Indian Economy, 5th edition (57 page)

If investment have been done in a well-managed MF, the advantages outweigh disadvantages and in the long term, which is 10 years or more. There is a very high probability for investors of making more money than by investing in other risk-free investments such as FDs, public provident fund, etc. Advantages of investing in MFs include diversification, good investment management services, liquidity, strong government-backed regulatory help, professional service, and all these at a low cost. An investor, by investing in a mutual fund scheme that has blue chip stocks in its portfolio, indirectly gets an exposure to these stocks. Compared to this, if the same investor wants to have each of these stocks in his portfolio, the cost of buying and managing the portfolio will be much higher.

Introduction

The sense in which we today use the term banking has its origin in the western world to which India was introduced by the British rulers, way back in the 17
th
century. Since then, enough water has flown and today Indian banks are considered among the best banks in the developing world and its attempts to emerge among the best in the world is going on as the
Union Budget 2007-08
said.

Bank & Non-Bank Institutions

A financial institution which accepts different forms of deposits and lends them to the prospective borrowers as well as allows the depositors to withdraw their money from the accounts by cheque is a
bank
.

If the financial institution has all the same functions but does not allow depositors to issue cheque and withdraw their money from deposits then it is a
non-bank institution.

NON-BANKING FINANCIAL
COMPANIES (NBFCs)

A non-banking financial company (NBFC) is a company
1
registered under the Companies Act, 1956 and is engaged in the business of loans and advances, acquisition of shares/stock/bonds/debentures/securities issued by government or local authority or other securities of like marketable nature, leasing, hire-purchase, insurance business, chit business, but
does not include
any institution whose principal business is that of agriculture activity, industrial activity, sale/purchase/construction of immovable property.

A non-banking institution which is a company and which has its principal business of receiving
deposits
under any scheme or arrangement or any other manner, or lending in any manner is also a non-banking financial company (residuary non-banking company i.e. RNBC).

NBFCs are doing functions akin to that of banks, however there are a few differences:

(i)
An NBFC cannot accept demand deposits (which are payable on demand), like the
savings
and
current accounts
.

(ii)
It is not a part of the payment and settlement system and as such
cannot issue cheques
to its customers; and

(iii)
Deposit insurance facility is not available for NBFC depositors unlike in case of banks (It means the public deposits with them are ‘unsecured’. In case a NBFC defaults in repayment of deposit, the depositor can approach Company Law Board or Consumer Forum or file a civil suit to recover the deposits).

Under the RBI Act, 1934, the NBFCs have to get registered with RBI. However, to obviate
dual regulation
, certain category of NBFCs which are regulated by other regulators are exempted from the requirement of registration with RBI such as:

(i)
venture capital fund, merchant banking companies, stock broking companies register with Sebi;

(ii)
insurance company holding a valid certificate of registration issued by IRDA;

(iii)
nidhi
companies under the Companies Act, 1956;

(iv)
chit companies under the Chit Funds Act, 1982;

(v)
housing finance companies regulated by National Housing Bank (of the RBI).

A company incorporated under the Companies Act, 1956 and desirous of commencing business of the NBFC should have a minimum net owned fund (NOF) of Rs 25 lakh (raised to Rs 2 crore from April 21, 1999). NBFCs registered with RBI have been reclassified (since 2006) as – the Asset Finance Company (AFC); Investment Company (IC); and the Loan Company (LC).
Provisions
for accepting deposits are:

•
There is ceiling on acceptance of public deposits an NBFC maintaining required NOF and CRAR and complying with the prudential norms can accept public deposits maximum upto 4 times of NOF;

•
Can offer the maximum 11% rate of interest;

•
Minimum investment grade credit rating (MIGR) is essential (may get itself rated by any of the four rating agencies namely, CRISIL, CARE, ICRA and FITCH Ratings India Pvt. Ltd.);

•
Are allowed to accept/renew public deposits for a minimum period of 12 months and maximum period of 60 months; and

•
Effective from April 2004, cannot accept deposits from NRIs except deposits by debit to NRO account of NRIs provided such amount do not represent inward remittance or transfer from NRE/FCNR (B) account, however, the existing NRI deposits can be renewed
(
Note
: different foreign currency accounts opened by the Indian banks have been given as the last sub-topic of this Chapter).

There is no ceiling on raising of deposits by RNBCs
but every RNBC has to ensure that the amounts deposited and investments made by the company are not less than the aggregate amount of liabilities to the depositors. To secure the interest of depositors, such companies are required to invest in a portfolio comprising of highly liquid and secured instruments viz. Central/State Government securities, fixed deposit of scheduled commercial banks (SCB), Certificate of deposits of SCB/FIs, units of Mutual Funds, etc. The amount payable by way of interest, premium, bonus or other advantage, by whatever name called by them in respect of deposits received shall not be less than the amount calculated at the rate of 5% (to be compounded annually) on the amount deposited in lump sum or at monthly or longer intervals; and at the rate of 3.5% (to be compounded annually) on the amount deposited under daily deposit scheme. Further, an RNBC can accept deposits for a minimum period of 12 months and maximum period of 84 months from the date of receipt of such deposit. Like the NBFCs they cannot accept deposits repayable on demand (it means they, too can not open saving and current accounts).

Reserve Bank of India

The Reserve Bank of India (RBI) was set up in 1935 (by the
RBI Act, 1934
) as a private bank with two extra functions—regulation and control of the banks in India and being the banker of the Government. After nationalisation in 1949, it emerged as the central banking body of India and it did not remain a ‘bank’ in the technical sense. Since then, the governments have been handing over different functions
2
to the RBI which stand today as given below:

(i)
It is the issuing agency of the currency and coins other than rupee one currency and coin (which are issued by the Ministry of
f
inance itself with the signature of the Revenue Secretary on the note).

(ii)
Distributing agent for the currency and coins issued by the Government.

(iii)
Banker of the Government.

(iv)
Bank of the banks/Bank of the last resort.

(v)
Announces the credit and monetary policy for the economy.

(vi)
Stabilising the rate of inflation.

(vii)
Stabilising the exchange rate of rupee.

(viii)
Keeper of the foreign currency reserves.

(ix)
Agent of the Government of India in the IMF.

(x)
Performing a variety of developmental and promotional functions under which it did set up institutions like IDBI, SIDBI, NABARD, NHB, etc.

Credit and Monetary Policy

The policy by which the desired level of money flow and its demand is regulated is known as the credit and monetary policy. All over the world it is announced by the central banking body of the country—as the RBI announces it in India. In India there has been a tradition of announcing it twice in a financial year—before the starting of the
busy
and the
slack
seasons. But in the reform period, this tradition has been broken. Now the RBI keeps modifying this as per the requirement of the economy, though the practice of the two policy announcements a year still continues.

In India, a debate regarding autonomy to the RBI regarding announcement of the policy started when the Narasimham Committee-I recommended on these lines. As the Governor RBI it was Bimal Jalan who vocally supported the idea. No such move came from the governments officially but it is believed that the RBI has been given almost working autonomy in this area. In most of the developed economies, the central bank functions with autonomous powers in this area (bifurcation of politics from the economics). Though we lack such kind of officially open autonomy for the RBI, we have learnt enough by now and are better off today.

There are many tools by which the RBI regulates the desired/required kind of the credit and monetary policy—CRR, SLR, Bank Rate, Repo rate, Reverse Repo rate, PLR, Exim interest rate,
s
mall
s
aving Schemes’ interest rates (SSSs), interest changes for the instruments of the
m
oney Market, etc.

CRR

The cash reserve ratio (CRR) is the ratio (fixed by the RBI) of the total deposits of a bank in India which is kept with the RBI in cash form. This was fixed to be in the range of 3 to 15 per cent.
3
A recent Amendment (2007) has removed the 3 per cent floor and provided a free hand to the RBI in fixing the CRR.

At present it is 4.75 per cent and a 1 per cent change in it today affects the economy with
`
64,000 crore
4
—an increase sucks this amount from the economy while a decrease injects this amount into the economy.

Following the recommendations of the Narasimham Committee on the Financial System (1991) the Government started two major changes concerning the CRR:

(i)
reducing the CRR was set as the medium-term objective and it was reduced gradually from its peak of 15 per cent in 1992 to 4.5 per cent by June 2003
5
.

After the RBI (Amendment) Act has been enacted in June 2006, the RBI can now prescribe CRR for scheduled banks without any floor or ceiling rate thereby removing the statutory minimum CRR limit of 3 per cent.
6

(ii)
Payment of interest by the RBI on the CRR money to the scheduled banks started in financial year 1999–2000 (in the wake of banking slow down). Though the RBI discontinued interest payments from mid-2007.
7

SLR

The statutory liquidity ratio (SLR) is the ratio (fixed by the RBI) of the total deposits of a bank which is to be maintained by the bank with itself in non-cash form prescribed by the Government to be in the range of 25 to 40 per cent.
8

At present it is 25 per cent (done in October, 1997 after CFS suggestions)
9
. It used to be as high as 38.5 per cent. The CFS has recommended the Government not to use this money by handing G-Secs to the banks. In its place a
market-based interest
on it should be paid by the Government it was being advised. However, there has been no follow up in this regard by the governments. The Government of India has removed the 25 per cent floor for the SLR by an Amendment (2007) providing the RBI a free hand in fixing it.

Bank Rate

The interest rate which the RBI charges on its
long-term
lendings is known as the Bank Rate. The clients who borrow through this route are the GoI, State governments, Banks, Financial Institutions, Co-operative Banks, NBFCs, etc. The rate has direct impact on the long-term lending activities of the concerned lending bodies operating in the Indian financial system. Tha rate was realigned
10
with the MSF (Marginal Standing Facility) by the RBI in February, 2012.

Repo Rate

The rate of interest the RBI charges from its clients on their
short-term
borrowing is the repo rate in India which is at present 8 per cent.
11
Basically, this is abbreviated form of the ‘rate of repurchase’ and in western economies it is known as the ‘rate of discount’.
12

In practice it is not called an interest rate but considered a discount on the dated Government Securities which are deposited by the institution to borrow for the short term.
w
hen they get their securities released from the RBI, the value of the securities is lost by the amount of the current repo rate. This rate functions as the benchmark rate for the inter-bank short-term market (i.e.
c
all Money Market) in India. Banks usually use this route for one-day borrowing to fulfill their short-term liquidity crunch. Higher the repo rate costlier the loans banks forward and vice versa. It has direct impact on the
nominal interest
rates of the bank’s lending. The
repo rate
was introduced in December 1992.

Reverse Repo Rate

It is the rate of interest the RBI pays to its clients who offer short term loan to it.

It is reverse of the repo rate and this was started in November 1996 as part of
l
iquidity Adjustment Facility (LAF) by the RBI. In practice, financial instituions operating in India park their surplus funds with the RBI for short-term period and earn money. It has a direct bearing on the interest rates charged by the banks and the financial institutions on their different forms of loans.

This tool was utilised by the RBI in the wake of over money supply with the Indian banks and lower loan disbursal to serve twin purposes of cutting down banks losses and the prevailing interest rate
13
. It has emerged as a very important tool in direction of following cheap interest regime—the general policy of the RBI since reform process started.

Marginal Standing Facility (MSF)
14

MSF is a new scheme announced by the RBI in its Monetary Policy, 2011-12 which came into effect from 9th May 2011. Under this scheme, banks can borrow overnight upto 1 per cent of their net demand and time liabilities (NDTL) from the RBI, at the interest rate 1 per cent (100 basis points) higher than the current repo rate.

The MSF would be the last resort for banks
once they exhaust
all borrowing options including the liquidity adjustment facility by pledging through government securities, which has lower rate (i.e. repo rate) of interest in comparison with the MSF. The MSF would be a
penal rate
for banks and the banks can borrow funds by pledging government securities within the limits of the statutory liquidity ratio. The scheme has been introduced by RBI with the main aim of reducing volatility in the overnight lending rates in the inter-bank market and to enable smooth monetary transmission in the financial system.