UNIT 1

Financial System

A financial system plays a vital role in the economic growth of a country. It intermediates between the
flow of funds belonging to those who save a part of their income and those who invest in productive
assets. It mobilises and usefully allocates scarce resources of a country. A financial system is a
complex, well-integrated set of sub-systems of financial institutions, markets, instruments, and
services which facilitates the transfer and allocation of funds, efficiently and effectively.
Types of Economic Units
In any economy, there are two types of economic units or entities—surplus-spending economic units
and deficit-spending economic units.

 Surplus-spending Economic Units

These are units whose consumption and planned investment are less than their income. The surplus
savings that they have is held in the form of cash balances or financial assets. The acquisition of
financial assets or making of loans is, in fact, lending for productive investment. Such lending by the
surplus-spending sector can be termed as demanding financial assets or supplying loanable funds. In
India, the household sector is a net-surplus spending economic unit. The household and other sectors
are discussed in detail in the flow of funds analysis.

 Deficit-spending Economic Units

These are units whose consumption and planned investment exceeds income. The deficit-spending
economic units have negative savings; they finance their needs by borrowing or by decreasing their
stock of financial assets. Borrowing by deficit-spending units creates a supply of financial securities
or demand for loanable funds. In India, the government and the corporate sector are deficit-spending
economic units.
The surplus savings of the surplus-spending household units have to be transferred to the deficit-
spending economic units. A link in the form of a financial system is necessary to transfer surplus
savings to deficit units. The surplus and deficit units can be brought together either directly through
external financing or indirectly through intermediation (banks and other financial institutions).

Components of The Formal Financial System

The formal financial system consists of four segments or components. These are: financial
institutions, financial markets, financial instruments, and financial services.
1. Financial Institutions
These are intermediaries that mobilise savings and facilitate the allocation of funds in an efficient
manner.
Financial institutions can be classified as banking and non-banking financial institutions. Banking
institutions are creators and purveyors of credit while non-banking financial institutions are purveyors
of credit. While the liabilities of banks are part of the money supply, this may not be true of non-
banking financial institutions.
Financial institutions can also be classified as term-finance institutions such as the Industrial
Development Bank of India (IDBI), the Industrial Credit and Investment Corporation of India (ICICI),
and the Industrial Financial Corporation of India (IFCI).
Financial institutions can be specialised finance institutions like the Export Import Bank of India
(EXIM), the Tourism Finance Corporation of India (TFCI), ICICI Venture, the Infrastructure
Development Finance Company (IDFC), and sectoral financial institutions such as the National Bank
for Agricultural and Rural Development (NABARD).
Investment institutions in the business of mutual funds Unit Trust of India (UTI), public sector and
private sector mutual funds and insurance activity of Life Insurance Corporation (LIC), General
Insurance Corporation (GIC) and its subsidiaries are classified as financial institutions.
Investment institutions in the business of mutual funds Unit Trust of India (UTI), public sector and
private sector mutual funds and insurance activity of Life Insurance Corporation (LIC), General
Insurance Corporation (GIC) and its subsidiaries are classified as financial institutions.

2. Financial Markets
Financial markets are a mechanism enabling participants to deal in financial claims. The markets also
provide a facility in which their demands and requirements interact to set a price for such claims.
The main organised financial markets in India are the money market and the capital market. The first
is a market for short-term securities while the second is a market for long-term securities, i.e.,
securities having a maturity period of one year or more. Financial markets can also be classified as
primary and secondary markets.
While the primary market deals with new issues, the secondary market is meant for trading in
outstanding or existing securities. There are two components of the secondary market: over-the-
counter (OTC) market and the exchange traded market. In an OTC market, spot trades are negotiated
and traded for immediate delivery and payment while in the exchange-traded market, trading takes
place over a trading cycle in stock exchanges. Recently, the derivatives market (exchange traded) has
come into existence.

3. Financial Instruments
A financial instrument is a claim against a person or an institution for payment, at a future date, of a
sum of money and/or a periodic payment in the form of interest or dividend. The term ‘and/or’
implies that either of the payments will be sufficient but both of them may be promised. Financial
instruments represent paper wealth shares, debentures, like bonds and notes. Many financial
instruments are marketable as they are denominated in small amounts and traded in organised
markets. This distinct feature of financial instruments has enabled people to hold a portfolio of
different financial assets which, in turn, helps in reducing risk. Different types of financial
instruments can be designed to suit the risk and return preferences of different classes of investors.
Financial securities are financial instruments that are negotiable and tradeable. Financial securities
may be primary or secondary securities. Primary securities are also termed as direct securities as they
are directly issued by the ultimate borrowers of funds to the ultimate savers. Examples of primary or
direct securities include equity shares and debentures. Secondary securities are also referred to as
indirect securities, as they are issued by the financial intermediaries to the ultimate savers. Bank
deposits, mutual fund units, and insurance policies are secondary securities.
4. Financial Services
These are those that help with borrowing and funding, lending and investing, buying and selling
securities, making and enabling payments and settlements, and managing risk exposures in financial
markets. The major categories of financial services are funds intermediation, payments mechanism,
provision of liquidity, risk management, and financial engineering.
Funds intermediating services link the saver and borrower which, in turn, leads to capital formation.
New channels of financial intermediation have come into existence as a result of information
technology. Payment services enable quick, safe, and convenient transfer of funds and settlement of
transactions.
Liquidity is essential for the smooth functioning of a financial system. Financial liquidity of financial
claims is enhanced through trading in securities. Liquidity is provided by brokers who act as dealers
by assisting sellers and buyers and also by market makers who provide buy and sell quotes.
Financial services are necessary for the management of risk in the increasingly complex global
economy. They enable risk transfer and protection from risk. Risk can be defined as a chance of loss.
Risk transfer of services help the financial market participants to move unwanted risks to others who
will accept it. The speculators who take on the risk need a trading platform to transfer this risk to
other speculators.

Functions of a Financial System

 Mobilise and allocate savings: One of the important functions of a financial system is to link
the savers and investors and, thereby, help in mobilising and allocating the savings efficiently
and effectively. By acting as an efficient conduit for allocation of resources, it permits
continuous upgradation of technologies for promoting growth on a sustained basis.
 Monitor corporate performance: A financial system not only helps in selecting projects to
be funded but also inspires the operators to monitor the performance of the investment.
Financial markets and institutions help to monitor corporate performance and exert corporate
control through the threat of hostile takeovers for underperforming firms.
 Provide payment and settlement systems: It provides a payment mechanism for the
exchange of goods and services and transfers economic resources through time and across
geographic regions and industries. Payment and settlement systems play an important role to
ensure that funds move safely, quickly, and in a timely manner.
 Optimum allocation of risk-bearing and reduction: It limits, pools, and trades the risks
involved in mobilising savings and allocating credit. It reduces risk by laying down rules
governing the operation of the system. Risk reduction is achieved by holding diversified port
folios and screening of borrowers. Market participants gain protection from unexpected losses
by buying financial insurance services. Risk is traded in the financial markets through
financial instruments such as derivatives.
 Disseminate price-related information: A financial system also makes available price-
related information which is a valuable assistance to those who need to take economic and
financial decisions. This information dissemination enables a quick valuation of financial
assets.
 Offer portfolio adjustment facility: A financial system also offers portfolio adjustment
facilities. These are provided by financial markets and financial intermediaries such as banks
and mutual funds. Portfolio adjustment facilities include services of providing a quick, cheap
and reliable way of buying and selling a wide variety of financial assets.
 Lower the cost of transactions: A financial system helps in the creation of a financial
structure that lowers the cost of transactions. This has a beneficial influence on the rate of
return to savers. It also reduces the cost of borrowing. Thus, the system generates an impulse
among the people to save more.
 Promote the process of financial deepening and broadening: A well-functioning financial
system helps in promoting the process of financial deepening and broadening. Financial
deepening refers to an increase of financial assets as a percentage of the Gross Domestic
Product (GDP). Financial broadening refers to building an increasing number and variety of
participants and instruments.

Nature and Role of Financial Institutions (Intermediaries) And Financial Markets

Financial institutions (intermediaries) are business organisations serving as a link between savers and
investors and so help in the credit-allocation process. Good financial institutions are vital to the
functioning of an economy. If finance were to be described as the circulatory system of the economy,
financial institutions are its brain. They make decisions that tell scarce capital where to go and ensure
that it is used most efficiently.
Lenders and borrowers differ in regard to terms of risk, return, and terms of maturity. Financial
institutions assist in resolving this conflict between lenders and borrowers by offering claims against
themselves and, in turn, acquiring claims on the borrowers. The former claims are referred to as
indirect (secondary) securities and the latter as direct (primary) securities.
Financial institutions provide three transformation services:

 Liability, asset, and size transformation consisting of mobilisation of funds, and their
allocation by providing large loans on the basis of numerous small deposits.
 Maturity transformation by offering the savers tailor-made short-term claims or liquid
deposits and so offering borrowers long-term loans matching the cash-flows generated by
their investment.
 Risk transformation by transforming and reducing the risk involved in direct lending by
acquiring diversified portfolios.
Through these services, financial institutions are able to tap savings that are unlikely to be acceptable
otherwise. Moreover, by facilitating the availability of finance, financial institutions enable the
consumer to spend in anticipation of income and the entrepreneur to acquire physical capital.
Banks
Commercial Banks are the oldest, biggest and fastest growing financial intermediaries in India. They
are also the most important depositories of public saving and the most important disbursers of finance.
Commercial Banks ordinarily are simple business or commercial concerns which provide various
types of financial services to customers in return for payments in one form or another, such as interest,
fees, commission, etc.
However, what distinguishes them from other business concerns is the degree to which they have to
balance profit maximisation and certain other principles. In India, banks are required to modify their
performance in profit making if that clashes with their obligations in areas such as social welfare,
social justice, and promotion of regional balance in development.

Banking Regulation Act 1949

The Banking Regulation Act 1949 is a legislation in India, that states all banking firms will be
regulated under this act. There is a total of 55 Sections under the banking regulating act. Initially the
law was only applicable to banks, but after 1965, it was amended to make it applicable to co-operative
banks and also to introduce other changes.
The act provides a framework that regulates and supervises commercial banks in India. This act gives
power to the RBI to exercise control and regulate banks under supervision. The act came into force on
March 16 1949. It relates to various aspects vis-a-vis banking in India.
The main objective of the banking regulation act is to ensure sound banking through regulations
covering the opening of branches and the maintenance of liquid assets.

Features of Banking Regulation Act 1949:

 Prohibition of trading (Section 8): According to Section 8 of the Banking Regulation Act, a
bank cannot directly or indirectly deal with buying or selling or bartering of goods. However,
it may barter the transactions relating to bills of exchange received for collection or
negotiation.
 Non-banking asset (Section 9): A bank cannot hold any immovable property, howsoever
acquired, except for its own use, for any period exceeding seven years from the date of
acquisition thereof. The company is permitted, within a period of seven years, to deal or trade
in any such property for facilitating its disposal.
 Management (Section 10): This rule states that every bank shall have one of its directors as
Chairman on its Board of Directors. It also states that not less than 51% of the total number of
members of the Board of Directors of a bank shall consist of persons who have special
knowledge or practical experience in accountancy, agriculture, banking, economics, finance,
law and co-operatives.
 Minimum capital (Section 11): Section 11 (2) of the Banking Regulation Act, 1949, states
that no bank shall commence or carry on business in India, unless it has minimum paid-up
capital and cash reserve prescribed by the RBI.
 Payment of commission (Section 13): According to Section 13, a bank is not permitted to
pay directly or indirectly by way of commission, brokerage, discount or remuneration on
issues of its shares in excess of 2.5% of the paid-up value of such shares.
 Payment of dividend (Section 15): According to Section 15, no bank shall pay any dividend
on its shares until all its capital expenses (including preliminary expenses, organisation
expenses, share selling commission, brokerage, amount of losses incurred and other items of
expenditure not represented by tangible assets) have been completely written-off.
 Reserve fund (section 17): Every banking company must generate a reserve fund out of its
earnings after tax and interest. Such reserve amount should be at any rate 20 percent of such
profits. Exemption can be provided only if the cumulative amount of reserve fund &
securities premium is greater than the paid up capital of the company.

Reserve Bank of India Act 1934

The Reserve Bank of India Act 1934 is an Act to constitute a Reserve Bank of India (RBI) and
provide the central bank (RBI) with various powers to act as the central bank of India.
Features of the RBI Act:

 Section 3: Establishment and incorporation of Reserve Bank: Section 3 of the RBI act
provides for establishment of Reserve Bank of India for taking over the management of the
currency from Central Government and of carrying on the business of banking in accordance
with the provisions of this Act.
 Section 17: The business that RBI can carry out: This section deals with the functioning of
RBI. The RBI can accept deposits from the central and state governments without interest. It
can purchase and discount bills of exchange from commercial banks. It can purchase foreign
exchange from banks and sell it to them. It can provide loans to banks and state financial
corporations. It can provide advances to the central government and state governments. It can
buy or sell government securities. It can deal in derivative, repo and reverse repo.
 Section 21: Bank to have the right to transact Government business in India.: This
section assigns RBI the duty of being banker to the central government and manage public
debt.
 Section 22: Right to issue bank notes.: This section grants power to RBI to issue the
currency.
 Section 24: Denominations of notes. (1) Subject to the provisions of sub-section (2), bank
notes shall be of the denominational values of two rupees, five rupees, ten rupees, twenty
rupees, fifty rupees, one hundred rupees, five hundred rupees, one thousand rupees, five
thousand rupees and ten thousand rupees or of such other denominational values, not
exceeding ten thousand rupees.
 Section 42: Cash reserves of scheduled banks to be kept with the Bank.: This section
provides that every scheduled bank needs to hold an average daily balance with the RBI.
 The second schedule of the Act lists all the SCHEDULED BANKS in India. The RBI defines
the scheduled banks which are mentioned in the 2nd Schedule of the Act. These are banks
which have paid up capital and reserves above.
Non-Banking Financial Companies

In the Indian financial system, the NBFCs fall within the description of 'shadow banking' as defined
by the Financial Stability Board (FSB). Shadow banking is defined as credit intermediation involving
entities and activities outside the regular banking system. Shadow banks look like a bank but they are
not banks. Shadow banking system has a role in supplying credit or liquidity to the economy but it is
also the source of systemic risk. Because of its interconnectedness with the regular banking system, it
could affect the overall system.

But as far as India is concerned, the NBFCs which are the 'shadow banks' as per international
definitions, have been under prudential regulation for a long time and the sector as a whole holds a
small share of the total assets of the system. Through stringent regulatory norms, the Indian financial
system is able to contain the systemic risk of the so called 'shadow banks'.

An NBFC, in a layman's language, is simply a finance company. It is a non-banking institution which

does not accept demand deposits and is not part of the payment and settlement system as that of
banks. NBFC is registered as a company under the Companies Act and is subject to regulation and
supervision by the Board for Financial Supervision (BFS) of the RBI.

The legal definition of NBFCs is given in the RBI Act. According to RBI, a company is considered as
NBFC if it carries on the business of loans and advances, acquisition of shares and other securities,
leasing, hire purchase finance, insurance business, chit fund activities or lending in any manner. The
principal business of such companies should not be in agriculture or industrial activities, and
construction and real estate activities.

The NBFCs activities appear similar to that of banks. NBFCs invite deposits, grants loans and
advances, and discounts the bills. In this aspect, it looks like a banking activity. But there are certain
differences: First, the NBFCs do not accept any demand deposits. Second, the NBFCs are not part of
the payment and settlement system; and third, unlike the case of banks, the deposits in the NBFCs are
not covered under the deposit insurance facility of the Deposit Insurance and Credit Guarantee
Corporation.

Classification
The classification stated above was modified with effect from December 2006. The reclassification of
the NBFCs was as follows:

1. Asset Finance Company (AFC). 2. Investment Company (IC). 3. Loan Company (LC).

AFC is defined as any company which is a financial institution carrying on as its principal business
the financing of physical/real assets supporting productive or economic activity, such as automobiles,
tractors, lathe machines, generator sets, earth moving and material handling equipment, moving on
own power and general-purpose industrial machines etc. Mainly, AFCs are engaged in vehicle finance
and financing of construction equipment, consumer durables, etc. Principal business for this purpose
is defined as aggregate of financing real or physical assets supporting economic activity, and income
arising there from is not less than 60% of its total assets and total income, respectively.

IC is a company whose principal business is the acquisition of securities.

LC is an NBFC that provides finance by making loans and advances but does not include a leas-ing
company or a hire—purchase company.

NBFC-D and NBFC-ND Classification

The above type of companies was further categorised into NBFCs deposit taking (NBFC-D) and
NBFCs non-deposit taking (NBFC-ND) based on their liability structure.

This categorisation has been done in connection with the application of prudential norms to specific
categories. NBFCs-D are subject to the requirements of capital adequacy, liquid assets maintenance,
exposure norms, ALM discipline and reporting requirements.

The NBFC-ND category has been further classified into NBFC-ND (those companies with assets less
than Rs. 500 crore) and NBFC-ND-SI (NBFC-Non Deposit taking, Systemically Important)
(companies with assets of Rs. 500 crore and above).

For the purpose of regulation, the RBI has also evolved what is described as 'Systemically Important
NBFCs (NBFC-ND-SI)'. The NBFCs-ND-SI are subject to prudential regulations such as capital
adequacy requirements, exposure norms, asset classification norms etc. NBFCs with assets less than
Rs. 500 crore shall not be subjected to pruden-tial norms if they are not accessing public funds.
Summarising the discussion on the initial classification, re-classification and the categorisation into
NBFCs-D and NBFCs-ND it could be inferred that there are three different types of classifications:

Salient Features of NBFCs

1. Registration:
It is mandatory that every NBFC should be registered under the RBI commence or carry on its
business. This applies to both deposit-taking as well as non-deposit taking NBFCs. Exemptions are
given to venture capital firms, merchant banking firms, stock broking firms from registration because
those firms are regulated under the SEBI Act. Insurance companies, Nidhi companies and chit fund
companies and housing finance com-panies are also exempt from registration with the RBI for the
same reasons because they are regulated by different agencies.

2. Acceptance of deposits:
Public deposits are one of the sources of funding for the NBFCs. However, all NBFCs are not entitled
to invite deposits from the public. Only those NBFCs who have obtained the authorisation from the
RBI can accept public deposits. This is subject to the company fulfilling the stipulated Net Owned
Fund (NOF) requirements and complying with the norms for investments in liquid assets and
necessary reserve requirements.

3. Regulation by the RBI:

NBFCs are well regulated now by the RBI. The regulations govern the deposit acceptance,
maintenance of liquid assets and creation of reserve fund. Prudential norms pertaining to CRAR, asset
classification, non-performing assets, etc. have been imple-mented by the RBI to strengthen the
sector.

4. Supervision by the RBI:

The RBI has an effective supervisory mechanism for NBFCs through the BFS. The objective of such
supervision is to ensure that NBFCs function on healthy lines and avoid excessive risk taking. The
RBI follows a four-pronged supervisory framework: On-site inspection, off-site monitoring, market
intelligence and exception reports of statutory auditors. The selection of supervisory mechanism
depends on the asset size and whether the NBFC is a deposit-taking firm or otherwise. The system of
on-site examination is structured on the basis of Capital, Assets, Management, Earnings, Liquidity
and Systems and Procedures (CAMELS) approach and this is akin to the supervisory model adopted
for the banking system.

Types of Activities of NBFCs

1. Equipment leasing: Leasing finance is a dominant line of business for NBFCs. Leasing finance is
provided for the use of fixed assets by business firms. In India, financial lease is a predominant
activity of the leasing companies. Due to taxation and other legal issues, the industry has been
stagnating in recent years.

2. Hire-purchase finance: It is a significant method of financing in the Indian financial sys-tem. It is

popular in truck financing sector. The HP finance industry has a long history in Its .Backed by the
Indian Hire Purchase Act, the industry is well regulated.

3. Investment activities: NBFCs invest the deposits in approved securities as a mandatory in

requirement. Besides this, the main line of business for many firms might be investment money
market instruments. For example, a primary dealer is an example of an IC. Primary dealers purchase
government securities as an investor and also serve as market makers in government securities. IDBI
Gilts Limited is an example of primary dealers in India.

4. Loans: Granting loans is another activity of NBFCs. The RBI classification has 'loan compa-nies'
as one of the categories. Inter-corporate loans are common among the companies. Broadly grouped as
'loans and advances' this category specialises in loans. It, however, excludes hous-ing finance
activities of HFCs and lease finance activities of leasing companies.

5. Housing loans: HFCs extend housing loans for construction, purchase and renovation of houses.
These loans are long term in nature and are based on mortgage of the property in favour of the HFC.
Besides loans to individual borrowers, HFCs fund bigger projects in urban infrastructure
development. HDFC Limited is an example of a housing finance company.

6. Mutual benefit funds: Mutual benefit funds or Nidhis are primarily in the business of deposit
acceptance and loan granting exclusively to members of the society or Nidhi. These are differ-ent
from mutual funds which are governed by SEBI regulations. Registered under the Com-panies Act,
Nidhis serve the public in a particular location. It was more regional in nature. Chennai was one place
where there was a concentration of Nidhis. But in the recent years, these institutions have run into
rough weather and many Nidhis have ceased to do their business.

Regulation of NBFCs
NBFCs are subject to the RBI's regulation and supervision. Their activities are monitored by the RBI
and suitable directions are issued keeping in mind the protection of depositors' interest and ensure a
healthier development of industry.
The principles of regulation are broadly aimed at (a) protection of interests of depositors (b)
mitigating the systemic risks emanating from inter-connectedness with the rest of the financial system
and (c) consumer protection.

Where both public funds are accepted and customer interface exist, such companies will be subjected
to limited prudential regulations and conduct of business regulations. However, the norms would be
relatively easier for the NBFCs which neither access public funds nor have a customer-facing
business.

Salient features of these regulatory provisions are discussed in the following paragraphs:

1. Entry norms:
A non-banking financial company can commence business only after obtaining a Certificate of
Registration (CoR) from RBI. For this purpose, it should be a registered company under the
Companies Act and should have the minimum capital requirement prescribed by RBI.

The companies should have a minimum NOFs of Rs. 2 crore (since April 1999) for seeking
registration as an NBFC. The minimum net worth for NBFCs, which were granted licences before
1999, was retained at Rs. 25 lakh. Now, all NBFCs are to attain a minimum net-owned funds of Rs. 2
crore by Marchi 2017.

The terms 'owned funds' and 'net owned funds' require clarification. Owned funds is the total of share
capital and free reserves in the latest balance sheet of the firm. Intangible assets, accumulated losses
and deferred revenue expenditure will be deducted to arrive at the 'owned funds'. From this amount,
investments in shares of subsidiary companies or shares of companies in the same group, debentures,
bonds, loans and advances made to and deposits with subsidiary companies are deducted to arrive at
'net owned fiends'.

2. Deposit acceptance norms:

Some of the important regulations relating to acceptance of deposits by NBFCs are as follows:
• The NBFCs are allowed to accept or renew public deposits for a minimum period of 12 months and
a maximum period of 60 months. They cannot accept deposits repayable on demand.
• NBFCs cannot offer interest rates higher than the ceiling rate prescribed by the RBI from time to
time. The present ceiling is 12.5% per annum. The interest may be paid or corn-pounded at rests not
shorter than monthly rests.
• NBFCs cannot offer gifts or incentives or any other additional benefit to woo the depositors.
• NBFCs (except certain AFCs) should have minimum investment grade credit rating.
• The deposits with NBFCs are not insured.
• The repayment of deposits by NBFCs is not guaranteed by the RBI.
• Certain mandatory disclosures are to be made about the company in the application form issued by
the company soliciting deposits.

3. Liquid asset maintenance requirements (or SLR requirements):

Deposit-taking NBFCs have the obligations to maintain a minimum level of liquid asset. The RBI
requires that a minimum of 15% of public deposits on the last working day of the second preceding
quarter must be in liquid assets.
Liquid assets mean the approved securities (also known as SLR securities) and term deposits with
commercial banks. Of the 15%, NBFCs have to invest not less than 10% in unencumbered approved
securities and the remaining 5% in term deposits with commercial banks.

Approved securities are the government securities and government-guaranteed bonds. NBFCs have
been directed to maintain the mandated liquid asset securities in dematerialised form with the
depositories through the depository participants at a place where the registered office of the company
is situated.

4. Reserve requirements:
An NBFC has to create a reserve fund and transfer every year an amount not less than 20% of the
profits to such reserve fund from the profit and loss account well as Lanncannei before payment of
any dividends. This provision is applicable for deposit-taking as non-deposit-taking NBFCs.

The transfer of 20% of the profits will take place until the reserve fund reaches the level of paid up
capital. Thereafter, a sum not less than 5% has to be trans-ferred from profits every year.
Appropriations from the reserve fund cannot be made without the prior approval of the RBI.

5. Capital Adequacy Requirements:

NBFCs are required to adopt capital adequacy norms in the same lines as that of commercial banks.
These norms are intended to ensure adequate capitalisation of the NBFCs; to meet the possible losses
from the non-performing assets. NBFCs extend loans and advances to clients. It is possible that some
of its assets might face the risk of clients not paying the dues. As a result, the asset becomes a loss
asset or an irrecoverable 'bad debt'.

To meet such losses an NBFC is required to keep certain minimum amount in the form of 'own funds'
on the liabilities side of the balance sheet which is computed as a percentage of assets. This is what is
called as capital adequacy requirement in the finance sector.

For the purpose of computing the capital adequacy requirement, we need to understand the two layers
or tiers of capital and the risk weights associated with the individual assets on the asset side of balance
sheet.
Tier-1 items consists of net own funds which is the aggregate of equity capital and free reserves.
Tier-2 consists of preference shares, revaluation reserves, general provisions and loss reserves and
other subordinated debt items. Subordinated debts are unsecured in nature and rank last in the order of
preference as compared to claims of other creditors.

At any point of time, the total of Tier-2 capital should not exceed Tier-1 capital.

6. Asset Classification and Provisioning Assets

NBFCs are mainly loans and advances and other receivables. International norms (Basel Norms) are
made applicable to the banks in India. In a similar vein, NBFCs' assets are also subject to asset
classification norms. All forms of credit (including receivables) are to be classified into the following
four categories:
1. Standard asset (i.e. an asset where there is no default in payment).
2. Substandard asset (i.e. an asset which is a non-performing asset for less than 18 months)
3. Doubtful asset (i.e. an asset which is a sub- standard asset for more than 18 months).
4. Loss asset (i.e. an asset which is outstanding for more than 2 years overdue)

Provisioning is required for meeting the risks of non-performing assets. Provisioning norms state that
for standard assets 0.25% is required to be made. This is proposed to be increased to 0.40% by March
2018, in line with banks. For sub-standard assets a provision of 10% of the assets is to be made. For
doubtful assets, a provision of 100% is necessary for those unsecured loans and advances.

7. Concentration Norms
The exposure of NBFCs to various loan accounts is also regulated through credit or investment
norms. The norms are as follows:
1. Single Borrower: Credit — 15% of owned funds; investment — 15% of owned fund.
2. Group Borrower: Credit — 25% of owned fund; investment — 25% of owned fund.
3. Composite (credit + investment): Single Borrower — 25% of owned funds; Group Borrower —
40% of owned funds.
4. Infrastructure related activities: Single — Additional 5%; Group — additional 10%
5. Asset Finance activities: Single party and single group of parties up to further 5% of owned funds.
Universal Banking
Universal banks provide a comprehensive set of services and products under the same roof to a wide
variety of customers. They are like a one-stop-shop where all customer needs can be fulfilled.

Services Provided

Indian Scenario
ln India, two reports in 1998 mentioned the concept of universal banking. They are, the Narasimham
Committee Report and the S.H. Khan Committee Report. Both these reports advised to consolidate
(bring together) the banking industry through mergers and integration of financial activities. That is,
they advised a combination of all banking and financial activities. That is, they suggested a Universal
banking. In 2000, ICICI asked permission from RBI to become a universal bank. RBI wants some big
domestic financial institutions to become universal banks.

Advantages
1. Investors' Trust: Universal banks hold stakes (equity shares) of many companies. These
companies can easily get other investors to invest in their business. This is because other
investors have full confidence and faith in the Universal banks. They know that the Universal
banks will closely watch all the activities of the companies in which they hold a stake.
2. Economics of Scale: Universal banking results in economic efficiency. That is, it results in
lower costs, higher output and better products and services. In India, RBI is in favour of
universal banking because it results in economies of scale.
3. Resource Utilisation: Universal banks use their client's resources as per the client's ability to
take a risk. If the client has a high-risk taking capacity then the universal bank will advise him
to make risky investments and not safe investments. Similarly, clients with a low risk-taking
capacity are advised to make safe investments. Today, universal banks invest their client's
money in different types of Mutual funds and also directly into the share market. They also do
equity research. So, they can also manage their client's portfolios (different investments)
profitably.
4. Profitable Diversification: Universal banks diversify their activities. So, they can use the
same financial experts to provide different financial services. This saves cost for the universal
bank. Even the day-to-day expenses will be saved because all financial services are provided
under one roof, i.e. in the same office.
5. Easy Marketing: The universal banks can easily market (sell) all their financial products and
services through their many branches. They can ask their existing clients to buy their other
products and services. This requires less marketing efforts because of their well-established
brand name. For e.g. ICICI may ask their existing bank account holders in all their branches,
to take house loans, insurance, to buy their Mutual funds, etc. This is done very easily
because they use one brand name (ICICI) for all their financial products and services.
6. One-stop Shopping: Universal banking offers all financial products and services under one
roof. One-stop shopping saves a lot of time and transaction costs. It also increases the speed
or flow of work. So, one-stop shopping gives benefits to both banks and their clients.

Disadvantages
1. Different Rules and Regulations: Universal banking offers all financial products and
services under one roof. However, all these products and services have to follow different
rules and regulations. This creates many problems. For e.g. Mutual Funds, Insurance, Home
Loans, etc. have to follow different sets of rules and regulations, but they are provided by the
same bank.
2. Effect of failure on Banking System: Universal banking is done by very large banks. If
these huge banks fail, then it will have a very big and bad effect on the banking system and
the confidence of the public. For e.g. Recently, Lehman Brothers a very large universal bank
failed. It had very bad effects in the USA, Europe and even in India.
3. Monopoly: Universal banks are very large. So, they can easily get monopoly power in the
market. This will have many harmful effects on the other banks and the public. This is also
harmful to economic development of the country.
4. Conflict of Interest: Combining commercial and investment banking can result in conflict of
interest. That is, Commercial banking versus Investment banking. Some banks may give more
importance to one type of banking and give less importance to the other type of banking.
However, this does not make commercial sense.
Core Banking Solution
Core Banking Solution (CBS) is networking of branches, which enables customers to operate their
accounts, and avail banking services from any branch of the Bank on CBS network, regardless of
where he maintains his account.
The customer is no more the customer of a Branch. He becomes the Bank’s Customer. Another
interesting fact regarding CBS is that all CBS branches are inter-connected with each other.
Therefore, Customers of CBS branches can avail various banking facilities from any other CBS
branch located anywhere in the world.
Core Banking is a term given to a centralised system wherein all banking functions, activities,
processes and departments are linked across all the branches. They enable all customers of a bank,
and not just the branch, to receive banking operations from anywhere. As the full form of CORE
suggests – “Centralised Online Real-time Exchange”, banks have access to business in real-time
through data centres

Advantages
Advantages to Customers
▪ Quicker services at the bank counters for routine transactions like cash deposits, withdrawal,
passbooks, statement of accounts, demand draft etc.
▪ Anywhere banking by eliminating branch banking
▪ Fast payment processing through internet, banking, mobile banking
▪ All Branches access applications from central servers/datacentre, so deposits made in any
branch reflects immediately and customer can withdraw money from any other branch
throughout the world.
Benefits to banks
▪ Process standardization within bank & branches
▪ Retention of customers through better customer service
▪ Accuracy in transaction & minimization of errors
▪ Improved management of documentation & record having centralized databases result in
quick gathering of data & MIS reports.
▪ Ease in submission of various reports to the government & regulatory bodies
▪ Convenience in opening accounts processing cash, servicing loans, calculating interest,
implementing change in policies like charging interest rates etc.

Disadvantages
▪ Excessive reliance on technology.
▪ Any failure in computer systems can cause entire network to go down.
▪ If data is not protected properly and if proper care is not taken, hackers can gain access to the
sensitive data.