore or more. As a result of the income velocity of money, considerable savings will be accruing in the unaccounted income sector. These savings seek outlets which again escape from the tax-net and thus enlarges the unaccounted sector. In view of the plethora of liquid funds in the unaccounted sector and the high rates of return in the speculative holding of goods, the production circuit is severely disturbed. In an international context, there are high returns from in-smuggling and out-smuggling of goods, drugs and precious metals. These high-staked, high-return activities are invariably financed from the unaccounted money. Likewise, unaccounted money is also found in real estate and also a useful source of finance for the political process. In the process, the unaccounted sector has acquired respectability he high rates of return in the speculative holding of goods, the production circuit is severely disturbed. In an international context, there are high returns from in-smuggling and out-smuggling of goods, drugs and precious metals. These high-staked, high-return activities are invariably financed from the unaccounted money. Likewise, unaccounted money is also found in real estate and also a useful source of finance for the political process. In the process, the unaccounted sector has acquired respectability and at the same time, running a parallel money market with a continued drain to the exchequer and violation of foreign exchange laws. The operation of the unaccounted income (money) sector is illustrated as follows:




I Speculative holding, gold, silver diamonds, and other jewellery

I Foreign Exchange, under-invoici ng of imports, overinvoicing of inputs, over-invoicing of exports. Hotel & Tourist Industry



Growth, stocks, Inventories of Commodities


Financing of political parties (by this process the operators have acquired high respectability in the society with wide contacts)

I Real Estate, building sites, vacant flats, agricultural lands, sites of mines, etc.

I Holding of Government permits, transport, imports, exports etc.

The unique aspect of unaccounted currency is that, except when hoarded, it never remains permanently concealed, not for a continuously long term. A large portion of it is in circulation and constantly changes its character. The impact of unaccounted money on the money market is very significant. With its growth in the country, a number of mushroom indigenous bankers have sprung up, who are quite different from the traditional bankers; and it has been reported that they lend money at very high rates of interest. The indigenous money market has itself become a lawless market, and the old conventions have very little relevance to it. The unaccounted money as part of the indigenous money market is invested in property, small-scale industries, smuggling, and trade. This fact has further limited the effective implementation of the monetary policy. Unaccounted money has further strengthened the indigenous market in India. However, with the devaluation of the Rupee, the effective use of unaccounted money is expected to decline somewhat, though its impact on the market will continue as before (Fig. 4.5).



Fig. 4.5 The broad-basing of the unorganised money market with the growth of unaccounted money.

Since there is no direct link between the unorganised and organised money markets, it is essential to establish such a link. The link of commercial banks between the two markets is so weak that it is more advantageous to the unorganised market than to the organised sector. EFFECflVEMANAGEMENf The money market performs three broad functions. One, it provides an equilibrating mechanism for demand and supply of short-term funds. Two, it enables borrowers and lenders of short-term funds to fulfill .their borrowing and investment requirements at an efficient market clearing price. Three, it provides an avenue for central bank intervention in influencing both quantum and cost of liquidity in the financial system, thereby transmitting monetary policy impulses to the real economy. The objective of monetary management by the central bank is to align money market rates with the key policy rate. As excessive money market volatility could deliver confusing signals about the stance of monetary policy, it is critical to ensure orderly market behaviour, from the point of view of both monetary and financial stability. Thus, efficient functioning of the money market is important for the effectiveness of monetary policy.


In order to meet these basic functions efficiently, money markets have evolved over time spawning new instruments and participants with varying risk profiles in line with the changes in the operating procedures of monetary policy. Changes in financial market structures, macroeconomic objectives and economic environment have called for shifts in monetary regimes, which, in tum, have necessitated refinements both in the operating instruments and procedures, and in institutional arrangements by central banks. Internationally, following the breakdown of the Bretton Woods system, there was a shift from rule-based frameworks towards discretion in the use of monetary policy instruments, which ultimately led to the gradual abandonment of exchange rate targets. Changes in financial structures and financial innovations also rendered monetary targeting ineffective by making the money demand functions unstable. Accordingly, since the early 1990s there has been a shift towards greater exchange rate flexibility and adoption of inflation targeting by some central banks partly because of increased capital mobility, greater financial market integration and repeated episodes of currency crises. Commensurate with these changes, central banks have moved away from conventional (direct) instruments of monetary control (working through the quantum channel towards more use of indirect instruments (operating through the price channel). Accordingly, the use of reserve requirements and direct credit controls has been gradually de-emphasized, while relying more on interest rates for signalling the monetary policy stance. As central banks have only limited control over long-term interest rate, the most commonly adopted strategy has been to extert direct influence only on short-term interest rates and permitting market expectations to influence long-term interest rates through financial market inter-linkages. Thus, the choice of monetary policy instruments is guided by the structure of the money market. MONEY MARKET DEVELOPMENT

The development of the money market contributes to the efficiency of the financial sector by allowing financial institutions to transfer surplus funds to other financial institutions instead of directly financing inefficient borrowers or discouraging depositors; and by facilitating the management of bank liabilities through refinancing, thereby increasing the availability of long-term finance for investment. In addition, open-market operations could be conducted more effectively and their effects on banks' marginal cost of funds felt more rapidly. Specific policies to develop and strengthen money markets have been addressed in Fund programs of technical assistance. Such policies include strengthening broker-dealer services and their regulation, introducing money market instruments, reforming the central bank's discount window operations to support money market development consistent with monetary control, setting up auction systems in the primary market for money market financial instruments, and favourable tax treatment of interest income of financial assets. The Indian money market prior to the 1980s was characterized by paucity of instruments, lack of depth and dichotomy in the market structure. The money market consisted of the inter-bank call market, Treasury Bills, Commercial bills and participation certIficates. Historically, the call money market has constituted the core of the money market structure in India due to lack of other instruments and strict regulations on interest rates and participation. In the call/notice money market, overnight money and money at short notice (up to a period of 14 days) are lent and borrowed without collateral. This market enables banks to bridge their short-term liquidity mismatches arising out of their short-term operation. The call money market in India was purely an inter-bank market until 1971 when the erstwhile Unit Trust of India (UTI) and Life Insurance Corporation (LIC) of India were allowed to participate as lenders. The interest rate in the call money market was freely determined by the market till December 1973. However, as call money rates sharply to touch 25-30 percent, the Indian Banks Association (IBA) instituted an administered system of interest rates by imposing a ceiling interest rate of 15 percent in December 1973 so as to maintain systemic stability and quell any abnormal rise in the call rates. The ceiling was subject to several revisions but there were several instances of violation of the ceiling rates through other means (like buy-back arrangements) during phases of tight liquidity. Treasury Bills constituted the main instrument of short-term borrowing by the Government and served as a convenient gilt-edged security for the money market. The characteristics of high liquidity, absence of default risk and negligible capital depreciation of Treasury Bills made them another attractive instrument for short-term






Major Participants

Call Money


Notice Money

2 to 14 days

Scheduled commercial banks (excluding RRBs), co-operative banks, primary dealers (PDs) & till August 5, 2005 select all-India Fls, insurance companies & mutual funds.

Term Money

IS-days to 1- year

Certificates of Deposit (1989)

Minimum 7 days

Banks, all-India financial institutions & PDs. Scheduled commercial banks (excluding RRBs & Local Area Banks) & select all-India financial institutions. Corporates, all-India financial institutions & PDs.

Commercial Paper (1990) Forward Rate Agreements! Interest Rate Swaps (1999) Bills Rediscounting

Contracts are available maturities upto lO-years

Repurchase Agreements

RBI Repo (LAP) Treasury Bills

Inter-bank Participation Certificates (1988)


Banks, PDs, select all-India financi-al institutions, insurance companies & mutual funds. Banks, PDs,all-India financial institutions, insurance companies, mutual funds & listed corporates.


Market Repo

Scheduled commercial banks, PDs & all-India financial institutions.

Minimum 7 - days

I-day to I-year I-day· 91,182 & 364-days

91 to 180-days

Banks and PDs. Banks, PDs financial institutions & other non-bank entities. Scheduled commercial banks.

• The Reserve Bank retains the option to conduct longer term repo under LAF depending on market conditions and other relevant

investment by banks and other financial institutions. The Reserve bank, being the banker to the Government, issued Treasury Bills at a discount. The issuance system of Treasury Bills migrated from an auction to tap basis in July 1965 with the rate of discount administratively fixed at 3.5 percent per annum, which was raised to 4.6 percent by July 1974 and remained at that level, in respect of 91-day Treasury Bills till 1991. There was also a system of ad hoc treasury Bills from 1955, which were created by the Central Government in favour of the Reserve Bank to automatically restore its cash balances to the minimum stipulated level, whenever there was excess drawdown of cash. Participation Certificates (PCs) and commercial bills (under bills rediscounting scheme) were introduced in the money market in 1970. PCs were utilised mostly by financial institutions to park their funds for longer maturities and could not be developed for meeting liquidity mismatches between financial institutions and/or banks. Under the bills rediscounting schemem, the Reserve Bank rediscounted genuine trade bills at the Bank rate or at a rate specified by it. The underlying purpose of developing the bill market was to enable banks and other financial institutions to invest their surplus funds profitably by selecting appropriate maturities. Over the years, the rediscounting facility became restrictive and was made available on a discretionary basis. The main



factors inhibiting the development of bill finance were lack of a bill culture, non-availability of stamp papers of required denominations, absence of specialized credit information agencies and an active secondary market. Both these instruments (participation certificates and commercial bills), however, did not develop and activity in these instruments remained insignificant. Since the early 1990s, the money market has undergone a significant transformation in terms of instruments, participants and technological infrastructure. Various reform measures have resulted in a relatively deep, liquid and vibrant money market. The transformation has been facilitated by the Reserve Bank's Policy initiatives as also by the shift in the monetary policy operating procedures from administered and direct to indirect marketbased instruments of monetary management. The changes in the money market structure and monetary policy operating procedures in India have been broadly in step with the international experience and best practices. Along with the shifts in the operating procedures of monetary policy, the liquidity management operations of the Reserve Bank have also been fine-tuned to enhance the effectiveness of monetary policy signalling. The increasing financial innovations in the wake of greater openness of the economy necessitated the transition from monetary targeting to a multiple indicator approach with greater emphasis on rate channels for monetary policy formulation. Accordingly, short-term interest rates have emerged as key' instrument of monetary policy since the introduction of LAF, which has become the principal mechanism of modulating liquidity conditions on a daily basis. In line with the shifts in policy emphasis, various segments of the money market have been developed. The call money market was transformed into a pure inter-bank market, while other money market instruments such as market repo and CBLO were developed to provide avenues to non-banks for managing their short-term liquidity mismatches. Furthermore, issuance norms and maturity profiles of other money market instruments such as CPs and CDs were aligned for effective transmission of policy intent across various segments. The abolition of ad hoc Treasury bills and introduction of Treasury Bills auction have led to the emergence of a risk free rate, which acts as a benchmark for pricing other money market instruments. The increased market orientation of monetary policy and greater integration of domestic markets with global financial markets however, have necessitated the development of an institutional framework for appropriate risk management practices. BOX 4.1


The existence of a wide. deep and liquid money market is critical for the development of a smooth yield curve. which facilitates the conduct of monetary policy. As money market determines the cost of liquidity and anchors the short-end of the yield curve. the development of a deep and liquid money market is imperative for the emergence of a yield curve which would credibly transmit monetary policy signals. In this regard. the Reserve Bank has taken several measures since the mid-1990s to develop a short-term yield curve with deep liquidity. These are : (i) exempting inter-bank liabilities from the maintenance of CRR. (ii) operationalising the LAF whereby the reverse repo and repo rates are used as policy instruments to modulate liquidity conditions and stabilize call rates within the LAF corridor; (iii) transforming the call money market into a pure inter-bank The full implementation of the real time across settlement (RTGS) would further aid this process by contributing to systemic stability market by phasing out the non-bank lenders; (iv) developing other market segments with adequate access for non-banks; (v) developing a relatively vibrant non-RBI repo market; and (vi) developing the CBLO market as yet another instrument of overnight borrowingllending facility. Notwithstanding these initiatives. a short-term yield curve which is readily amenable for policy purposes is yet to emerge. In this regard, the single largest impediment for the emergence of a short-term yield curve has been the non-existence of a vibrant and liquid termmoney market. mainly due to the inability of market participants to build long-term interest rate expectations. skewed distribution of market liquidity. reduction in the minimum maturity period of term deposits of banks. and tendency on the part of banks to deploy their surplus funds in LAF auctions rather than in term money market. As a result, the yield curve has been flattening in recent years; it even remained inverted for a very brief period. For instance. the absorption of liquidity through sterilization operations had led the call rates and the cut-off yield on 91-day Treasury Bills to edge above the yield of 364 - day Treasury Bills. leading to an inversion of a segment of the yield curVe for a few days in October 2003. The prolonged flattening of the yield curve has. however. been influenced by structural factors such as considerable softening of yields due to dismantling of administered interest rate regime. favourable inflationary expectations and excess liquidity in the wake of capital flows. The moderation in yields has also been supported by rationalization of small savings interest rates administered by the Government. The stickiness of the reverse repo/repo rate could also have contributed to the flattened yield curve. Maintaining the reverse repo/repo rate at the unchanged level for an extended period of time could have also led to distortions in the term structure of interest rates. This can be



understood by the fact that while the lO-year gilt yield declined by 257 basis points during May 2002 to April 2004, the reverse repo rate declined by 150 basis points while call money rates declined by 180 basis points during the same period. These structural factors appeared to have contributed to the flattening of the yield curve. Owing to these distortions, the Indian yield curve does not fully reflect the market expectations on inflation and growth prospects. An important objective of money market reforms by the Reserve Bank in recent years has been to facilitate transparency in transactions in order to reduce transactions cost and improve price discovery. The Clearing Corporation of India Limited (CCIL) by providing for guaranteed settlement of all trades, ensures prevention of grid-lock in financial transactions. Furthermore, the introduction of CBLO by the CCIL in January 2003 and operationalisation of an order matching (OM) anonymous trading screen has made trading transparent and on a real time basis, thereby making the money market more efficient. In order to further enhance transparency in the money market, screenbased trading through the NDS-CALL was operationalised in September 2006. The full implementation of the real time across settlement (RTGS) would further aid this process by contributing to systemic stability. Notwithstanding considerable progress, a proper short-term yield curve, which facilitates the transmission of monetary policy signals and provides a benchmark for the pricing of other short-term debt instruments, is yet to emerge fully. In this regard, the constant interaction between the Reserve Bank and market participants through frequent meetings, speeches, interviews, press releases and publications is progressively expected to mute the surprise element of monetary policy and facilitate the process of formation of market expectations, which would increasingly get captured in the yield curve.

Instruments In view of the rapid changes on account of financial deregulation and global financial markets integration, central banks in several countries have striven to develop and deepen the money markets by enlarging the ambit of instruments, and participants so as to improve the transmission channels of monetary policy. The structure of money markets determines the type of instruments that are feasible for the conduct of monetary management. Evidence and experience indicate that preference for market-oriented instruments by the monetary authorities helps to promote broader market development (Forssbaeck and Oxelheim, op cit). The diminishing role of quantitative controls and search for alternatives gave rise to three major marketoriented instruments, viz., short-term securities, repurchase operations and swaps. Theses instruments prompted the central banks to create, stimulate and support the development of markets particularly, inter-bank deposit market and short-term securities market. In the absence of an efficient inter-bank market, there was a pressing need for the central banks to create adequate instruments to absorb liquidity and stimulate the formation of markets for alternative short-term assets. The emergence of the short-term securities market added a new dimension to liquidity management by central banks. In the absence of outright transactions in the securities market, the existence of a liquid securities segment in the money market is often believed to facilitate the central bank's operations by providing collateral to repurchase agreements and similar collateralized transactions. Notwithstanding depressed conditions in the capital market in the last few years, significance of the capital market in meeting the financing requirements of the corporate has generally improved. Since the initiation of the reforms, the reliance of the corporate sector on the capital market for funds increased markedly. In the secondary market, the move to an electronic trading system has resulted in transparency in trades, better price discovery and lower transaction costs. The efficiency of the market has improved through faster execution of trades. The operational efficiency of the stock market has also been strengthened through improvements in the clearing and settlement practices and the risk management process. Almost the entire delivery of securities now takes place in dematerialized form. During the last four years or so, there has been no instance of postponement or clubbing of settlements at two main stock exchanges (BSE and NSE) despite defaults by brokers. The cases of bad deliveries have become almost nil. The setting up of trade/ settlement guarantee funds in most of the exchanges has considerably reduced the settlement risk for investors. The corporate governance practices and disclosure norms have led to transparency in information flows, which, in tum, have improved the price discovery process.

Role of the Reserve Bank The first thing to which the Reserve Bank of India has to assign top priority is the introduction of effective monetary management and the co-ordination of the money market with a view to bringing indigenous bankers within the fold of its central banking policy. Even before the Reserve Bank was established, the Central Banking


Enquiry Committee considered it to be a matter of paramount importance. It had recommended the development of direct links between moneylenders and the Reserve Bank of India, in the same way in which it had established links with the joint-stock banks. "Such indigenous bankers as are engaged in banking proper or are prepared to shed their business other than banking should be eligible to be placed on the approved list of the Reserve Bank in the same manner as joint-stock banks." Some of the Provincial Banking Enquiry Committees had also suggested that: (i)


Indigenous bankers should be linked with the central banking institutions; They should be treated as member banks on the approved list of banks;


Commercial banks might discount their bills more easily; and


Indigenous bankers should be licensed.

The scheme suggested by the Central Banking Enquiry Committee was that the Reserve Bank should prescribe a standard which indigenous bankers must follow before they are given the concessions recommended. The maintenance of proper books of accounts in the recognised manner and the submission of these books to the Reserve Bank for inspection and audit were two of the important eligibility conditions. Although commercial banks are expected to pay much greater attention than they did in the past to the needs of small borrowers of various types, it is unlikely that they will be able to displace indigenous bankers altogether. The Banking Commission does not think that such displacement is ever possible or practicable. A more useful course would be to adopt measures which would enable these agencies to work in conformity with the overall credit policy of the Reserve Bank. The Reserve Bank of India is the central bank of the country. In order to exercise effective monetary management, the Bank has to introduce monetary discipline in the money markets. In this connection, its first and foremost task has been to consolidate commercial banking and extend banking facilities in the country. The apex bank stands committed today in this task. The mergers introduced by the Bank since 1970 should be strengthened and extended to more scheduled and non-scheduled banks, particularly to those that are sick. The branch expansion programme should be planned so as to meet the needs of the various regions. The State Bank and its associates should be merged, the nationalised banks should be reorganised into viable units, and the link between the State Bank and commercial banks should be codified. Again, the Reserve Bank should acquire powers to control the other financial institutions in the country which substantially influence the money market. A direct link between the unorganised and organised money markets must be established. Co-operative banks should be brought within the full control of the Reserve Bank. Only then the Central Bank will be able to implement its monetary policy more effectively. In a country like India, with large geographical dimensions, a huge population of over 68 crore and a large number of banking offices, co-operative banks and indigenous bankers, it is necessary that there should be regional central banks which would be effective with their constituents, subject to the overall control of the Central Monetary Authorities. The regional central banks thus established should be co-ordinated, guided and controlled by a Central Monetary Board, like the Federal Reserve Bank in the U.S.A. A leading banker observes: "There may be, say,four or five autonomous regional reserve banks, co-ordinated by a Central Board, which will evolve policies and take important decisions, the execution being entrusted to the Regional Banks. Such decentralisation will bring the local management in closer and more intimate contact with the respective regions; this will facilitate not only better appreciation of the local problems and needs but also the development of the desired relationship between the regional reserve banks and commercial banks. s

8. B. K. Dutt's Prof. Benoy KumarSarkar's Memorial Lectures (1960)attheCalcutta University, Commerce, October 15, 1960.




BOX 4.2



The money market forms the first and foremost link in the transmission of monetary policy impulses to the real economy. Policy interventions by the central bank along with its market operations influence the decisions of households and firms through the monetary policy transmission mechanism. The key to this mechanism is the total claim of the economy on the central bank, commonly known as the monetary base or high-powered money in the economy. Among the constituents of the monetary base, the most important constituent is bank reserves, i.e., the claims that banks hold in the form of deposits with the central-bank. The bank's need for these reserves depends on the overall level of economic activity. This is governed by several factors: (i) Banks hold such reserves in proportion to the volume of deposits in many countries, known as reserve requirements, which influence their ability to extend credit and create deposits, thereby limiting the volume of transactions to be handled by the bank; (ii) Bank's ability to make loans (asset of the bank) depends on its ability to mobilize deposits (liability of the bank) as total assets and liabilities of the bank need to match and expand/contract together; and (iii) Bank's need to hold balances at the central bank for settlement of claims within the banking system as these transactions are settled through the accounts of banks maintained with the central bank. Therefore, the daily functioning of a modem economy and its financial system creates a demand for central bank reserves which increases along with an expansion in overall activity (Friedman, 2000b). The central bank's power to conduct monetary policy stems from its role as a monopolist, as the sole supplier of bank reserves, in the market for bank reserves. The most common procedure by which central banks influence the outstanding supply of bank reserves is through 'open market operations' - that is, by buying or selling government securities in the market. When a central bank buys (sells) securities, it credits (debit) the reserve account of the seller (buyer) bank. This increases (decreases) the total volume of reserves that the banking system collectively holds. Expansion (contraction) of the total volume of the reserves in this way matters because banks can exchange reserves for other remunerative assets. Since reserves earn low interest, and in many countries remain unremunerated, banks typically would exchange them for some interest bearing asset such as Treasury Bill or other short-term debt instruments. If the banking system has excess (inadequate) reserves, banks would seek to buy (sell) such instruments. Ifthere is a general increase (decrease) in demand for securities, it would result in increase (decline) in security prices and decline (increase) in interest rates. The resulting lower (higher) interest rates on short-term debt instruments mean a reduced (enhanced) opportunity cost of holding low interest reserves. Only when market interest rates fall (rise) to the level at which banks collectively are willing to hold all of the reserves that the central bank has supplied will the financial system reach equilibrium. Hence, an "expansionary" (contractionary) open market operation creates downward (upward) pressure on short-term interest rates not only because the central bank itself is a buyer (seller) but also because it leads banks to buy (sell) securities. In this way, the central bank can easily influence interest rates on short-term debt instruments, In the presence of a regular term structure of interest rates and without market segmentation such policy impulses get transmitted to the longer end of the maturity spectrum, thereby influencing long-term interest rates, which have a bearing on household's consumption and savings decisions and hence on aggregate demand. There are alternative mechanisms of achieving the same objective through the imposition of reserve requirements and central bank lending to banks in the form of refinance facilities. Lowering (increasing) the reserve requirement, and , therefore, reducing (increasing) the demand for reserves has roughly the same impact as an expansionary (contractionary) open market operation, which increases (decreases) the supply of reserves creating downward (upward) pressure on interest rates. Similarly, another way in which central banks can influence the supply of reserves is through direct lending of reserves to banks. Central banks lend funds to bank at a policy rate, which usually act as the ceiling in the short-term market. Similarly, central banks absorb liquidity at a rate which acts as the floor for short-term market interest rates. This is important, since injecting liquidity at the ceiling rate would ensure that banks do not have access to these funds for arbitrage opportunities whereby they borrow from the central bank and deploy these funds in the market to earn higher interest rates. Similarly, liquidity absorption by the central bank has to be at the floor rate since deployment of funds with the central bank is free of credit and other risks. Typically, the objective of the central bank is to modulate liquidity conditions by pegging short-term interest rates within this corridor. While the above mechanism outlines how central banks can influence short-term interest rates by adjusting the quantity of bank reserves, the same objective can be achieved by picking on a particular short-term interest rate and then adjusting the supply of reserves commensurate with that rate. In many countries, this is achieved by targeting the overnight inter-bank lending rate and adjusting the level of reserves which would keep the inter-bank lending rate at the desired level. Thus, by influencing short-term interest rates, central banks can influence output and inflation in the economy, the ultimate objectives of monetary policy.

LIQUIDITY MANAGEMENT Although significant progress has been made in refining the liquidity management practices in India, several new challenges have emerged. First, during periods of abundant liquidity, the LAF window becomes a first resort for parking surplus funds by banks. Second, the Reserve Bank has developed the MSS as a sterilisation mechanism for arresting the liquidity impact of foreign exchange inflows of a more enduring nature, while the LAF continues to be used for managing liquidity at the margin. There is, however, no way of knowing ex-ante whether the liquidity situation is temporary or permanent. Furthermore, the MSS remains immobilized for the


entire period of its maturity. There is, therefore, a need to explore further instruments/options to undertake liquidity management, particularly in the context of a move to fuller capital account convertibility. Third, the Reserve Bank may not be in a position to conduct sterilisation operations indefinitely as its inventory of Government paper is limited. There is also a limit on MSS issuances. Furthermore, the Reserve Bank has withdrawn from primary market auctions of Government paper from April 1, 2006 in terms of provisions of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003. Fourth, the absence of a vibrant corporate debt market continues to impede further refinements in liquidity management in terms of eligible instruments as collaterals. In this context, it may be noted that State Development Loans, which are treated as eligible securities for collaterals under LAF operations effective April 3,2007, have widened the collateral base for LAF. Fifth, as many banks are now operating close to the prescribed levels of SLR securities, in case of liquidity tightness, banks may find it difficult to approach the LAF window in the absence of sufficient collateral securities. Sixth, while the Reserve Bank now holds the auctions twice on each working day to facilitate intra-day liquidity, a moral hazard issue arises as some market participants may not be actively managing their own liquidity in the wake of the Reserve Bank's market operations. The above issues need to be addressed, especially in the wake of a progressive move to fuller capital account convertibility. First, there is a need to further refine the system of assessing liquidity conditions, which calls for an improved framework of liquidity forecasting. The short span within which liquidity conditions have been changing by large amount has posed a major challenge for targeting short-term interest rates. The understanding of the fiscal position and the Government's cash balances as also the timing and extent of capital inflows assumes added significance. In this context, there may be a need to consider the regular release of information on Government cash balances held with the Reserve Bank. Second, progressively more weightage needs to be given to movements in international interest rates in view of increased capital mobility. Third, destabilizing large and sudden capital flows call for more flexible and swift monetary policy responses through small and gradual changes in policy rates, as has been practiced in recent years, as large changes can be disruptive. Fourth, open market operations (aMOs), apart from being used for modulating liquidity conditions, could also be used to correct any serious distortions in the yield curve. Finally, while the Reserve Bank has progressively deemphasized the use of reserve requirements as an instrument of monetary policy, given the present state of market development, it is necessary to retain the flexibility of using reserve requirements, as and when necessary. 9

Market Maken Market makers are entities who give a two-way quote in the market. This means that they are willing to buy and sell the shares in a particular company. The price on both the buy and sell sides are announced by them and this keeps on changing with conditions.

What is their role in the share market? The main role of the market maker is to create an opportunity for trading in shares and hence increase liquidity in the area. Any investor who wishes to buy or sell the shares would be sure that they would be able to transact at the prices that are available.

When does the demand for them peak? Earlier there were several market makers that were appointed for specific issues that hit the market but this has been rare in recent times. Usually, such demands come up when times are tough in the primary market and investor confidence is shaken.

9. The provisions of Section 3 of the Reserve Bank of India (Amendment) Act,2006 came into force effective April, 2007, which provides the necessary flexibility to the Reserve Bank in the use of the eRR.




How do they quote their price? There will be a difference between the buy price and sell price, which becomes the earning for the market maker. The price at which shares are sold to other investors would be slightly higher than the price at which they are bought. MONEY MARKET BEHAVIOUR AND MONETARY POLICY The effectiveness of monetary policy hinges on the ability of the monetary authority to communicate with the public in a clear and transparent manner. In this regard, the signalling of policy assumes key importance as it conveys the stance of monetary policy. While the signalling mechanisms in developed countries are quite robust, they tend to be weak in emerging market economies, particularly in the wake of market segmentation and absence of a well-defined transmission mechanism. Financial markets are typically characterized by asymmetric information, where some agents are better informed than others, that gets reflected in the problems of moral hazard and adverse selection. Seminal research on the economic theory of information has demonstrated that better-informed agents in a market could credibly "signal" (transmit) their information to less informed agents, so as to avoid some of the problems associated with adverse selection and improve the market outcome (Spence, 1973). The effectiveness of monetary policy is strongly related to the signalling of policy, the reason being that important variable such as the exchange rate and long-term interest rates reflect expectations about future monetary policy. Central banks usually consider, viz., (a) speeches of executives, (b) views about future inflation, (c) changes in policy instruments and (d) publication of the minutes of policy meetings. In particular, the announcement of an inflation forecast or a monetary condition's index (MCI) is used to signal central bank's intentions. In India, several measures have been initiated in the post-reform period to develop indirect instruments for transmitting policy signals. An important measure was the Introduction reactivation of the Bank Rate in April 1997 by initially linking it to all other rates, including Reserve Bank's refinance rates. The introduction of fixed rate reverse repo helped in creating an informal corridor in the money market with the reverse repo rate as the floor and the Bank Rate as the ceiling, which enabled the Reserve Bank to modulate the call rate within this informal corridor. Subsequently, the introduction of the Liquidity Adjustment Facility (LAF) from June 2000 facilitated the modulation of liquidity conditions and also short-term interest rates on a daily basis through the LAF window, while signalling the medium-term stance of policy through changes in the Bank Rate. An increase in the Bank Rate, as the signalling mechanism of policy stance over the medium-term, appears to have an instantaneous effect on call, government securities and forward premia because of the news effect. The long-term impact, however, gets muted as refinance at the Bank Rate is formula driven and not adequate to have a liquidity impact. In the stock market, hardening of the Bank Rate is construed as restrictive monetary policy, which dampens the market sentiment. The instantaneous impact of monetary policy signals on most financial market segments points towards increasing integration and sophistication of markets. Therefore, increasing reliance on direct instruments, greater market integration and technological innovations prima facie have improved the channels of communication between the Reserve Bank and the financial market and facilitated the conduct of monetary policy. The liberalisation of capital controls resulted in increased integration of the Indian economy with the global economy, however, posed new challenges and dilemmas for monetary management. These developments called for a greater emphasis on orderly conditions in financial markets for ensuring financial stability. In this context, the need for developed and well-integrated money market also assumes critical importance. In the emerging scenario of increasing integration of domestic and international markets, several issues have come to the fore. First, the absence of a developed term money market is one of the important gaps in the development of domestic financial markets. This is affecting the development of a money market yield curve, and, in tum, the development of the derivative market and the integration of the foreign exchange market and the


domestic currency market. Accordingly, greater efforts would be required to expedite the development of the term money market in the country, given the critical role of this market in the development of other segments. Well-developed term money market would, inter alia. contribute to the emergence of deep and vibrant markets for interest rate derivatives and provide useful inputs of market expectations for the conduct of monetary policy. Second, in view of the transformation of the money market into a pure inter-bank market, there may be a need to provide greater flexibility to banks and PDs to borrow or lend in this market, depending on the robustness of the risk management practices being followed by them. Prudential limits on borrowing and lending in the inter-bank market could be replaced, in stages, by a system where such limits are taken care of by the banks' own internal ALM framework Third, in view of sustained credit demand in recent years, there has been some revival of interest in InterBank Participation Certificates (IBPCs). IBPCs, by enabling banks to even out their short-term liquidity mismatches, provide greater degree of flexibility in banks' credit portfolios. Accordingly, the IBPC scheme needs a thorough review to improve asset liability management and liquidity management. This will also help in developing a market for credit risk transfer instruments. Fourth, the Reserve Bank in its operations would have to progressively give somewhat more weightage than hitherto to international interest rates in view of increased capital mobility. Fifth, potentially destabilising large and sudden capital flows may call for more flexible and swift monetary policy responses. Sixth, open market operations (OMO), apart from being used for modulating liquidity conditions, could also be used to correct any serious distortions in the yield curve. Seventh, although the Reserve Bank has progressively deemphasised reserve requirements as an instrument of monetary policy, given the present state of market development, it may be necessary to keep the option of flexible use of reserve requirements. Finally, as the banking system is moving to maintenance of SLR securities close to the prescribed minimum levels, liquidity provision would become more difficult unless the instrument set is widened to facilitate market participants to even out liquidity mismatches. MONEY MARKET REFORMS A major objective of reforms is to develop the money market eliminate segmentation and smoothen the process of transmission, easing the liquidity management process and making resource allocation process more efficient. Since the early 1990s, the RBI and the government have taken various measures to strengthen and improving depth and liquidity in the money market. The reforms also emphasised on improving the transparency and efficiency of the money market. The key reform measures undertaken are briefly presented below: •

A ceiling of 10 per cent on call money rates imposed by the Indian Banks Association was withdrawn in 1989.

Initially, the participation in the call market was gradually widened by including non-banks, such as, financial institutions, non-banking finance companies, primary/satellite dealers, mutual funds, corporates (through primary dealers), etc. The process of transformation of call money market to a pure interbank market commenced effective May 2001.

The 182-day treasury bills were introduced effective November 1986, followed subsequently by phasing out of on-tap treasury bills, introduction of auctioning system in 91 day treasury bills since January 1993, and introduction of 14-day and 364-day treasury bills. The system of ad hoc treasury bills (with a fixed 4.6 per cent interest rate since July 1974), which were issued by the Central Government to the Reserve Bank, was abolished effective April 1997. Currently only the 91-day and 364-day treasury bills exist.

The Discount and Finance House of India (DFHI) was set up in April 1988, and was allowed to participate in the call/notice money market both as a borrower and lender commencing from July 1988.

Several new financial instruments were introduced, such as inter-bank participation certificates (1988), certificates of deposit (June 1989), commercial paper (January 1990) and repos (December 1992).




Derivative products like forward rate agreements and interest rate swaps were introduced in July 1999 to enable banks, FIs and PDs to hedge interest rate risks.

A full-fledged Liquidity Adjustment Facility was introduced on June 5,2000 with a view to modulating short-term liquidity under diverse market conditions.

With a view to adopting the sound risk management procedures and eliminating counter-party risk, the Clearing Corporation of India Ltd. was set up on February 15,2002. The CCIL acts as a central counter-party to all trades involving foreign exchange, government securities and other debt instruments routed through it and guarantees their settlement.

The segment refinance facility for banks is gradually being phased out. Collateralised Borrowing and Lending Obligations (CBLO) was launced by CCIC in January, 2003.

Institutionalisation of the Clearning Corporation of India Limited (CCIL) as a central counter party.

Issuance norms have been modified to encourage wider participation while strengthening the transmission of policy signals.

Upgradation of payment system technologies.

CONCLUSION The money market, which is the market for short-term funds with maturity ranging from overnight to one year, providers an avenue for the central bank intervention in influencing both quantum and cost of liqudity in the financial system, thereby transmitting monetary policy impulses to the real economy. The central bank strives to align money markets rates with the key policy rate. Ensuring stability in the money market is critical Since the early 1990s, the money market has undergone a significant transformation is terms of instruments, participants and technological infrastructure. Various reform measures have resulted in a relatively deep, liquid and vibrant money market. The RBI's approach has been to foster balanced development of the money market, introduce new innovative instruments and make the existing instruments more flexible, reduce dependence of participants on uncollateralised exposures, facilitate price discovery in the short-end and upgrade the payment system infrastructure. The RBIs stratey has focused on instituting full-fledged liquidity Adjustment facility, developing infrastructure, promoting transparency and initiating various measures pertaing to instruments for non-bank participants. These measures have helped in containing volatality in the 'money market, improved significantly the depth and liqudity in the market, and also improved the signalling mechanism of monetary policy while ensuring financial stability. However, there is a need to develop the money market further, particularly in the context of a move towards fuller capital account convertibility. Notwithstanding the considerable progress made so far, there is a need to develop the money market further, particularly in the context of a move towards fuller capital account convertibility. Further development of the money market participants which would enable banks to evolve appropriate prudential limits on their money exposures from their internal control systems. In order to develop the term money market, participants need to take a long-term view on interest rates. Furthermore, there is a need to expand the eligible set of underlying collateral securities for repo transactions. This would not only facilitate liquidity management but also promote the development of underlying debt instruments. Finally, liquidity forecasting techniques need to be further refined for proper assessment of liquidity conditions by the Reserve Bank. This would facilitate finer changes in the operating procedures of liquidity management and enable the Reserve Bank to flexibly meet the emerging challenges. As these developments take place, it needs to be understood that monetary will continue to be conducted in and intermediate regime that will have to respond creatively and carefully to the emerging and evolving monetary and macroeconomic conditions, both domestic and global. In India, although the ultimate goals of monetary policy, viz., growth and price stability, have remained unchanged over the yyars, the Reserve Bank has modified its operational and intermediate objectives of monetary policy several times in response to changes in the economic and financial environment. For instance, in the mid-


1980s, the Reserve Bank formally adopted monetary targeting with feedback as a nominal anchor to fight inflation, partly induced by the large-scale monetisation of fiscal deficits. The operating procedure in this regime was modulation of bank reserves by varying reserve requirements. In order to meet reserve requirements, banks borrowed primarily from the inter-bank (call money) market. Hence, these transactions were reflective of the overall liquidity in the system. Accordingly, the Reserve Bank focussed on the money market, in particular, the call money market by using various direct instruments of money control to signal the policy stance consistent with the overall objectives of achieving growth and price stability. As interest rates were regulated, monetary management was undertaken mainly through changes in the Cash Reserve Ratio (CRR), which was used to influence indirectly the marginal cost of borrowing by having an initial impact on the call money market. Accordingly, the Reserve Bank's emphasis has been on encouraging migration towards the collateralized segments and developing derivatives for hedging market risks. This has been complemented by the institutionalization of CCIL as a central counter party to mitigate the settlement risk. The upgradation of payment technologies has further enabled market participants to improve their asset liability management. Cumulatively, these measures have helped in containing volatility in the money market, thereby improving the signalling mechanism of monetary policy while ensuring financial stability. In the money market, the policy thrust of the Reserve Bank would continue to encourage the development of collateralized market, broad-base the pool of· securities to act as collateral for repo and CBLO markets and provide avenues for better risk management with further improvements in the ALM framework. In the Govemment securities market, in the FRBM environment short-selling with appropriate safeguards, developing "When issued' market, active consolidation and ensuring effective debt management are likely to be some of the challenges facing the Reserve Bank. In the forex market, further liberalization of the capital account in line with CACs customer recommendations could pose fresh challenges to the Reserve Bank. Greater attention may have to be paid on aspects such as upgrading risk management systems, derivatives accounting standards, customer suitability and appropriateness standards and improve -disclosure. Their native origin is mainly responsible for some of their unique features, which have few parallels among similar agencies in Europe. The money market provides a focal point for the central bank's operations in influencing liquidity and thereby transmitting monetary policy impulses. The Reserve Bank of India (RBI) has been playing a proactive role in developing the money market for ensuring stability, avoiding volatility, minimizing default risk and achieving a balanced development of various segments. In the process, the RBI has introduced new instruments, broadened the participants' base and strengthened institutional infrastructure. The policy thrust given to the growth of the collateralised segment has improved options for liquidity management while reducing risks. Likewise, developments in institutional and technological infrastructure have also helped in improving transparency, facilitating price discovery process and providing avenues for better liquidity and risk management.







Major Participants






Federal Funds

Mostly overnight (there are also long -term for few weeks)

Banks & other depository institutions.

Discount Window

Usually overnight

Banks & other depository institutions *.

Certificates of Deposit

Mostly 1-12 months (some have 5 years or more)

Banks(money centre banks & large regional banks)*

Negotiable Certificates of Deposit

1-12 months

Well capitalized banks.

Eurodollar CDs

Mostly 3-6 months (some have long-term)

Banks (foreign branches of US banks or foreign banks located abroad) *. These are sold to brokers, investment banks, institutional investors, & large corporations.

Eurodollar Time Deposits

Overnight, I-week, 1-6 months & longer


Repurchase Agreements

Short-term: overnight or a few days. Longer-term: 1,2,3weeks & 1,2,3,6-months.

Banks, securities dealers, nonfinancial corporations & Governments (principal Participants).

Treasury Bills

4,13 & 26-weeks (52-weeks bill suspended in 2001)

US Government & primary dealers.

Municipal Notes

30-days to I-year

StateILocal Governments.

Commercial Paper

Mostly 270-days Average 30-days

Non-financial & financial businesses (corporations & foreign Governments) *.

Banker's Acceptances

Up to 270-days Non-financial & financial businesses (firms involved in imports & exports)*.

Government-Sponsored Enterprise Securities: - Discount Notes - Bonds

30 to 360-daysmore than I-year

Shares in Money Market Instruments Money Market mutual funds

Less than 90-days

• Principal borrower.

Farm Credit System, Federal Home Loan Bank System & Federal National Mortgage association *.

Average: 318-days (1-1044 days) 3-months

Money market mutual funds & Local Government




2 - Local Government Investment pools Futures Contracts



Exercise at strike price on or before prearranged expiration date.

Investment Pools.

Exchange of interest streames over the lives of underlying debt issues.

Dealers, banks & non-banks.

Dealers & banks·




Reserves AveOlging

I-month between MPC decision dates

Standing Lending & Deposit Facilities


OMOs:Repurchase Agreements (Gilts, HM Government non-sterling marketable debt, Sterling Treasury Bills, Bank of England Euro Bills & Euro notes, eligible bank & local authority bills, Sterling denominated securities issued by European Economic Area, Central Governments & Interna-tional Institutions).

I-week at Bank Rate; 3,6,9, I2-months at market rates

Treasury Bills

Upto I-year (some have maturity over I-year)

Dealers, banks & non-banks. 43 banks & building societies.

More than 60 UK banks & building societies. 43 UK banks, building societies & securities dealers.

Issued by the government.

Bills of Exchange

Issued by banks.

Certificates of deposit

Issued by building societies & traded by banks & discount houses.

Commercial Paper - Bank acceptance - Trade paper

Issued by industry Traders

Main refinancing operations I-week Long-term refinancing operations (Teir-l& Tier-2 assets)

Counterparties: eligible credit institutions.

3-months Eligible credit institutions.

Fine-tuning/structural reverse transactions (Tier-l & Tier-2 assets)


Fine tuning/structural outright purchase (only Tier-l assets)


Non- standardised Eligible credit institutions.

• Principal borrower. Blenk D, et al. (2001).

@ Source:

Overnight Less than 12-months

Eligible credit institutions.







Eligible credit institutions. Fine-tuning foreign exchange swap Marginal lending facility (Tier-l & Tier-2 assets)

overnight Eligible credit institutions.

Structural issuance of debt securities Deposit facility Japan

Call money market short-term securities: - Commercial paper - Certificates of deposit - Treasury Bills

I-week to 6-months Counterparties: Banks, securities companies, securities finance comp-anies, money market brokers (Tanshi companies).

Repurchase Agreements (Eligible collateral: Government bonds/bills, Government guaranteed bonds, municipal bonds, & foreign government bonds, commercial bills, corporate bonds & asset backed securities)

Citybanks (borrowers), regional banks (lenders), investment trusts, trust banks, regional banks, Keito, life insurance companies, specialized money market brokers.

Non-collateralised market

Australia Outright transactions Government Securities - Treasury notes - Treasury bonds - Treasury indexed bonds

Semi-government Securities: - Semi-government Promissory notes - Semi-government Bonds - Semi-government Indexed Bonds Repurchase Agreements Government Securities - Treasurry Notes - Treasury Bonds - Treasury Indexed Bonds Semi-Government Securities - Semi-Government Promissory Notes - Semi-Government Bonds - Semi-Government Indexed Bonds

Of less than 18months Of less than 18months

Of less than 18months Of less than 18months Of less than 18months

Issued by Governments.


Issued by State government & Territory Central Borrowing Authorities.

Issued by Governments.


Issued by the State Government and Territory Central Borrowing Authorities.






Domestic Securities

Issued by the foreign Sovereigns, Supranationals & Government Agency Securities.

Accepted Bills of Exchange

Issued by eligible banks.

Negotiable Certificates of Deposit

Issued by eligible banks.

Treasury Bills

I-month to I-year

Money market strips

Up to IS-months

Government Guaranteed Commercial Paper

I-month to I-year

Treasury Bills and Promissory Notes

I-month to I-year

Banker's Acceptances

I-month to I-year

Commercial paper



Refinancing Mechanisms: - Intra-day loans - Overnight loans - Lombard loans - Loans against collateral (Promissory Notes) and Guarantees Repo operations: - Government Bonds - Federal Government Bills - Bank of Russia Bonds

Issued by the Government of Canada. Issued by the Crown Corporati- ons such as Canadian Wheat Board, Federal Business Development Bank, etc. Issued by the Provincial Governments.

I-month to I-year

Issued by the corporations (with an unconditional guarantee of a major Canadian chartered bank).

I-working day 7 or 14-days

Major corporations.

Up to ISO-days

Financially sound credit institutions complying with the regulatory requirements.

Overnight,3&6-months 6-months 3 to 6 months

Credit institutions having account in 22 Bank of Russia regional branches.

Securities accepted as collateral for Bank of Russia loans: - Regional Government Bonds - Credit institution's bonds - Mortgage backed bonds - Resident corporate bonds - Bonds of international financial institutions Currency swaps Deposit operations:- Deposit operations at fixed rates - Deposit operations at auction rates

Issued by the Government of Canada.

Daily (with overnight & 1week) Weekly (4-weeks & 3months)



1 China

2 Inter-bank lending instruments: Repurchase Agreements or outright basis OMOs: - Government Securities - Negotiable Certificates of Deposit - Commercial Paper

3 1,7,20,30,60,90 & 120 days


Repurchase Operations: - Government Bonds - Treasury Bills - Financial Institution Development Fund (FIDF) Bonds - Government Guaranteed State Enterprises Bonds

Banks, settlement non-bank credit institutions & non-bank credit institutions conducting deposit & lending operations. Participants in OMOs: Central Bank, large domestic commercial banks & other fmancial institu- tions approved by PBC.

Participants in inter-bank market: All authorized commercial banks, trust & investment corporations, finan- cialleasing companies, finance companies of business conglomerates, urban credit co-operatives & rural credit co-operatives, securities compa-nies, insurance companies & financing intermediaries.

Discount Window Eligible bills: - Banker's Acceptance - Trade Acceptances - Promissory Notes



1, 7, I4-days, 1,2,3 & 6-months

60 members: commercial banks, finance companies, finance & securities companies

& specialized financial institutions, FIDF.

Bilateral Repurchase Operations


Bilateral primary dealers.

Bank of Thailand (BOn Bonds

I2-months or less

Commercial banks, specialized financial institutions, finance companies, finance & securities companies, govern-ment pension fund, provident funds, mutual funds, social security office, life & nonlife insurance companies & other institutions having current account at BOT.

Foreign Exchange Swaps

Overnight up to I-year (typically concentrated on the short endsup to 3-month)

Both onshore & offshore commercial banks.

End-of-day Liquidity Window


Bank of Indonesia Certificates (SBI)

I-month & 3-months

Fasilitas Bank Indonesia (FASBI) deposit facility.

1 to I4-days

SBI Repurchase Agree ments phased out in Aug. 2005 & replaced by FineTune Expansion (PTE)

1 to I4-days

Commercial banks, finance companies, finance and securities companies and specialized financial institutions. Banks







SWBI or Wadiah Certificate (SBI using Sharia principles) Malaysia


Malaysian Government Securities

Treasury Bills

91,182, 364-days

Repurchase Agreements (Repos) (The securities normally used in repo transactions are Malaysian Government Securities, Banker's Acceptances & Negotiable Certificates of Deposits, Treasury Bills, Cagamas Bonds, Central Bank Certificates, other trade bills, etc.)

Overnight to a few months

Bank Negara Bills


Bank Negara Monetary Notes

Up to 3-years

Direct borrowing

Up to 6-months (average: 20-30 days)

Negotiable Certificates of Deposit

In multiples of 3-months, up to 5-years

Banker's Acceptances

30 to 200-days

Business enterprises, banks, discount houses, statutory authorities, savings & pension funds, the Government & individuals.

Call money

Overnight, 3, 5,7,9,11 & 15days loans.

Commercial banks & merchant banks.

Repo (Securities eligible for OMOs: Government Bond, Government Guaranteed Bonds & Land Develop- ment Bonds)

South Africa

Security institutions, banking system & the employees provident fund.

Commercial banks, merchant banks, finance companies & discount houses.

15 to 91-days

Treasury bills Market Stabilization Bonds

Commercial banks, discount houses, principal dealers & finance companies.


Liquidity adjustment loans

14 -days to 2 years & 546days

Intra-day Overdrafts.

Not more than I-month Close of business day.

Commercial banks, specialized banks, regional banks, investment & finance companies, merchant banking corporations, investment trust companies, insurance companies, the Korea Securities Finance Corporation, the Credit Insurance fund & foreign bank branches in Korea. Select financial institutions.

Select financial institutions.






Negotiable Certificates of Deposit


Applicant banks.

Commercial Paper

Select commercial banks, special banks, local banks & foreign banks. Banks

Treasury Bills

Eligible non-finance companies, investment and finance companies and merchant banking corporations. 91-days & 182-days

Negotiable Certificates of Deposit

Up to 3-years Primary dealers.

Banker's Acceptances Up to 3-months & in some cases longer Repurchase Agreements

Banks, mining houses, pension funds, insurance companies, commercial ccoupanies, municipal authoritie~, public corporations & individuals.

1 to 7-days Reserve Bank Debentures. 28 to 56-days

Merchant banks & commercial banks.

Foreign Currency Swaps Reserve bank & other financial institutions.

Singapore Reposlreverse repos Singapore Government Securities

End-of-day Facility

3-months to 15 years with 3month & I-year benchmarks for T-Bills & 2, 5, 7, 10 & 15-year benchmark for bonds.


Forex Swaps & Reverse Swaps.



Primary dealers, secondary dealers covering banks, merchant banks, & stock broking firms, finance companies, insurance companies, corporations & individuals. (In the case of the repo, only PDs).


Source: Websites of respective central banks. Report on Currency and Finance, 2005-06.



Chapter INTRODUCTION The Call1Notice money market which formed the core segment of the Indian money market for many decades. The banks were the main players for a long time. The call money market plays a crucial role in liquidity management. Prior to the rnid-1980s. the market participants heavily depended on the Call money market for meeting their funding requirements. The reforms in the called money market commerced in 1988 of various measures, new markets, new instruments have been introduce to ensure orderly market behaviour. Even then, the call money market has been playing a active role in the economy. Against the above backdrop, this chapter discusser the development in the call money market. SEGMENTSOF~ONEY~RKET

The money market is the market in which short-term funds are borrowed and lent. The money market is not a single homogeneous one but is composed of several submarkets, each one dealing in different types of short-term credits. The most important components of the money market are: (i) (ii)


Call money market; Acceptance market; Bill market; (a) Treasury bills market (b) Commercial bills market (c) Commercial Paper (CP) market


Repo Market


Term money market


Certificate of deposits market


(viii) (ix)

Collateralised Borrowing and Lending Oblisation (CBLO) Government securities market and Gilt-edged market.


The call money market, which deals in overnight funds, is a key segment of the money market in India. Funds for 2-14 days are termed as notice money. Various reform measures initiated in this segment have resulted in more orderly conditions and increased liquidity. The call money market refers to the market for extremely short-period loans. Bill brokers (Le., those who buy bills) and dealers in the stock exchange require financial accommodation for short periods to finance their customers' trading on margin and their own holdings of securities and this financial accommodation is provided by the banks. The money advanced by banks to bill brokers and stock exchange dealers is lent up to seven days, but more often it is lent from day-to-day or for overnight only. These loans are commonly known as call loans



or call money since the bank can call them at the shortest possible notice. Call loans are found useful by banks for more than one reason. First of all, since they can be converted to cash at any time, they are almost like cash and banks consider their money at call and short notice as their secondary cash reserves. Secondly, unlike cash, they bring some income for the banks. The call money market, composed of commercial banks as lender and the stock exchange brokers and dealers as borrowers, has always been a very important segment of the money market. The Indian call money market is currently undergoing a historic transformation. It is moving from acting as a mechanism for ensuring liquidity amongst banks to performing a more dynamic and ac!ive role in the Indian money market. In the recent past extremely volatile conditions prevailed in this market, seriously jeopardising the levels of profitability of many banks. Before the causes for this volatility are identified, it would be useful to take a quick look at the evolution of the market to its present stage. HIsTORICAL PERsPECTIVE The Indian call money market is about seventy years old. Earlier stages of its evolution were characterised by the presence of individuals in the market as participants. Call money operations used to be the foreign exchange banks' original mainstay and the Indian banks' participation was minimal. Indian banks have been actively participating in the market only since 1956. In 1970, the monetary authorities permitted the LIC and the UTI to operate in the call money market. With their entry, the call money market no lunger remained the exclusive preserve of banks and became an inter-institutional call money market. The State Bank Group entered the call money market as late as October 1970. By this time, individuals had ceased to operate in the market: Brokers were very active in the call money market ti1l1977. Towards the end of 1977, the Reserve Bank suddenly stopped the participation of brokers in the call money market. At first, the brokers continued without brokerage in the hope that their role will be restored. Banks initially felt helpless without brokers and tried to persuade the Reserve Bank to allow the participation of the brokers. Finally, despite representations by banks and brokers, the Reserve Bank insisted on eliminating brokers from the call money market. During 1973, suddenly, the rate in the call money market shot up to 39%, reflecting acute shortage of funds, excessive credit squeeze and financial tightness everywhere. It was at this stage that the Indian Banks' Association (IBA) decided to step in and fixed a ceiling of 15% on the call money rate. This persuasive and forceful action on the part of the IBA with moral support from the Reserve Bank ensured enforcement of voluntary ceiling and self-discipline among the participants, though from time to time discipline tended to burst at critical times like yearly closing of accounts or peak season pressures. But by and large, the IBA's discipline and good sense of banks survived and the IBA was also able to bring down the ceiling progressively from 15% in December 1973 to 10% in 1978 and it worked almost in this manner for a decade. The situation, however, began to change dramatically since the mid-1980s. Banks faced with a slower rate of deposit growth on the one hand and restrictive credit policy of the Reserve Bank on the other, experienced a growing pressure on their profitability and tight conditions prevailed in the money market. The result was that the IBA imposed ceiling on the call money rates which was observed more in breach. The lending banks, while officially sticking to the ceiling rate, sought compensation elsewhere, particularly in ready forward deals in government securities. It was against this background that the Vaghul Working Group on Money markets recommended freeing of call money rates for inter-bank transactions. The Reserve Bank responded promptly, initially by exempting the operations of the DFHI in the call money market from the provisions of the ceiling rate of interest and from May 1, 1989, completely withdrawing the ceiling on interest rates on call/notice money. The Reserve Bank, in fact, went a step further and permitted other Financial Institutions (FIs) to operate in the call money market as lenders with a view to broadening the market. Establishment of the DFHI in April 1988 added a new dimension to the call money market. The latest innovation has been the Reserve Bank's decision to permit banks to establish Money Market Mutual Funds (MMMFs) through which cash rich corporates and even individuals could operate in the call money market.



The Indian call money market has thus undergone a virtual metamorphosis in recent years. The call money market during the 1990s witnessed orderly conditions barring a few episodes of volatility (Chart 1). The call rates first came under pressure in May 1992 when they touched a peak of 35.3 per cent, essentially reflecting liquidity tightness due to high levels of statutory preemptions and withdrawal of all refinance facilities except for export credit refinance. After witnessing tranquil conditions during July 1992-December 1994, the call money market came under pressure again during 1995-96. The call rate touched a peak of around 35.0 per cent in November 1995, largely mirroring turbulence in the foreign exchange market. To stabilise the market, the Reserve Bank injected liquidity through reverse repos, enhanced banks' refinance facilities against government securities and reduced the CRR. The call rate softened to a single digit level thereafter till December 1997. However, the call rate hardened again and touched a high of around 29 per cent, in January 1998, reflecting the mopping up of money market liquidity by the Reserve Bank to squelch the pressure in the foreign exchange market. During 999-2000, the inter-bank call money rates ruled steady within a narrow range, excepting few bouts of volatility, primarily attributable to the unanticipated demand for reserves by commercial banks.

40 35 30 C 25



20 15

10 5 O~T-~~~~~~~~~~~~~~-'

~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~

9 9

~ ~

~~~8~~~~~g~~~~~8~ Chart 5.1 Behaviour of Call Rates (Monthly Average)

Thus, excepting a few episodes of volatility conditions in the call money market remained stable in the 1990s. The full-fledged Liquidity Adjustment Facility (LAP), which was introduced on June 5, 2000, with a view to modulating short-term liquidity under diverse market conditions, has emerged as an effective instrument to provide a corridor for the overnight call rate movement. This has resulted in stability and orderly market conditions through clear signaling (Chart 2). The LAF combined with strategic open market operations (OMOs) has since been used to signal the monetary stance by removing shortfalls and excesses of liquidity in the system so as to keep the short-term interest rates reasonably stable. 16.5 LAF Stage I


LAF Stage"

~ 12.5 u (j) 10.5


a. 8.5 6.5 4.5


~ ~ ~ ~ 9 0 9 9 9 9 99 ..,c:: ~8 00Q) If.c «a ..,c:: ~8 00CD If.c «a ~


9999~ ..,c:: ~8 ~ If.c ~


Chart 5.2 Evolution of Liquidity Adjustment Facility



The level of weighted average call money borrowing rates declined from around 7.5 per cent in April 2001 to 5.7 per cent in February 2003. The LAF has also enabled a reduction in the volatility in call rates (measured by coefficient of variation) from 85.7 per cent during 1997-98 to 7.6 per cent during 2002-03 so far (April to February). During the first half of the 1990s, volumes in the call money market at Mumbai remained more or less steady. However, the turnover increased sharply and fluctuated widely during the last few years. The average daily turnover rose from Rs. 23,221 crore in 1999-2000 to Rs. 30,320 crore in 2000-01 and further to Rs 35,144 crore in 2001-02, before falling to Rs. 29,857 crore in 2002-03 so far (up to February 2003). The turnover in the callI notice market should also be seen alongside the repo amount accepted by the Reserve Bank on a daily basis where one can observe substantial volatility. LAF has been effective in reducing the volatility in the call notice money market. While these developments are worth a welcome, what is causing concern in the minds of the bankers is the growing volatility of the call money rates. Immediately after the withdrawal of the ceiling from May 1, 1989, particularly during the month of May 1989, the rates were less than 10 per cent for just 3 days, between 11 and 20 per cent for 12 days, between 21 and 30 per cent for 3 days and between 31 per cent and 40 per cent for 6 days. The lowest rate was 4 per cent in the first week of May and the highest rate was 40 per cent in the last complete week of that month. The trend continued in the following months and relatively steady conditions became an exception rather than the rule. After years of the regime, the somewhat regimented interest rates (with a ceiling of 10 per cent), the freedom given to determine the rate without any ceiling or floor caused problems for the market participants to adjust to this new reality. The call market where oligopolistic conditions were then prevalent with few big 40 40








25- 1: 25


t; 15000




.. If

!10000 ::J



.4(.,.,.·.... 151f 10



__ ,,,~', ..... 5000


CDs ••• , CPs -

Chart 5.3

Call Rate (right scale)

_ Call Rale, -

CD Rate -

8000 7000 6000 5000 4000 3000 2000 1000

CP Rate ••• 91-day T-Bills Rate

200000 180000 160000 140000 !II 120000 l5 100000 t; 80000 60000 40000 20000



o 0 888888oooooo~~~~~~8 @@@@@@@@@@@@@@@@@@@ fa 1iI ~"5 g-~ fa 1iI ~"5 g-~ a 1iI ~"5 g-~ fa ~~~~wz~~~~wz~~~~wz~

~~~~~~~~~~~~~~~~~~~ ~~~ ~~~~~ ~~rrr rrr

Number of Contracts • • National Amount Outstanding (right scale)

Chart 5.5


Chart 5.4


lenders dominating the market, smaller borrowing banks were the worst sufferers and doubts were often raised whether withdrawal of the ceiling was a step in the right direction. With the entry of many PIs as lenders, the market is no longer oligopolistic today as it was then. OPERATIONS IN CALL MARKET Borrowers and lenders in a call market contact each other over telephone. Hence, it is basically over-thetelephone market. After negotiations over the phone, the borrowers and lenders arrive at a deal specifying the amount of loan and the rate of interest. After the deal is over, the lender issues FBL cheque in favour of the borrower. The borrower in tum issues call money borrowing receipt. When the loan is repaid with interest, the lender returns the duly discharged receipt. Instead of negotiating the deal directly, it can be routed through the Discount and Finance House of India (DFHI). The borrowers and lenders inform the DFHI about their fund requirement and availability at a specified rate of interest. Once the deal is confirmed, the Deal Settlement Advice is exchanged. In case the DFHI borrows, it issues a call deposit receipt to the lender and receives RBI cheque for the money borrowed. The reverse is taking place in the case of lendings by the DFHI. The duly discharged call deposit receipt is surrendered at the time of settlement. Call loans can be renewed upto a maximum period of 14 days only and such renewals are recorded on the back of the deposit receipt by the borrower.

Call Loan Market Transactions and Participants In India, call loans are given for the following purposes: (i)

To commercial banks to meet large payments, large remittances, to maintain liquidity with the RBI and so on.


To the stock brokers and speculators to deal in stock exchanges and bullion markets.


To the bill market for meeting matured bills.


To the Discount and Finance House of India and the Securities Trading Corporation of India to activate the call market.


To individuals of very high status for trade purposes to save interest on O.D. or cash credit.

The participants in this market can be classified into two categories viz. (i)

Those permitted to act as both lenders and borrowers of call loans.


Those permitted to act only as lenders in the market.

CALL MONEY RATES The inter-bank call money rates zoomed to 85 per cent levels on 01-11-1995 after opening at 40.5 - 41.75 per cent levels. The volatility in call money rates relatively depends on the liquidity in the market. The recent interventions in the forex markets by the RBI also seem to have sucked a considerable amount of liquidity out of the market. The RBI and the Securities Trading Corporations of India (STCI) has pumped in Rs. 500 and Rs. 250 crores each into the call money market. The Securities Trading Corporation ofIndia Limited was set up in May 1994 by the Reserve Bank ofIndia (RBI) jointly with public sector banks and all-India financial institutions for developing the market infrastructure to foster the growth of an active secondary market in Government securities and public sector bonds. ' The STCI is a leading participant in the call money market. The primary function of the STCI is to regulate the call rates during volatile situation. The business of dealing in Government dated fixed income securities is somewhat risky as even a slight upward movement in yield curve could result in significant depreciation in the value of the portfolio. Similarly, a rise in call rates could significantly raise the funding costs. The callI notice money market essentially serves the purpose of equilibrating the short-term liquidity position of banks and other participants. The turnover in the call1notice money market depends on the amount




of surplus funds available with some participants and the requirements of funds by some other participants. Over the years, the number of participants in the market has gradually increased to include banks and Primary Dealers both as lenders and borrowers, and select mutual funds, insurance companies, development financial institutions and corporate through Primary Dealers (as lenders). The supply of and demand for funds in the market arise on account of (i) compliance with cash reserve requirement of banks as mandated by the Reserve Bank, (ii) as a funding source to build up assets, (iii) temporary surpluses that are avaihible with lenders, (iv) foreign exchange flows and (v) seasonal factors such as festival, election, harvesting, advance tax payments, etc. Over the years, a few banks tended to be overly exposed to the call/notice money market. Such banks relied excessively on the call money market for carrying out banking operations and long-term as secretion. The Narasimham Committee II recommended that there must be clearly defined prudent limits beyond which banks should not be allowed to rely on the calli notice money market and that access to this market should essentially be for meeting unforeseen mismatches and not as regular means of financing banks' lending operations. With the progressive regulations, asset liability management system was put in place, which kept the mismatches in cash flows in the 1-28 days bucket under check. As part of streamlining the Liquidity Adjustment Facility and improving the transmission channel of monetary policy, the phasing out of non-bank participants from the call money market commenced from May 2001. Furthermore, recognizing that building up of substantial exposure to the call/notice money market relative to the balance-sheet size by some participants on a continuous basis has the potential not only for default and the consequent systemic instability but also impeding other segments of the money markets, participants are now operations within limits on both lending and borrowing operations. Thus, the call/notice money market is evolving as a pure inter-bank market with ALM discipline for participants and prudential limits for borrowing and lending. With the establishment of the Clearing Corporation and the enhanced liquidity in the repo market both in government and non-government securities, it is envisaged that eventually both the call market and the repo market combined with other money market instruments, would constitute an integrated market for equilibrating short-term funds for both banks and non-banks.

DEVELOPMENTS IN THE SHORT-TERM MONEY MARKET A freely operating money market is a sensitive barometer of current conditions in the financial markets and, ideally, it should provide for market clearing of short-term surpluses and deficits. In a series of measures since 1987, a number of liberalisations have been made to develop the money market. Briefly, these are:' (i) Introduction of 182-Day Treasury Bills on an auction basis, (ii) Introduction of two new money market instruments, viz., Certificates of Deposits (CD) and Commercial Paper (CP). While the CD provides for a market-determined rate of return on bulk deposits, the CP enables prime borrowers to raise short-term funds from the market. The scope and eligibility criteria in respect of these instruments have also been liberalised in successive credit policy pronouncements of the RBI, (iii) Rationalisation of the bill discount rates and stipulations as to the use of bills for credit purchases and credit sales by large bank borrowers, (iv) Introduction of two kinds of Inter-Bank Participation Certificates (IBPCs) with risk and without risk, (v) Removal of interest rate ceilings on call and notice money, inter-bank term money, inter-bank participations without risk and rediscounting of commercial bills, (vi) Setting up of the Discount and Finance House of India (DFHI) to develop an active secondary market in money market instruments, which has very recently been allowed to engage in secondary trading in government securities, and (vii) Enlarging the scope of the call money market, where, apart from the LIC and UTI, the GIC, IDB! and NABARD were allowed as lenders from May 1990, to be followed in October that year by all institutions participating in the bills market. Steps were also taken to contain the spiralling of money market rates which remain free and have to bear the burden of equilibrating the system. Developments in the inter-bank call money market have always been causing concern for the bankers and RBI, as the call money rates of interest during liquidity crisis has been rising to astronomical level, though official ceiling on call money rate was prescribed. This concern was posing a challenge for a long time and an effective solution was being evaded. With the recent new measures introduced to activate the money market, a



Over the last few days, developments in the inter-bank call money market have dominated the headlines on the front pages of most newspapers. What is this market? Here is a handy primer on the market: What is the inter-bank call market? : The inter-bank call market is part of the domestic money market from where banks borrow and lend on a daily basis. The daily turnover of funds in this market is currently estimated at Rs. 8,000 crore. Who can participate in this market? : All scheduled commercial banks (private sector, public sector and cooperative banks), financial institutions (term-lending institutions, insurance companies) and mutual funds can participate in this market. Non-banking finance companies, however, are not allowed to participate in this market as yet. Participants are split into two categories. The first comprises those who can both borrow and lend in this market, and the second, those who can lend but borrow. Only the banks can do both. Why does a bank borrow in the call market?: Banks borrow in the call market to meet any temporary shortfall in funds on any given day. There are mainly two reasons why a bank may face such a shortfall. Banks normally lend out of the deposits that they mobilise. But there are temporary gaps, or mismatches. The call money market is used to manage these gaps. The second reason is to meet the cash reserve ratio (CRR) which is the cash reserves it must maintain with the Reserve Bank of India, to meet daily cash needs of the banks' clientele. In India, banks have to keep 14.5 per cent of all their borrowings from the public (in the form of savings and term deposits) and other banks with the RBI. The CRR is calculated on the basis of the bank's borrowings or net time and demand liabilities (NDTL), broadly its deposit base, every alternate Friday. This day is also called the reporting Friday, on which the banks report their positions to the RBI. So, the CRR for the current fortnight is calculated at 14.5 per cent of the NDTL as of the last Friday. For how long can a bank borrow these funds? : Technically, the call money market is an overnight money market. But a bank can borrow these funds for between one day upto 14 days. Normally, funds are borrowed for one day, and up to three days on weekends. How is the rate of interest paid? : The rate of interest is calculated on a daily basis; but the rate quoted in the market is an annualised one. Once the deal is struck the funds are immediately available to the borrowing bank and is returned with interest the next day. The funds are lent and paid back through a banker's pay order which is cleared by the special high value banker's clearing cell in the RBI. Can the RBI lend in the call market? What does intervention by the central bank mean? : The RBI is the market regulator and cannot lend or borrow funds in the call market. However, as a regulator, it can intervene in the market as it did when rates go through the roof. It intervenes in the market through two market intermediaries - the Securities Trading Corporation of India and Discount Finance House of India. The STCI lends funds against the govefQment securities that a bank holds with an offer to sell back the security (called repurchases or repos), while the DFHI lends funds that it receives from the central bank against repos of certain securities specified as eligible for theme. The RBI also allows banks to rediscount proceeds of export bills of exchange. Why do rates fluctuate? What does this indicate? : The rates fluctuate in the market depending on the demand and supply of money in the market. High rates indicate a tightness of liquidity in the financial system, while low rates indicate an easy liquidity position. In India, rates in the call market are prone to fluctuations and are unidirectional. This is due to the fact that it has a limited number of players whose needs are similar.

solution to overcome the problem of liquidity crisis faced by the banks seemed to be in sight. The establishment of DFHI is expected to go a long way in bringing about equilibrium and stability in the call money operations. The Reserve Bank of India's decision to permit private sector mutual funds to lend funds in the inter-bank call money market would help them earn higher returns. The immediate impact would be limited as an estimated Rs. 50 crores may flow to the call money market, but the RBI decision opens a new avenue for parking shortterm funds. This is seen to a certain extent in the market. Moreover, the announcement would also have a positive impact on a macro level as it would bring some amount of stability to the volatile call money market as the liquidity would now enter the call money market in "consolidated bunch" rather than from scattered sources. While the decision to allow private sector mutual funds the access to call money market as lenders has found favour with managers of these funds, they are not expecting a huge quantum of money to flow into the call money market. Their contention is that the funds that would be diverted to the call money market would be a tiny fraction of the 25 per cent of the total corpus that a mutual fund can invest in the money market.




ROLE OF DFHI The Discount and Finance House of India (DFHI) entered the call money market at the end of July 1988. And, from October 1988, the DFHI was no longer subject to the provisions of the ceiling on the call/notice money set out by the IBA. Thus, DFHI was permitted to borrow and lend and also arrange funds in the interbank call/notice market. .In the October 1988 credit policy announcement, the Reserve Bank of India set out that the operations of DFHI in the call and short notice money market will not be subject to the provision of the ceiling rate fixed by the Indian Banks Association. The limited freeing of the interest rate in the call and short notice money market was expected to bring about some improvement in the equilibrating mechanism of the market without raising the rates too high. The DFHI also played an effective role in the inter-bank call/short notice money market with the active support of banks, UTI and LIC. The lending rates generally ruled within the ceiling rate during the slack season and almost upto middle of January 1989. As the stringency for funds grew, the overnight call money rate slowly edged up and remained in the region of 11.50 - 13.50 per cent per annum. To enable price discovery, interest rates in the money market were freed in 1989. In the case of call money, the rates were deregulated in stages. DFHI is thus a market leader in stabilising the call money market. The presence of DFHI in the call money market facilitates the financial sector. . Nevertheless, DFHI insists on being able to hold the reins of the market and intervening in the market to balance liquidity, especially in the overnight money market, despite resourcefully strong institutions and large public sector banks being at an advantage. The DFHI, in close coordination with the RBI, works out an indicative volume of funds when the market is in need. The RBI, in turn, based on its liquidity assessment and its monetary policy stance, routes the funds through DFHI to conduct repos, even though the amount suggested by the DFHI and the amount released by the RBI has often differed.

Advantage for Banks for Holding of 182 Days Treasury Bills The DFHI would buy and sell outright 182 Days Treasury Bills and selectively repurchase/resell the Bills only from/to banks for short periods upto 14 days at pre-determined prices. It will quote its bid and offer rates for different maturity bonds with a fine spread. Prices quoted by DFHI would depend upon the demand and supply of bills in the money market. The presence ofDFHI in the 182 Days Treasury Bill Market would help in developing considerable depth to the market and the transactions in the secondary market would turn attractive with genuine two-day operations. Reserve and Funds Management is a key functional area in banks. SLRlCRR management could be skilfully managed if in the investment portfolio, there is a reasonable proportion of investments in Treasury Bills. Better cash management can release balances which can be invested in Treasury Bills. Banks could acquire such bills in the primary market and now in the secondary market as well. DFHI will buy and sell Treasury Bills in between auction periods and thus provide liquidity for these investments. From the reserve management angle, it is highly desirable for banks to invest in Treasury Bills. Banks can then convert the SLR surpluses which are held in the form of Treasury Bills into cash balances as and when required for meeting the CRR obligations, thus optimising the use of funds. Banks can also create a second tier in the secondary market by trading in Treasury Bills with their clients.

Constitution of a Money Market (Stabilisation) Fund Development of the money market on sound lines is an avowed objective of the monetary policy. To achieve this objective, it is suggested that the Reserve Bank take initiative in constituting a fund styled 'Money Market (Stabilisation) Fund' for the orderly functioning of the call money market. For this fund, an initial nonrecurring contribution can be made by the Reserve Bank and a fixed amount can be set apart annually from the profits of the banks. The fund can act as a market intervention agency to protect the interests of both lenders and borrowers and would eventually supplant the discretionary and stand-by refinance facilities from the Reserve

Statutory Liquidity Ration Drill in Banks Cash Inflow


Whole-bank DTL

.,. Weekly abstracts of Regional Offices or Local Head Offices

CRR LEVEL __--__--.-_________-__--________•______________:"::__::'1_


--_ .. ---_-- ....... .. ---_ .. -_-"'..... - ............. -_.........-.. .. ......... ...... _........ -.. _.......... . ------_................... ....... ---_....... _.... -.. ---_ .. -_ ..... .. .... _.. _----_ -_ .............. _... --_ .... .... ----_...... _...... _................ .. -_........ .............. ------_................--___..... ---_..__............ __ ........... _.... : Local Accounts with :: : Reserve Bank of India:: ~-- .. ----....... --... --.. --.. - .... --.!!



-----_ .................... _-_ ......-_... -_ ................. _.. __ ...........


::::: Principal ::::: ::::Accounts with --Reserve Bank of India

...... _---.......... _........ .... ---..... .......... -.... -__--_..---_ ... ----------__.... .. _.... ------_ .. _--Branch Weekly Abstracts

::rl':n'!"n---::-n--r:"-:: :: ::

:: ::

I: :


SGL accounts with Reserve Bank of India or Other Investment accounts Hand balance with bank's offices in India

:: ::


Cash Outflow

I to 5 Inflow/outflow of cash through bank's local accounts with Reserve Bank of India 6 Operations at whole-bank level- for CRR - Borrowings from Reserve Bank of India/Call Market 7 -do- Lendings in Call MarketlPurchase of Treasury Bills 8 -do- for SLR - Investment Decisions for SLR Obligations

Fig.s.l Statutory Liquidity Ratio Drill in Banks

CD ....

Cash Reserve Ratio Maintenance Function

11 1

Determined by DTL each week









Cash Pool the Bank



.................. ........................................... ..............................................................



.............................................................. ............................................................... ................................................................ . ................................................................. u............................................................... ............................................ .. ............ u .... ••••••• • •••• • ••••• u . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . .




· · ·. ·mnm·nlinIr. · · ·


2. Currency Chest - Government account 3. Transactions on behalf of other banks


> z o


> ::0

CRR level



:::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::: ...............................................................

.............................................................. ........................u........................................ • .................. u ............................................ .

............................................................ .

Lending in inter-bank market

> z o


z > z


» r-

............................... ................................




Operations at apex level



Treasury Bills

4. Other transactions - at Local Head Offices - Apex levels

Currency Chest - Bank account



iffifiiHfiffiifffffffiffiii~fiififfiiiiiffiiff¥iififfiiii::::::::::::iffffiifiifiiififfifffffiWfifffffi!iiififffffffiiffffiiff;ff. ................................................................ .......... ......................................................

............................................................... ..........·· ......................................... 1........ ............................................ . . .................

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................................................................ ..............................................................

Borrowings from Reserve Bank of India inter-bank



6. Lending

Fig.S.2 Cash Reserve Ratio Maintenance Function

< c=;



Bank, which essentially represent created money. The objective of the fund should be to allow the call rates to fluctuate in a permissible band of, say, 6 per cent to 25 per cent. During easy conditions in the call market, funds would be invested in other money market instruments such as CPs, CDs, Commercial Bills and 182 Days Treasury Bills. In conditions of general stringency in the call money market, funds would be pumped in the call market through the DFHI and this would enable the call rates to remain in the permissible band. The operations of the fund would bring about an effective integration of various segments of the money market and could emerge as an effective instrument of the monetary policy. The band could be reviewed at periodical intervals to be in tune with the objectives of credit policy. In the present self-regulatory environment, the task of administration of the fund could be left to a joint institutional committee with adequate representation from the Reserve Bank and participants of the call money market. The Reserve Bank can take lead in introducing and popularising these risk management techniques in the Indian financial markets. The task would involve setting up of futures exchanges, framing suitable legislation and identifying supervisory and regulatory bodies to oversee these operations. This could be the Reserve Bank's contribution to the structural transformation of the financial system in India. The Reserve Bank of India (RBI) employs two forms of interventions to cool an overheated call money market. The first and more regularly employed tool these days is that of ready forward transactions, or 'repos.' The second tool is that of open market operations (OMOs). The difference between the two is that while the former provides the players liquidity only for a short period, recourse to the latter gives the players a slightly more permanent source of liquidity.

REPOS OR READY FORWARD TRANSACTIONS Repurchase Agreements (Repo), a short-term money market instrument is used for smoothing volatility in money market rates by RBI through, injection of short-term liquidity into the market, as well as absorbing excess liquidity from the system. To put it very simply, a ready forward or a repo transaction is like collateralised lending. It is a contract between two parties wherein one bank, say A, who is short of Cash, places some security, in exchange for cash, with a second bank B. The securities sold will be repurchased on an agreed-upon future date; normally, this future date is about three days from the date of 'sale.' The difference between sale and repurchase prices is the cost of borrowing. The entire transaction thus has two legs: LEG ONE: The first party sells the security to the second at a particular price for a particular period with an undertaking that it will purchase back the same security at a predetermined price at the end of the period.


OA~ ' 1





tlf,r t1tpul"Chas ;~f~ from'S'fQr



* 1.

The rates are used only for the purpose of illustration. 2. The safe of securities is on a spot basis but repurchase is on a forward basis. 3. When DFHI does a repo transaction with a bank, it does a transaction with the RBI back-to-back. Leg TWO: Thefirst party repurchases the security from the second at the predetermined price. The difference between the sale rate in the first leg . and the repurchase rate in the second leg is the cost to the first party and the capital gain of the second.




As per RBI rules, the minimum period of a repo transaction has to be three days. There is no cap on the maximum number of days. The RBI also has a list of securities, in which such transactions are permitted. Since a repos transaction is basically a money market transaction, the maximum period is usually 14 days. In the recent past, the RBI has been intervening in the market through the Securities Trading Corporation of India (STCI) and the Discount Finance House of India (DFHI). When the inter-bank call money rates started spiraling upwards with money in short supply, both these institutions pumped in liquidity by way of repos deals with banks. The money generated was used by the banks in maintaining their cash reserve ratio (CRR) requirements.

OPEN MARKET OPERATIONS (OMOs) The OMO route of intervention is resorted to in order to provide market participants with another source of liquidity. From time to time, the central bank announces a list of securities indicating the price at which it will sell or purchase a particular security. Those banks holding securities in excess of their statutory requirements but strapped for cash are thus provided a window, where they can sell any security to generate liquidity. The window can also be used by those who have surplus cash and want to exchange them for securities.

Future Scenario With the convertibility of rupee, the degree of integration of Indian money market with the world money markets were expected to increase. The Indian call money market would then no longer remain an insular market that it is today. The dividing line between domestic money market operations and foreign exchange operations would fast become thinner and the Indian call money market would become a part of the global financial system. As India enters into this brave new world of financialliberalisation and globalisation, it is essential to place the call money market, which is the core of the Indian money market and one of its most sensitive segments, on a sound footing to ensure smooth transition. This has been achieved to a large extent. The calVnotice money market essentially serves the purpose of equilibrating the short-tenn liquidity position of banks and other participants. The turnover in the call/notice money market depends on the amount of surplus funds available with some participants and the requirements of funds by some other participants. Over the years, the number of participants in the market has gradually increased to include banks and Primary Dealers both as lenders and borrowers, and select mutual funds, insurance companies, development financial institution and corporates through primary dealers (as lenders). The supply of and demand for funds in the market arise on account of (i) compliance with case reserve requirement of banks as mandated by the Reserve Bank, (ii) as a funding source to build up assets, (iii) temporary surpluses that are available with leaders, (iv) foreign exchange flows and (v) seasonal factors such as festival, election, harvesting, advance tax payments, etc. Eventually, the call market would constitute an integrated market for equilibrating short-tenn funds for both banks and nonbanks.

THE NARASIMHAM COMMI'ITEE The Narasimham Committee (1998) made several recommendations to further develop the money market. First, it reiterated the need to make the call/notice money market strictly inter-bank market, with PDs being the sole exception, as they perfonn the key function of equilibrating the call money market and are fonnally treated as banks for the purpose of inter-bank transactions. Second, it recommended prudential limits beyond which banks should not be allowed to rely on the call money market. The access to the call money market should only be for meeting unforeseen fund mismatches rather than for regular financing needs.


Third, the Reserve Bank's operations in the money market need to be market-based through LAF repos and reverse repo auctions, which would determine the corridor for the market. Fourth, non-bank participants could be provided free access to rediscounting of bills, CP, CDs, Treasury Bills and money market mutual funds. Following the recommendations, steps were taken to reform the call money market by transforming it into a pure inter-bank market in a phased manner. The corporates, which were allowed to route their transactions through PDs, were phased out by end-June 2001. The non-banks ' exit was implemented in four stages beginning May 2001, whereby limits on lending by non-banks were progressively reduced along with the operationalisation of negotiated dealing' system (NDS) and CCIL, until their complete withdrawal in August 2005. In order to create avenues for deployment of funds by non-banks following their phased exit from the call money market, several new instruments were created such as market repos and CBLO. Maturities of other existing instruments such as CPs and CDs were also gradually shortened in order to align the maturity structure to facilitate the emergence of a rupee yield curve. The Reserve Bank has been modulating liquidity conditions through OMOs (including LAp). MSS and refinance operations which, along with stipulations of minimum average daily reserve maintenance requirements, have imparted stability to the call money market. Despite these reforms, however, the behaviour of banks in the call market has not been uniform. There are still some banks, such as foreign and new private sector banks, which are chronic borrowers and public sector banks, which are the lenders. Notwithstanding excessive dependence of some banks on the call money market, the short term money markets are characterised by high degree of stability. The Reserve Bank has instituted a series of prudential measures and placed limits on borrowings and lendings of banks and PDs in the call/notice market to minimise the default risk and bring about a balanced development of various market segments. In order to improve transparency and strengthen efficiency in the money market, it was made mandatory for all NDS members to report all their call/notice money market transactions through NDS within 15 minutes of conclusion of the transaction. The Reserve Bank and the market participants have access to this information on a faster frequency and in a more classified manner, which has improved the transparency and the price discovery process. Furthermore, a screen-based negotiated quote-driven system for all dealings :in the call/notice and the term money markets (NDS-CALL), developed by CCIL, was operationalised on September 18, 2006 to bring about increased transparency and better price discovery in these segments. Although the dealing on this platform is optional, 85 banks and 7 PDs have taken membership of NDS-CALL.




CONCLUSION The inter-bank call money market is the core of the formal money market. It is at present the most important short-term money market. Banks borrow from the call money market in order to meet the sudden , dOOland for funds for payments and to obtain funds to meet any likely shortfalls in their cash reserves to meet the CRR stipulation, or in the liquid assets required to be held to meet the SLR stipulation. In India, the interbank call money market is the single most important source for banks for getting ov~rnight and short-term funds. The call loans generally have a maturity of one day to a fortnight. The State Bank of India along with its subsidiaries, as also insurance companies and the UTI, are the primary lenders in the call money market. In recent years, there has been a considerable growth of the market due to the participation of investment institutions like LIC, GIC, UTI and mutual funds, whose supply of funds to the market as compared to the assets of the banking system is still quite small. In the initial phase of money market reforms in the late 1980s, considerable volatility was noticed in the call rate, resulting primarily from a free call money market while interest rates in other segments of the money market remained regulated. As a result, any fluctuation in the liquidity conditions impinged on the call money market. A noteworthy development in the money market since 2004-05 has been the substantial migration of money market activity from the uncollateralized call money segment to the collateralized market repo and collateralised borrowing and lending obligations (CBCOS). This has helped in reducing the systematic risk in the market. The full-fledged Liquidity Adjustment Facility (LAF), which was introduced on JuneS, 2000 has emerged as a effective instrument to provide a corridor for the overnight call rate moment. In fact LAF and market stabilization scheme (MSS) have been successful in restricting the call-money rates. Various reform measures initiated have transformed the call money market into a pure inter-bank including PDS. The process which was initiated in 1999 was completed in August 2005.



Chapter INrRODUcnON

The bill market or discount market refers to the market where short dated bills and other papers are bought and sold. The treasury bills are the most important instrument used in the bill market. The bill market is an important sub-mar~et of the money market. The co-ordinated and developed bill market accelerated resources for rapid development. The practice of re-discounting bills by Discount Houses with the Bank of England to relieve the stringency of liquid funds in the market imparted to the central bank the power to influence the cost of money and the rediscount rate or bank rate slowly emerged as a major weapon of monetary control. It is noteworthy in the context of the monetary history of Britain, that the bill market developed in the country autonomously and the central bank sought to influence the cost of credit in the economy through its medium subsequently and not vice versa, as is being attempted in other parts of the world. All developed and organised money markets have a developed commercial bills of exchange market in which funds are borrowed by the government for 3 months (a Treasury Bills Market), a market for foreign exchange dealings etc.' In an underdeveloped country wherein unorganised money market predominates, the bill market acts as a governor of the unorganised money market within the fold of the central bank control and also links the unorganised money market with that of the organised. Among the bill markets functioning in the world, the London Bill Market, commonly known as the 'London Discount Market', is looked upon as the leading bill market in the world. Discount Houses have a unique place in the Houses, alone, that the Bank of England operates as lender of resort. It is through Discount Houses that the Bank of England used to channel the marginal amounts of the cash with which it sees fit to provide the economy.2 Although the importance of the discount market has been delegated to a secondary place in the short-term market in the post-war period, it still continues to playa very crucial role in the money market. The Committee on the Working of the Monetary System in England observed: "It is no service to claim that the discount market is indispensable to the functioning of the monetary system; but the fact remains that the discount market, by smoothening out irregularities in the ebb and flow of funds among the commercial banks and others, does simplify the functioning of the banks and enables them, free from the embarrassment of temporary disturbances in their liquidity, to concentrate on their major task of providing credit for the production of goods and services. It would be beyond human ingenuity to replace the work of the discount houses; but they are doing the work effectively, and they are doing it at a trifling cost in terms of labour and other real resources."3 Although the importance of the discount market in the post-war period in England is on decline, they are still considered as the direct and effective link between the Central Bank and the money market.

1. Messrs Madan and Nadler have mentioned the possible existences of six different sub-markets in their book, International Money Markets. 2. Radcliffe Committee Report (1959), p. 58. 3. Ibid., p. 64.



COMMERCIAL BILLS MARKET OR DISCOUNT MARKET A commercial bill is one which arises out of a genuine trade transaction, i.e., credit transaction. As soon as goods are sold on credit, the seller draws a bill on the buyer for the amount due. The buyer accepts if immediately agreeing to pay the amount mentioned therein after a certain specified date. Thus, a bill of exchange contains a written order from the creditor to the debtor, to pay a certain sum, to a certain person after a certain period. A bill of exchange is a 'self-liquidating' paper and negotiable. It is drawn always for a short period ranging between 3 months and 6 months.

Definition Section 5 of the Negotiable Instruments Act, defines a bill of exchange as follows: "An instrument in writing containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to, or to the order of a certain person or to the bearer of the instrument" .

Types of Bills Many types of bills are in circulation in a bill market. They can be broadly classified as follows: (i)

Demand and usance bills


Clean bills and documentary bills


Inland and foreign bills


Export bills and import bills


Indigenous bills


Accommodation bills and supply bills.

ThE REsERVE BANK OF INDIA AND THE BILL MARKET SCHEME A well organised bill market is essential for the smooth working of the credit system, the progress of commercial banking as well as linking up the various credit agencies effectively-to the central bank of a country. A bill market is the market for short-term bills generally of three months duration. Three types of bills of exchange or trade bills, finance bill or promissory notes and treasury bills are dealt within the bill market. The commercial banks can keep their liquid cash profitably in these bills for short periods. In times of necessity the banks can dispose of the bills easily or rediscount them with the central bank. So the bill market plays a significant part in the money market. The Central Banking Enquiry Committee emphasised the need for developing a bill market in India as early as 1931. But it did not develop even after the establishment of the Reserve Bank due to several reasons. In January 1952, for the first time, the Reserve Bank introduced a Bill Market Scheme. Under Section 17 (4) of the Reserve Bank of India Act, the apex bank undertook to make advances to scheduled banks against the security of usance promissory notes or trade bills having a maturity of 90 days and bearing two signatures, of which one would be that of a scheduled bank. The salient features of the Scheme, as originally formulated by the Reserve Bank, were as follows: (i)

The Reserve Bank undertook to make demand loans at its banking offices in India to scheduled banks against their promissory notes supported by usance bills or promissory notes of their constituents. Section 17(4)(c) of the Reserve Bank of India Act permits the Reserve Bank to make advances against bills of exchange and promissory notes drawn on and payable in India and arising out of bonafide commercial or trade transactions bearing two or more good signatures (one of which shall be that of a scheduled bank) and maturing within ninety days. As banks normally finance business through loans, cash-credits and overdrafts, they were permitted to convert a part of the borrowings


(representing the minimum requirements of the borrower during the next three months) into usance promissory notes of ninety days which they could lodge with the Reserve Bank as collateral securities for advances. (ii)

As an inducement to banks to popularise the bill as an instrument of credit, the Reserve Bank offered to make advances against bills at half per cent below the Bank Rate, i.e., at 93 per cent per annum. (The Indian Central Banking Enquiry Committee had recommended that the rate on loans against authorised securities should be higher than the rate on bills and that it would be useful to have a larger margin between these rates at the outset.)


As a further incentive, the Bank agreed to bear the cost of the stamp duty incurred in converting demand bills into time bills. [The Indian Central Banking Enquiry Committee (1931) had recommended the abolition of the stamp duty on bills. The State Governments did not, however, accept the suggestion, though in 1940 it was reduced to two annas per thousand Rupees.]


The minimum value of individual bills tendered to the bank was fixed at Rs. 1 lakh each, while the maximum limit for a single advance which a bank might take at any time was fixed at Rs. 25 lakh.

The scheme, however, has one very important limitation. It makes no provision for the indigenous banker's hundi, which is the most important credit instrument in the market sector of the economy. The present hundi market constitutes the nucleus of a real bill market. The Reserve Bank has, therefore, failed to integrate the two sectors of the market. The progress achieved under this scheme is quite limited. Despite its name, there is no market for these bills. It is primarily a bill accommodation scheme, for which purpose banks create bills by converting a portion of their cash credit overdraft accounts into bills so as to conform to the requirements of Section 17(4)(c) and 17(2)(a) of the Reserve Bank of India Act, 1934. The borrower executes a promissory note in favour of the bank, which adds its own signature (to conform to the "two good signatures" requirement for eligibility for borrowing from the Reserve Bank) and submits this as collateral security to the Reserve Bank. Though a market may not have been created for genuine trade and industrial bills, the Bill Market Scheme has served well as a device to ensure the elasticity of funds during the busy season and has permitted a degree of qualitative control in terms of retaining to the Reserve Bank the right to check any particular packet of bills. This Bill Market Scheme undoubtedly had some achievements to its credit. It, no doubt, 'served well as a device to ensure the elasticity of funds during the busy season and has also permitted a degree of qualitative control in terms of reserving to the Reserve Bank the right to check any particular packet or bills.... It has sought to fit into the framework of the existing eligibility criteria the requirements for seasonal finance without too much disturbance of banking practices.' In retrospect, one could say that considering the popularity of the cash credit system with the industry and trade as a facile source of finance and the predominance of these interests in the ownership and management of commercial banks in India at that time, any attempt on the part of the banks to force them to switch over to bill finance in lieu of cash credit would have been effectively thwarted by them. In 1957, on the recommendations of the Export Promotion Committee, the Reserve Bank of India, extended the scheme to include export bills in order to enable scheduled banks to provide finance to exports on a liberal scale. The extension of the bill market scheme to export bills has been continued further year after year.

The New Bill Market Scheme 1970 The 1952 Bill Market Scheme remained a partial success. It was criticised that it did not develop the good bill market in India. The scheme appears to be a device for extending credit for banks during busy season. It is not based on genuine trade bills but on the conversion of loans and advances by scheduled banks into usance bills. The Deheja Committee set in motion the introduction of a new bill market. The report brought out the abuses of cash credit system and suggested the use of bill financing and for the supervision of the end use of funds lent by commercial banks.




A study group was appointed by the Reserve Bank in February 1970, under the chairmanship of Shri M. Narasimham to go into the question of enlarging the use of the bill of exchange as an instrument for providing credit and creation of a bill market in India. The group submitted the report in June 1970. Following its recommendations, the Reserve Bank announced a new bill market scheme under Section 17(2)(a) of the Reserve Bank oflndiaAct in November 1970. (i) (ii) (iii)

(iv) (v)

All eligible scheduled banks are eligible to offer bills of exchange for rediscount. The bills of exchange should be a genuine trade bills and should have arisen out of the sale of goods. Accommodation bills are not eligible for this purpose. The bill should not have a maturity time of more than 120 days and when it is offered to the Reserve Bank for rediscount, its maturity should not exceed 90 days. The bill should have atleast two good signatures, one of which should be that of a licensed scheduled bank. The minimum amount of bill should be Rs. 5,000 and on one occasion, the value of bill offered for rediscount should not be less than Rs. 50,000.

In 1971, the Reserve Bank simplified the procedure for rediscounting the bills. To avoid delays and reduce the work involved in physically delivering and redelivering the bills to and from the Bank, it was decided to dispense with the actual lodgement of bills, each of the face value of Rs. 2 lakh and below. The minimum amount of a bill eligible for rediscount with the Bank was reduced to Rs. 1,000. The facility which was available only in Mumbai, Kolkata, Chennai and New Delhi, was extended to Kanpur and Bangalore. In April 1972, the bills drawn on and accepted by the Industrial Credit and Investment Corporation of India Limited on behalf of the purchasers were covered by the scheme provided they are presented to the Reserve Bank by an eligible scheduled bank. The New Bill Market Scheme has opened vistas of development of full fledged bill market in India. Certain criticisms were levelled against the working of the scheme. The unorganised money market has not been drawn within its fold. Most of the bills presented for rediscount related to trade and not agriculture. The period of the bill admitted under the scheme was also inadequate. The procedure followed for determining the eligibility of the bank for the purpose of rediscounting is far from satisfactory. The Reserve Bank has been making constant efforts for the orderly development of a bill market. However, it will take a long time to have a bill market of the type found in advanced countries. The two note worthy features of the new scheme are: (i)

The bills covered under the scheme are genuine trade bills; and


The scheme provides for their rediscounting

The Reserve Bank has been making constant efforts for the orderly development of a bill market. However, it will take a long time to have a bill market of the type found in advanced countries. A Bill of Exchange is an instrument in writing containing an unconditional order by the maker directing specified person to pay a sum of money to the order or to the bearer of the bill. Such bills elegment the instruments of financial transaction, supplementing the available resources in times of seasonal stringencies for the purpose of refinance from the Reserve Bank. DRAWBACKS The New Bill market Scheme has, however, the following drawbacks: (i) (ii) (iii)

Really speaking, it is not based on genuine trade bills. It is still based on conversion of bank loans into bills of usance. The scheme has not been confined to regular finance. Hundis are not acceptable under this scheme, hence indigenous bankers remain out of the circle. To enlarge the scope of the bill market in India, it is very essential to recognise Multani Hundis under the scheme.




The Reserve Bank has been exercising its discretionary power to the fullest in implementing this scheme. It would have been better if the scheme had been made an obligatory function of the Reserve Bank. Agricultural finance is also outside the purview of this scheme.

Other drawbacks of the bill market are: (i)

Absence of Bill culture,


Absence of rediscounting among banks,


Absence of second dry market, and


Absence of acceptance services.

To encourage the generation of bills and the development of a bill culture, the Working Group of Money Market (1987) had recommended that the Credit Authorisation Scheme (CAS) should be modified over a three year period by providing limits for bill transactions. There should be: (a) A phased increase in the proportion of bill acceptances to total credit purchases to a level of 75 per cent; the phasing should be done in such a manner that a proportion of at least 25 per cent reached by April I, 1988 and 50 per cent by April 1. 1989; (b) The banking system should move gradually away from receivable financing to bill financing. Commencing from April I, 1988, a gradual phasing out of recei vable financing was proposed to be undertaken. From April I, 1988, for calculating the drawing power on cash credit/overdraft limits against receivables, only 75 per cent of the eligible receivables was to be taken into account. This should be reduced to 50 per cent from April I, 1989 and 25 per cent from April I, 1990. In other words, regressively credit sales should be effected by drawing usance bills, since such bills could be discounted with banks.

Based on the recommendations of the Committee to review the working of the monetary system and the working Group on the Money Market, the following important measures were taken: (i)

Non-bank institutions were permitted to participate in the money market;


A number of instruments were developed to provide breadth and depth to the money market;


A Discount and Finance House of India (DFHI) was set up in 1988 as a Reserve bank subsidiary with participation from other money market institutions to facilitate smoothening of short-term liquidity imbalances and to impart greater flexibility to the money market;


A 364-day treasury bill on an auction basis was introduced in April 1992;


A 91-day auction treasury bill was introduced in January 1993; and


A new treasury culture has been developed among banks and institutions.

ACCOMMODATION BILLS AND SUPPLY BILLS If bills do not arise out of genuine trade transactions, they are called accommodation bills. They are known as "Kite bills' or 'wind bills". Two parties draw bills on each other purely for the purpose of mutual financial accommodation. These bills are discounted with bankers and the proceeds are shared among themselves. On the due dates, they are paid.

Supply bills are those drawn by suppliers or contractors on the Government departments for the goods supplied to them. These bills are neither accepted by the departments nor accompanied by documents of title to goods. So, they are not considered as negotiable instruments. These bills are useful only for the purpose of getting advances from commercial banks by creating a charge on these bills.

Operations in Bill Market From the operations point of view, the bill market can be classified into two viz. (i) Discount market (ii) Acceptance market




Discount Market Discount market refers to the market where short-term genuine trade bills are discounted by financial intermediaries like commercial banks. When credit sales are effected, the seller draws a bill on the buyer who accepts it promising to pay the specified sum at the specified period. The seller has to wait until the maturity of the bill for getting payment. But, the presence of a bill market enables him to get payment immediately. The seller can ensure payment immediately by discounting the bill with some financial intermediary by paying a small amount of money called 'discount rate'. On the date of maturity, the intermediary claims the amount of the bill from the person who has accepted the bill. In some countries, there are some financial intermediaries who specialize in the field of discounting. For instance, in London Money Market there specialized institutions called Discount Houses which specialize only in the field of discounting bills. Such institutions are conspicuously absent in India. Hence, commercial banks in India have to undertake the work of discounting. However, the DFHI has been established to activate this market.

Acceptance Market The acceptance market refers to the market where short-term genuine trade bills are accepted by financial intermediaries. All trade bills cannot be discounted easily because the parties to the bills may not be financially sound. In case such bills are accepted by financial intermediaries like banks, the bills earn a good name and reputation and such bills can be readily discounted anywhere. In London, there are specialist firms called acceptance houses which accept bills drawn by traders and impart greater marketability to such bills. However, their importance has declined in recent times. In India, there are no acceptance houses. The commercial banks undertake the acceptance business to some extent.

Advantages and Disadvantages Commercial bill market is an important source of shot-term funds for trade and industry. It provides liquidity and activates the money market. In India, commercial banks playa significant role in this market due to the following advantages and disadvantages.


Advantages 1.



Absence of bill culture


Self-liquidating and negotiable asset.


Absence of rediscounting among banks

3. 4. 5. 6. 7.

Certainty of payment

3. 4. 5.

Stamp duty

Ideal investment Simple legal remedy High quick yield Easy central bank control


Absence of secondary market Difficulty in ascertaining genuine trade bills Limited foreign trade.

AN INNOVATION In a broad sense, the Bill Market Scheme has emerged as an interesting innovation in the sense that it is a compromise between the convenience of banks and their borrowers on the one hand and that of the Reserve Bank and the banking system on the other. It has sought to fit into the framework of the existing eligibility criteria, the requirements for seasonal finance without too much disturbance in banking practices. The question, however, remains of enlarging the supply of bills representing genuine trade transactions. Inland D.A. bills, for instance, are reportedly very much in vogue and point to the possibilities in this direction. To emphasise the seasonal character of the bill market facility, the limits sanctioned in respect of the accommodation under the scheme are said to be now confined to a period of 8 months, namely, November to June (inclusive). The Bill


Market Scheme needed to, therefore, be viewed not as an instrument of enhancing central bank control on the Lombard Street model, but rather as a device to which a selective bias could be imparted in regulating central bank accommodation to the banking system. Bill financing in preference to cash credit lending would further result into better turnover of funds and ensure maximum utilisation of bank's resources. At present, to encourage the bill market, the Reserve Bank has agreed to rediscount bills offered by commercial banks at bank rate and such refinancing would not affect the Net Liquidity Ratio of the concerned bank. It is not known as to how long the re-discounting facilities would continue in this form but with the differential of 3 to 4 per cent between the Reserve Bank's re-discounting rate and the discounting rates of commercial banks, the bill business appeared to be an attractive proposition. However, one aspect of bill business which is often ignored by most of the supporters of the bill market from the commercial banking sector relates to its effect on the profitability of banks. As the discount rates are generally lower than the interest rates on similar advances, with the gradual replacement of cash credits by bill financing, the banks' earnings are bound to suffer unless discount rates are brought on par with interest rates.

Finance Companies' Entry In the more recent period, finance companies have been attracted to enter bill business. Some of them have reportedly transacted large volumes of business. While their capital base is not large they have been required to even apportion it among their various activities, such as leasing, bill discounting and hire purchase. Thus, they are said to be dependent on bank finance for their bill discounting activity. To a large extent, finance companies adopt anyone of the following methods of bill financing. They may co-accept the bills to facilitate discounting; they may discount the bills and the banks may rediscount them, especially where a letter of credit has been opened by the buyer who is a reputed party; they may get the bills discounted by banks and render only broking service to their clients. The "agency" approach seems to have been given encouragement in the name of expansion of the banks' bill business and improvement in profitability, especially since such finance is provided on the usual cash credit terms. The question that would arise is, Is bill discounting through the "agency" approach a short-term or a long-term strategy? Be that as it may, there emerged a need for fresh thinking for evolving a long-term corporate strategy, as bill financing has been referred to as the backbone of the banking business the world over.

Long-term Corporate Strategy The bank credit delivery system has vastly improved in India with the setting up of numerous bank branches. Bill financing has emerged as a strategy to enable parties to deal with customers at distant centres. Branches at different centres can serve one another well and conditions favourable for developing bill business exist by way of handling documents, remitting proceeds and other facilities. The branch network enables banks to produce customer profits and obtain credit reports quickly. The bill culture can ensure that it benefits everyone engaged in business, especially those in small businesses supplying goods and services to large potential customers. Large customers on the other hand would derive benefit by supporting small business by way of assured and continuous supplies, quality products and lower prices. The mutuality of interest should prompt all business to shift to bill financing in preference to the cash credit and overdraft system of financing trade. Both borrowers and banks at present seem to overlook certain long-term advantages of bill financing. Trade and industry have to consciously use bill financing as a more predictable means of cash budgeting than the cash credit system, under which cash flows cannot be forecast with any high degree of certainty. Bill financing facilitates efficient working capital management. The quicker re-cycling oflimited funds would ensure and promote efficiency and productivity which is the need of the hour. From the banking system's viewpoint, a large portfolio of bills in a reasonably secured mode of finance, is important since it improves liquidity and facilitates better fund management. The central banking authority is best suited to take a fresh look at the present state of affairs in the bill market and evolve a long-term strategy in consultation with the premier trade bodies and the banks.




CONCLUSION The Reserve Bank's new Bill Market Scheme is a big step towards the development of a bill market in India. In fact, it is the first serious attempt at developing a bill market which would bring about an integration of the credit structure in the country and make monetary control more effective. The Study Group on 'Enlarging the Use ofthe Bill of Exchange' has pointed out that the evolution of the bill market will also make the Bank Rate variations by the Reserve Bank a more effective weapon of monetary control as the impact of any such change could be transmitted through this sensitive market to the rest of the banking system. Once the bill market develops in the country and covers a large part of trade credit, apart from influencing the cost of credit in the economy, it would also be possible for the monetary authorities to vary the duration of the trade credit available to industry and trade by varying the usance of the bills eligible for discount. When it is felt that it is necessary to lighten trade credit in the economy, the usance of the bills eligible for discount can be reduced; but when it is felt necessary to relax credit, the usance of the bills eligible for discount can be enhanced. In this manner, the monetary authorities can influence the cost as well as the volume of trade credit available in the economy. A properly developed bill market will act as a link between the organised and unorganised money markets in the country. Moreover, where the unorganised money market occupies a more important place in relation to the total resources of the country, the growth of discounting facilities acts in the same way as a subsidy; but it has the additional advantage of developing contacts between the various parts of the banking system and making it easier for the central bank to enforce its policy.4 Thus, a link may be established between the two markets, which may also enable the Reserve Bank to implement its monetary policy more effectively in the future market developments.

4. Ibid.




Repo or repurchase agreement is a window which enables a bank or a financial institution to borrow money in the short-term. In the transaction, the entity in question sells government securities or bonds to the lender (another bank or institution), with an agreement to buy the securities back after a specified time and price. It is also called a repurchase agreement. (In the US, Repo has a different meaning, it is used to signify the repossession of hypothecated property by a financier). Repo (Repurchase Agreement) instruments enable collateralised short-term borrowing through sale operations in debt instruments. Under a repo transaction, the holder of securities sells them to an investor with an agreement to repurchase it at a predetermined date and rate. Reverse repo is a mirror image of repo, and represents acquiring of the debt securities with a simultaneous commitment to resell. In a developed financial market, repurchase agreements (repos) are recognised as a very useful money market instrument enabling smooth adjustment of short-term liquidity among varied categories of market participants. Repo offers flexibility and minimise default risk. A repo transaction is in the nature of secured borrowing: the difference between the sale and repurchase price is the borrowing cost. It is usually very short-term in nature with the market practice being to conclude the sale and repurchase within a timeframe of one day, to a fortnight.

REPO INSTRUMENT Repo stands for Repurchase. Under Repo transaction, the borrower parts with securities to the lender with and agreement to repurchase, them at the end of the fixed period at a specified price. At the end of the period, the borrower will repurchase the securities at the predetermined price. The difference between the purchase price and the original price is the cost for the borrower. This cost of borrowing is called "Repo Rate" which is little cheaper than pure borrowing. A transaction is called a Repo when viewed from the perspective of the seller of the securities and Reverse Repo when described from the point of view of the suppliers of funds. Thus, whether a given agreement is termed a Repo or Reverse Repo depends largely on which party initiated the transaction. Repo transactions are conducted in the money market to manipulate short term interest rate and manage liquidity levels. In India, Repos are normally conducted for a period of 3 days. The eligible securities for the purpose are decided by RBI. These securities are usually Government promissory notes, Treasury bills and public sector bonds. When the RBI announces a fixed rate Repo, for certain number of days/period it conveys its intention to market at the desirable level of short term interest rate. When RBI conducts 'repos' the short term interest rate in the money market may not go below the RBI Repo rate. If the interest is lower in other markets such as foreign exchange market, Treasury Bills market, holders of funds may go for Repos with RBI. Thus, Repo transactions ensure stability in short-term interest rates in the money market. In case, the RBI wants to inject fresh funds sin the market, it will conduct 'Reverse Repo' transaction~ with primary dealers against government securities.



Advantages of Repo Repo has several advantages over other collateralised instruments. 1.

Repo entails instantaneous legal transfer of ownership of the eligible securities.


It helps to promote greater integration between the money and the Government securities markets.


Repo can be used to facilitate Government's cash management.


Repo is a very powerful and flexible money market instrument for modulating market liquidity.


Repo also serves the purpose of an indirect instrument of monetary policy at the short-end of the yield curve.


When the Reserve Bank of India conducts a repo, what it does in effect is it lends to bank by purchasing securities and selling them back at a predetermined price. When RBI does a reverse repo, it borrows from bank by selling them securities and buying them back at a future date. When the RBI does reverse repo, it enables banks to park short-term surplus funds; on the other hand, it's a tool for RBI to manage short-term liquidity. RBI pays an interest of 5% to banks. The rate serves as a shortterm interest rate benchmark for banks and other intermediaries. Similarly, RBI makes fund available to banks through reserve repo at 6% in the reverse repo rate. RBI, which is the monetary authority as well as the financial regulator, raised the reverse repo rate to signal a change in the interest rate cycle. Between '00 and '04, interest rates fell relentlessly. Now the cycle has turned and rates inching up. It is also a way to alert banks and financial markets about the risks from a hardening interest rate.

Bank Rate and Repo/Reverse Repo Rate The Bank Rate (BR) was reactivated in April 1997 as a signalling mechanism to convey the stance of monetary policy. The rates of various standing facilities of the Reserve Bank were linked to the BR. The BR has served well as a signalling rate for the medium-term. In the recent period, however, short-term liquidity adjustment is being conducted through the repo/reverse repo rates under the LAF. The LAF scheme is being operated through overnight fixed rate repo and reverse repo from November 1, 2004. In view of the changing macroeconomic and overall monetary conditions, reverse repo and repo rates were regularly revised.

How is the interest on a repo calculated? Although there is no separate interest pay-out, there is an implicit interest cost in the form of a higher repurchase price. Thus, interest cost on the repo is calculated by dividing the difference between the sale and repurchase price by the initial sale price. Repos auctions: It involves sale of financial asset from one investor to another. The investor selling the asset simultaneously agrees to repurchase it from the purchaser on a stated future date at a predetermined price, which is higher than the original transaction price. In December 92, the first repos auction took place. Repos are one effective means of absorbing liquidity for very short periods and later reinjecting liquidity into the system. Presently, the period of repos are maintained at 14 days. Since March 1995 onwards, a scheme, auctioning of Central government dated securities of RBI portfolio was also introduced. The motivation for the banks and other organizations to enter into a ready forward (repo) transaction is that it can finance the purchase of securities at relatively competitive rates in a quick and informal manner. Under repo deal, the seller of the security is the borrower and the buyer of the security is the lender. Seller gets funds at a specified interest rate lower than prevailing call money rate and the buyer gets the specified security to meet its SLR requirements.




Effective Since 1 March 5, 2002 March 28, 2002 June 27, 2002 October 30, 2002 November 12,2002 March 3, 2003 March J, 2003 March 19,2003 August 22, 2003 March 31, 2004 October 27, 2004 April 29, 2005 October January 24, 2006 June 9, 2006 July 25,2006 October 31, 2006 January 31, 2007 March 31, 2007 July 31, 2008

Reverse repo rate

Repo rate 3


6.00 6.00 5.75 5.50 5.50 5.00 5.00 5.00 4.50 4.50 4.75 5.00 5.25 5.50 5.75 6.00 6.00 6.00 6.00 6.00

8.50 8.00 8.00 8.00 7.50 7.50 7.00 7.00 7.00 6.00 6.00 6.00 6.25 6.50 6.75 7.00 7.25 7.50 7.75 9.00

Effective Since

Bank rate Ratio 5


February 17, 2001 March 2, 2001 October 23 , 2001 October 30, 2002 April 30, 2003

7.50 7.00 6.50 6.25 6.00

Effective Since

6 December 29 , 2001 June 1,2002 November 16,2002 June 14,2003 September 18, 2004 October 2, 2004 December 23,2006 January 6, 2007 February 17, 2007 March 3, 2007 April 14, 2007 April 28, 2007 August 24, 2007 Novemeber 10,2007 April 26,2008 May 10, 2008 May 24, 2008 July OS, 2008 July 19, 2008 August 30, 2008 October 1 I, 2008

Cash Reserve 7 5.50 5.00 4.75 4.50 4.75 5.00 5.25 5.50 5.75 6.00 6.25 6.50 700 7.50 7.75 8.00 8.25 8.50 8.75 9.00 7.50

The scheduled commercial banks have been allowed to enter into ready forward transactions in Treasury Bills of all maturities issued by the Government of India, as are approved by RBI. All such ready forward transactions are effected at Mumbai and the deals are put through the Subsidiary General Ledger (SGL) account with the RBI. (SGL form is the form of transfer government securities from SGL account of the bank to SGL account of another bank maintained with public debt office RBI. It is signed by both transferor and transferor). The minimum period for repos should be three days. Reverse Repo facility: Reverse Repo facility with RBI -in Government dated securities has been extended to DFHI and STCI to provider liquidity support to their operations. The conduct of reverse repos enabled the RBI to arrest undue upward pressure on call money rates. Such facility has also been extended to Primary Dealers. Banks can also enter into such reverse repo transactions. Here, the counter party who is entering into a reverse repo is making a short term collateralised loan to the bank by providing funds in return for holding securities. At maturity, the counter party returns the securities to the banks and receives cash (which includes profit spread also). Reverse repo transaction facilitates some additional income on 'idle' cash for banks. Inter-Bank Repos: Commercial banks, DFHI and STCI were permitted to undertake repo transactions in Treasury Bills and nine specified Government of India dated securities to enable short-term adjustment in liquidity in the system. This enables the inter-bank adjustments in liquidity.

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Who can execute a repo/reverse repo? In India, only select institutions in the financial sector has RBI's permission to enter into repo and reverse repo transactions. Significantly, in the April 28 policy, RBI has for the first time allowed listed corporates to participate in the repo market as lenders. Thus, a corporate treasurer can choose between a liquid mutual fund and repo to park surplus money in the short term. For this, corporates will have to open a constituent subsidiary general account with a bank, which is a kind of a demat account for government securities.

A bank cannot do repo with brokerage. Why? The ban, still in force, was imposed after the '92 stock market scam masterminded by the Late Harshad Mehta. Mehta used a repo/reverse repo operation with various banks as a subterfuge to divert funds to the stock market. After the scam, RBI came up with strict guidelines for repo transactions. It also limited the ntlmber of players in repo transactions to participants such as banks and primary dealers.

THE MARKET The market for the Repurchase Agreements (Repos) is one of the fastest growing and important segments of the money markets in the developed countries. Simply stated 'repo' means a purchase and sale agreement. It is a contract to buy securities and then to sell them back at an agreed future date and price. It is thus an avenue for short-term investment of surplus funds for a short period and involves selling a security and simultaneously agreeing to repurchase it at a stated future date for a slightly higher price. The price differential represents interest element, the rate of which is slightly lower than the Call money rate and constitutes the cost of borrowing funds against the security. The instrument has provided liquidity and depth to the underlying securities markets like bond markets. In countries like the USA, Canada, Germany and Australia repos are effectively used by central banks as part of op