Dibrugarh University B.Com 6th Sem: Indian Financial System Solved Papers (May' 2018)

2018 (May)

COMMERCE

(General/Speciality)

1. Fill in the blanks: 1x4=4

a) Under Section 22 of the RBI Act, the RBI issues notes.

b) Indian financial system comprises of both organized and unorganised sector.

c) Demonetization has been implemented for three times in India till today.

d) RBI acts as a lender of last resort in Indian banking system.

2. State whether the following statements are True or False: 1x4=4

a) Non-banking assets and non-performing assets are synonymous terms. False

b) Money market deals with short-term investible fund. True

c) IDBI accepts deposits from public. False, It’s a development bank.

d) Price stability is an objective of monetary policy of RBI. True

3. Write short notes on (any four): 4x4=16

a) Mutual Fund: A mutual fund is an investment security type that enables investors to pool their money together into one professionally managed investment. Mutual funds can invest in stocks, bonds, cash and/or other assets.

There are certain key characteristics of mutual funds:

1. Mutual Fund Diversification: Most individual investors are unable to purchase 50 or 60 different issues of stocks. They typically have to rely on a few selections and hope for the best. An investor in a mutual fund gets the advantage of being invested in the entire fund’s portfolio. This helps lower the exposure to problems with any individual issue.

2. Mutual Fund Professional Management: The fund employs professionals to manage the fund's investments. Most small investors can’t possibly spend their days researching individual stocks or bonds and market trends. By owning a fund, the investors can take advantage of the abilities of the fund’s management team. The fund charges a management fee to cover the cost of management.

3. Mutual Fund Affordability: Investments in mutual funds can often be opened with small investments. Sometimes the initial investment may be as low as Rs.100, and subsequent investments into the fund may be made with similar small amounts.

4. Mutual Fund Liquidity - Mutual funds are liquid on every business day. They are sold at their net asset value which is computed on every business day after the close of the markets. The price you receive depends on the value of the securities in the fund

b) Treasury bills: Treasury bills are short term money market instruments which are used the central government to borrow money from the public. Treasury bills are first issued in India in 1917. There are four types of treasury bills:

1. 14-day Tbill- maturity is in 14 days. Its auction is on every Friday of every week. The notified amount for this auction is Rs. 100 crores.

2. 91-day Tbill- maturity is in 91 days. Its auction is on every Friday of every week. The notified amount for this auction is Rs. 100 crores.

3. 182-day Tbill- maturity is in 182 days. Its auction is on every alternate Wednesday (which is not a reporting week). The notified amount for this auction is Rs. 100 crores.

4. 364-Day Tbill- maturity is in 364 days. Its auction is on every alternate Wednesday (which is a reporting week). The notified amount for this auction is Rs. 500 crores.

c) Primary Market (New Issue Market):. A primary market refers to any market where new shares of stock are sold. The primary market is the entry market for companies and investors, where a company or institution that requires initial or additional capital sells its shares or financial instrument to the investors. For example, Initial Public Offering (IPO), public offer, rights issue and bond issue are done on the primary market. The primary market is also unique that the initial buyer is the only person who can exchange the securities for funds. When companies are willing to go for publicly listed on the stock exchange and wants to collect funds from general investors, they first sell their financial instrument in the primary market. Primary market is the first place for trading financial instruments including stocks and bonds.

d) Merchant Banking: Merchant bankers are body corporate who engaged in issue of securities. It acts as manager or advisor or consultant to issuing company. A merchant banker requires compulsory registration under the regulation 3 of SEBI (Merchant Bankers) Regulations, 1992. These activities mainly includes determining the composition of capital structure, compliance with procedural formalities , appointment of registration , listing of securities, arrangement of underwriting , selection of brokers and bankers, publicity and advertisement agent , private placement of securities, advisory services, etc.

The merchant bankers are responsible to make all efforts to protect the interest of investors. The merchant bankers has to exercise due diligence, high standards of integrity, dignity. The merchant bankers are also responsible in providing adequate information without misleading about the applicable regulations and guidelines. It is now mandatory for all public issue s to be managed by merchant bankers functioning as the lead managers.

e) Securities and exchange board of India:

With the growth in the dealings of stock markets, lot of malpractices also started in stock markets such as price rigging, ‘unofficial premium on new issue, and delay in delivery of shares, violation of rules and regulations of stock exchange and listing requirements. Due to these malpractices the customers started losing confidence and faith in the stock exchange. So government of India decided to set up an agency or regulatory body known as Securities Exchange Board of India (SEBI).

Securities Exchange Board of India (SEBI) was set up in 1988 to regulate the functions of securities market. SEBI promotes orderly and healthy development in the stock market but initially SEBI was not able to exercise complete control over the stock market transactions.

It was left as a watch dog to observe the activities but was found ineffective in regulating and controlling them. As a result in May 1992, SEBI was granted legal status. SEBI is a body corporate having a separate legal existence and perpetual succession.

The Organisational Structure of SEBI:

1. SEBI is working as a corporate sector.

2. Its activities are divided into five departments. Each department is headed by an executive director.

3. The head office of SEBI is in Mumbai and it has branch office in Kolkata, Chennai and Delhi.

4. SEBI has formed two advisory committees to deal with primary and secondary markets.

5. These committees consist of market players, investors associations and eminent persons.

Purpose and Role of SEBI: SEBI was set up with the main purpose of keeping a check on malpractices and protect the interest of investors. It was set up to meet the needs of three groups.

1. Issuers: For issuers it provides a market place in which they can raise finance fairly and easily.

2. Investors: For investors it provides protection and supply of accurate and correct information.

3. Intermediaries: For intermediaries it provides a competitive professional market.

f) Marketable and non-marketable securities: Marketable securities are instruments which are liquid and can be easily sold in stock market or bond market. Marketable securities are classified into two categories marketable equity securities and marketable debt securities. Marketable equity securities includes equity shares and preference shares which are quoted and traded in stock exchange. Marketable debt securities includes debentures and bonds which are quoted and traded in bond market.

Non-marketable securities are instruments which are not traded in stock exchange. These are generally bought and sold privately or in other the counter exchange of India. Non-marketable securities includes government bonds, shares of a private company etc.

4. What is financial system? Discuss the elements of Indian financial system. 2+12=14

Ans: The financial system is possibly the most important institutional and functional vehicle for economic transformation. Finance is a bridge between the present and the future and whether the mobilization of savings or their efficient, effective and equitable allocation for investment, it the access with which the financial system performs its functions that sets the pace for the achievement of broader national objectives.

According to Christy, the objective of the financial system is to “supply funds to various sectors and activities of the economy in ways that promote the fullest possible utilization of resources without the destabilizing consequence of price level changes or unnecessary interference with individual desires.”

According to Robinson, the primary function of the system is “to provide a link between savings and investment for the creation of new wealth and to permit portfolio adjustment in the composition of the existing wealth.

A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the deficit. It is a composition of various institutions, markets, regulations and laws, practices, money manager analyst, transactions and claims and liabilities.

Elements or Structure of Indian Financial System

The formal financial system comprises financial institutions, financial markets, financial instruments and financial services. These constituents or components of Indian financial system may be briefly discussed as below:

A. Financial Institutions: Financial institutions are the participants in a financial market. They are business organizations dealing in financial resources. They collect resources by accepting deposits from individuals and institutions and lend them to trade, industry and others. They buy and sell financial instruments. They generate financial instruments as well. They deal in financial assets. They accept deposits, grant loans and invest in securities.

On the basis of the nature of activities, financial institutions may be classified as: (a) Regulatory and promotional institutions, (b) Banking institutions, and (c) Non-banking institutions.

1. Regulatory and Promotional Institutions: Financial institutions, financial markets, financial instruments and financial services are all regulated by regulators like Ministry of Finance, the Company Law Board, RBI, SEBI, IRDA, Dept. of Economic Affairs, Department of Company Affairs etc. The two major Regulatory and Promotional Institutions in India are Reserve Bank of India (RBI) and Securities Exchange Board of India (SEBI). Both RBI and SEBI administer, legislate, supervise, monitor, control and discipline the entire financial system.

2. Banking Institutions: Banking institutions mobilise the savings of the people. They provide a mechanism for the smooth exchange of goods and services. They extend credit while lending money. They not only supply credit but also create credit. There are three basic categories of banking institutions. They are commercial banks, co-operative banks and developmental banks.

3. Non-banking Institutions: The non-banking financial institutions also mobilize financial resources directly or indirectly from the people. They lend the financial resources mobilized. They lend funds but do not create credit. Companies like LIC, GIC, UTI, Development Financial Institutions, Organisation of Pension and Provident Funds etc. fall in this category.

B. Financial Markets: Financial markets are another part or component of financial system. Efficient financial markets are essential for speedy economic development. It facilitates the flow of savings into investment. Financial markets bridge one set of financial intermediaries with another set of players. Financial markets are the backbone of the economy. This is because they provide monetary support for the growth of the economy.

Classification of Financial Markets: There are different ways of classifying financial markets. There are mainly five ways of classifying financial markets.

1. Classification on the basis of the type of financial claim: On this basis, financial markets may be classified into debt market and equity market.

Debt market: This is the financial market for fixed claims like debt instruments.

Equity market: This is the financial market for residual claims, i.e., equity instruments.

2. Classification on the basis of maturity of claims: On this basis, financial markets may be classified into money market and capital market.

Money market: A market where short term funds are borrowed and lend is called money market. It deals in short term monetary assets with a maturity period of one year or less. Liquid funds as well as highly liquid securities are traded in the money market. Examples of money market are Treasury bill market, call money market, commercial bill market etc.

Capital market: Capital market is the market for long term funds. This market deals in the long term claims, securities and stocks with a maturity period of more than one year.

3. Classification on the basis of seasoning of claim: On this basis, financial markets are classified into primary market and secondary market.

Primary market: Primary markets are those markets which deal in the new securities. Therefore, they are also known as new issue markets.

Secondary market: Secondary markets are those markets which deal in existing securities. Existing securities are those securities that have already been issued and are already outstanding. Secondary market consists of stock exchanges.

4. Classification on the basis of structure or arrangements: On this basis, financial markets can be classified into organised markets and unorganized markets.

Organised markets: These are financial markets in which financial transactions take place within the well established exchanges or in the systematic and orderly structure.

Unorganised markets: These are financial markets in which financial transactions take place outside the well established exchange or without systematic and orderly structure or arrangements.

5. Classification on the basis of timing of delivery: On this basis, financial markets may be classified into cash/spot market and forward / future market.

Cash / Spot market: This is the market where the buying and selling of commodities happens or stocks are sold for cash and delivered immediately after the purchase or sale of commodities or securities.

Forward/Future market: This is the market where participants buy and sell stocks/commodities, contracts and the delivery of commodities or securities occurs at a pre-determined time in future.

6. Other types of financial market: Apart from the above, there are some other types of financial markets. They are foreign exchange market and derivatives market.

Foreign exchange market: Foreign exchange market is simply defined as a market in which one country’s currency is traded for another country’s currency.

Derivatives market: It is a market for derivatives. The important types of derivatives are forwards, futures, options, swaps, etc.

C. Financial Instruments (Securities): Financial instruments are the financial assets, securities and claims. They may be viewed as financial assets and financial liabilities. Financial assets represent claims for the payment of a sum of money sometime in the future (repayment of principal) and/or a periodic payment in the form of interest or dividend. Financial liabilities are the counterparts of financial assets. They represent promise to pay some portion of prospective income and wealth to others. Financial assets and liabilities arise from the basic process of financing.

D. Financial Services: The development of a sophisticated and matured financial system in the country, especially after the early nineties, led to the emergence of a new sector. This new sector is known as financial services sector. Its objective is to intermediate and facilitate financial transactions of individuals and institutional investors. The financial institutions and financial markets help the financial system through financial instruments. The financial services include all activities connected with the transformation of savings into investment. Important financial services include lease financing, hire purchase, instalment payment systems, merchant banking, factoring, forfaiting etc.

Discuss the major reforms in Indian financial system during post-liberalization period. 14

Ans: Economic Reforms in India since 1991

The Indian Government has introduced many Economic Reforms in India since 1991. In 1990-91 India had to face grave economic problem. India was facing serious deficiency in her foreign trade balance and it was increasing. Since 1987-88 till 1990-91 it was increasing in such a rapid scale that by the end of 1990-91 the amount of this deficit balance became 10,644 crores of rupees.

At the same time the foreign exchange stock was also decreasing. In 1990 and 1991 the government of India had to take huge amount of loan from the IMF as compensatory financial facility. Even by mortgaging 46 tons of gold it had taken short term foreign loan from the Bank of England.

At the same time, India was also suffering from inflation, the rate of which was 12% by 1991. The reasons of that inflation were the increase in the procurement price of the agricultural products for distribution, the increase in the amount of monetized deficit in the budget, increase of import cost and decrease in the rate of currency exchange and Administered price like. Thus she was facing trade deficit as well as Fiscal Deficit.

To get relief from such a grave problem the government of India had only two ways before it to take foreign debt and to create favorable conditions within the country for increasing the flow of foreign exchange and also to increase the volume of export. The other was to establish fiscal discipline within the country and to make structural adjustment for the purpose.

Hence the government of India had to introduce a package of reforms which included:

a) To liberalize the industrial policy of the government and to invite foreign investment by privatization of industries and abolishing the license system as a part of that liberalization.

b) To make the import-export policy of the country more liberal and so that the export of Indian goods may become more easy and the necessary raw materials and instruments for both industrial development and production of exportable commodities may be imported and also to facilitate free trade by reducing the import duty.

c) To decrease the value of money in terms of dollar

d) To take huge amount of foreign debt from the IMF and the world Bank for rejuvenating the economic condition of the country and to introduce the structural adjustment in the economic condition of the country as a pre-condition of that debt,

e) To reform the banking system and the tax structure of the country and

f) To establish market economy by withdrawing and restricting government interference on investment.

The main objectives of the new fiscal policy are, however, to establish economic structural adjustment at the first stage and then to establish market economy by removing all controls and restrictions on it. There are two phases in the structural adjustment phase, the stabilization phase where all government expenditures are reduced and the banks are restricted on creating debt. The second phase is the structural adjustment phase where the production of exportable good and the alternative of import goods are increased and at the same time reducing governmental interference in industry, the management skill and productive capacity of the industries are increased through privatization.

Thus the new fiscal policy has introduced three significant things Deregulation, Privatization and Exit Policy. Excepting 15 important industries all other industries have been made free from license system. To encourage foreign investment its highest limit has been increased up to 51%. 38 industries have been made open for foreign investment like the Metal industry, Food Processing industry, Hotel and tourism industry etc. Exit Policy has been introduced in the industries which are running at a loss with surplus staff and the sick industries are scheduled to be closed.

The Economic liberalization have helped India to grow at faster pace. India is now considered one of the major economy of Asia. The Foreign investments in India have increased over the years. Many multinational companies have set-up their offices in India. The per-capita GDP of India have increased, which is a sign of growth and development.

India has emerged as a leading exporter of services, software and information-technology products. Many companies such as Wipro, TCS, HCL Technologies, Tech Mahindra have got worldwide fame. Thus the new economic policy is taking India towards liberal economy or market economy. It has relieved India much of her hardship that she faced in 1990-91.

5. Explain the credit creation process of the commercial banks. Mention its limitations. 10+4=14

Ans: Credit Creation by Banks

Money is said to be created when the banks, through their lending activity, make net addition to the total supply of money in the economy. Thus, the giving of loans by the banks in the form of derivates deposits leads to the creation of money. The banks create secondary deposits or derivation from the primary deposits. This creation of derivative deposits is known as Credit Creation.

The modern banks create deposits in two ways.

Firstly, in a passive way this results in primary or passive deposits.

Secondly, in a more active way this results in active or derivative deposits.

The bank creates passive when it opens a deposits account in the name of the customer who brings cash or cheques to be credited to his account. In this case, the rate of the bank is merely passive as it accepts the cash or the cheques brought by the customers and deposited them in his account. It is the primary deposits which later on form the basis of loan transaction by the bank. These primary deposits do not make any net addition to the stock of money in the economy. After keeping a small percentage of these deposits in cash, the bank utilities the balance for making loans and advances to the customer. The percentage of the primary deposits kept by the bank in cash is known as cash Reserve Ratio. The creation of these deposits can be explained with the help of an example.

Let us suppose that the bank grants a loan of Rs. 20,000 to his customers against some collateral security. What the bank actually does it that it opens an account in the name of the borrower and credit Rs. 20,000 to it. In any case, the bank does not pay Rs. 20,000 to the borrower in cash. The borrower may either withdrawn the entire amount at once or he may withdraw small accounts of money from time to time according to his requirements. Thus, by making loans the bank has at the sometime created new deposits in its books.

Hence, the well-known maxim is that “Every loan creates a deposit”. Such actively created deposits lead to a net increase in the total supply of money in the economy. The active deposits are also created by the bank when it purchases securities or other forms of assets from the public. The actual process of multiple creation of credit may be explained thus:-

When a bank grants loans to the borrowers, the loan money is created to his deposits account. Supposing, the borrower pays to his creditor, in connection with some business transaction, a cheque drawn upon his account with the bank. Let us further suppose that the creditor deposits the cheque in another bank in his account. The other bank now receives the primary deposits in the form of a cheque drawn upon the first bank. After keeping some cash as cash ratio the second bank may create another derivative deposit by giving loans to some borrowers. The second borrowers may make the payment to another creditor who happens to have a deposit account with the third bank. The third bank will know receive the primary deposits in the form of cheque drawn on the second bank. This process may be repeated until the total volume of derivative deposits created by all the banks would be a multiple of the initial amount created by the first bank.

The limitations of the credit creation process of commercial banks are:

a) Availability of primary deposits: The commercial banks create credit only on the basis of primary deposits. They cannot create a large number of credits from a small primary deposit.

b) Requisite cash reserve ratio: The size of the credit multiplier is inversely related to the cash reserve ratio. The higher the ratio, the smaller will be volume of excess reserve available and smaller will be volume of credit creation and vice versa.

c) Banking habits of the people: The banking habit of the people also sets the limit for the capacity of banks to create credit. If the people don’t have banking habit and prefer to transact by cash and not by cheque, then multiple credit creation of the bank will not be possible.

d) Availability of good collateral security: The availability of collateral securities also places a limit on credit creation of banks. If securities are not available in sufficient number, the banks cannot expand their lending activities and thus, cannot create credit.

e) Credit policy of the Central Bank: The extent of credit creation also depends on the monetary policy of the Central bank. The Central bank provides a limit to the commercial banks to create credit and they are bound to follow it.

Justify the need of a Central Bank in financial system of India.

6. Discuss the services provided my merchant banks in Indian capital market. 14

Ans: MERCHANT BANKER OR LEAD MANAGERS

Merchant bankers are body corporate who engaged in issue of securities. It acts as manager or advisor or consultant to issuing company. A merchant banker requires compulsory registration under the regulation 3 of SEBI (Merchant Bankers) Regulations, 1992. These activities mainly includes determining the composition of capital structure, compliance with procedural formalities , appointment of registration , listing of securities, arrangement of underwriting , selection of brokers and bankers, publicity and advertisement agent , private placement of securities, advisory services, etc.

Services provided by Merchant Bankers.

Following other services are provided by merchant bankers.

1. Corporate counseling: Corporate counseling covers entire field of merchant banking viz project counseling, capital restructuring, project management, loan syndication, working capital, lease financing, portfolio management, underwriting etc. Such counseling is provided to corporate and client units to solve their problems.

2. Project Counseling: Which includes preparing project reports, finance for cost of project, appraising projects from the angle of technical, commercial and financial viability, Getting approval of project from bank/Govt and other agencies & Planning for public issue.

3. Loan Syndication: Arranging loan for big projects not only from one bank or financial institution but from more than one bank or financial institution as amount of loan is very large.

4. Underwriting of public issue: Underwriting is a guarantee given by the underwriter that in the event of under subscription, the amount would be provided by him to the extent of under subscription. All public issues are to be underwritten fully. Merchant banks provide such service of underwriting pubic issue subject to some limitations.

5. Managers, Consultants or advisors to the issue: Managers to the issue assist in drafting of prospectus, application forms and completion of formalities under companies act, appointment of Registrar for dealing with share applications, transfer and listing of shared with stock exchange.

6. Portfolio Management: It refers to investments in different kinds of securities such as shares, debentures, bonds issued by different companies and securities issued by the Govt. Merchant bankers advise about mix of investments a company should follow to ensure maximum return with minimum risk and for this purpose merchant makers have to make a careful study of Govt. policies, capital market as well as financial position of companies.

7. Corporate restructuring: Merchant bankers are also advising companies ;about corporate restructuring including merger, acquisition, takeovers etc.

8. Off-share financing: Merchant bankers are also arranging foreign currency, foreign loans, foreign collaborations, financing exports imports etc.

9. Technical assistance: Merchant bankers are also providing services on technical aspects such as technological up gradation, modernization of industries etc.

10. Revival package for sick units: Merchant bankers are also liaisoning with Board of Industrial and Financial Reconstruction (BIFR) and industrial Reconstruction Bank of India (IRBI) and such helping their clients in this regard also.

What is secondary market? Distinguish between primary market and secondary market. 5+9=14

Ans: Stock Exchange or Secondary Market

Stock exchange also known as Secondary Market is a specific place, where trading of the securities, is arranged in an organized method. In simple words, it is a place where shares, debentures and bonds (securities) are purchased and sold. The term securities include equity shares, preference shares, debentures, government bonds, etc. including mutual funds.

According to the Securities Contracts (Regulation) Act 1956, the term 'stock exchange' is defined as ''An association, organization or body of individuals, whether incorporated or not, established for the purpose of assisting, regulating and controlling of business in buying, selling and dealing in securities."

Husband and Dockerary have defined stock exchange as: "Stock exchanges are privately organized market which are used to facilitate trading in securities."

In simple Words, a stock exchange provides a platform or mechanism to, the investors - individuals or institutions to purchase or sell the securities of the companies, Government or semi Government institutions. It is like a commodity market where securities are bought and sold. It is an important constituent of capital market.

From the above discussion, we get the following important features of a stock exchange:

Ø Stock exchange is a place where buyers and sellers meet and decide on a price.

Ø Stock exchange is a place where stocks or all types of securities are traded.

Ø Stock exchange is at physical location, where transactions are carried out on a trading floor.

Ø The purpose of a stock exchange or market is to facilitate the exchange of securities between buyers and sellers, thus reducing the risk.

Difference between primary Market and Secondary Market

Primary Market (New Issue Market):. A primary market refers to any market where new shares of stock are sold. The primary market is the entry market for companies and investors, where a company or institution that requires initial or additional capital sells its shares or financial instrument to the investors. For example, Initial Public Offering (IPO), public offer, rights issue and bond issue are done on the primary market. The primary market is also unique that the initial buyer is the only person who can exchange the securities for funds. When companies are willing to go for publicly listed on the stock exchange and wants to collect funds from general investors, they first sell their financial instrument in the primary market. Primary market is the first place for trading financial instruments including stocks and bonds.

From the above discussion, we find the following difference between Primary and Secondary Market

Primary Market	Secondary Market
It deals in new securities which are issue for the first time.	It deals in already issued securities.
For Primary market, no organizational set up required.	But for a secondary market, a proper organizational set up is required.
Life of primary market is limited to point of issue of securities.	But Secondary Market has perpetual life.
It provides funds to the issuers for a particular purpose.	Funds from sell of shares can be utilised in any manner.
Individual issues are managed individually.	Manage and controlled by a central authority.
No fixed place for market.	Located at known fixed places.

7. Explain how SEBI protects the interest of investors. 14

Ans: SECURITIES AND EXCHANGE BOARD OF INDIA