Submitted By : Santhosh Kumar Submitted to : Dr YogeshMaheshwari CCBMDO-09 Financial Management I Assignment I 31 Oct 2012
CORPORATE FINANCING ENVIRONMENT IN INDIA: A CRITICAL REVIEW

S No | Topic | Page No | 1. | Executive Summary | 2 | 2. | Financial Instruments | 3 | 3. | Financial Markets | 4 | 4. | Financial Intermediaries | 5 | 5. | The Regulatory Environment | 6 | 6. | The Way Forward | 9 |

Executive Summary 1. Corporate finance is used to collectively identify the various financial dealings undertaken by a corporation. Ideally, corporate finance is the division of the company that is mostly concerned with the financial operations of the company. In some businesses, corporate finance primarily focuses on raising money for ventures and projects. For other corporations and investment banks, corporate finance concentrates on analysis of corporate buyouts and other decisions. The core functions of corporate finance are making wise use of the financial resources available to the company. Corporate finance may also take on many different aspects of the overall management of the finances of the company. The functions may also include managing of investments like acquisition and selling stocks, bonds, and other investment ventures pertaining to other companies. It may also involve creating and managing the process for issuing shares of stock or offering corporate bonds to generate resources for expansion projects.

2. The pattern of corporate financing in India has been different throughout its economic history. The outline of corporate financing in India has been determined by the economic rules and regulations that operate at different points of time. During the 30-year period in Indian economy ranging from 1960 to 1990 the stress of Indian economy was on public finance. There were a lot of rules and regulations regarding various economic issues like rates of interest and many more. During the middle part of the decade of 80s there was some change in the Indian economic scenario. The performance of the capital markets in India improved. Certain measures that helped in this positive change include the following: a) Partial Relaxation of the Indian Industrial Sphere b) Advent of a Debenture Market c) Presentation of an Economic Policy for a Long Term

3. After 1992 a lot of reforms have been made in the capital markets of India. The performance of the stock markets of India was remarkable during the 1990s. This was keeping with the healthy state of the Indian economy in and around that time. All this altered the trend of corporate financing in India. The dependency on banks for loans or other financial assistance reduced to a significant extent. The equity capital that was gained from the capital markets came up as a suitable alternative for them. The Gross Domestic Product of India rose steadily in this period. The Gross Domestic Product went up by about 4.3% in 1992-93. The Gross Domestic Product of India again increased by almost 2% in the year 1995-96. The growth rate of the Gross Domestic Product of India has been impressive in the recent years. The banking sector of India has played an important role in the context of the development of Indian economy. The banks of India have been doing well with the distribution of funds and monetary resources for the purpose of the development of India's economy.

4. Since the global financial crisis, corporate investment has been weak in India. Sluggish corporate investment would not only moderate growth from the demand side but also constrain growth from the supply side over time. Analysis of macro data indicates that macroeconomic factors can largely explain corporate investment but that they do not appear to account fully for recent weak performance, suggesting a key role of the business environment in reviving corporate investment. Analysis of micro panel data suggests that improving the business environment by reducing costs of doing business, improving financial access, and developing infrastructure, could stimulate corporate investment.
Financial Instruments 5. Financial instruments can be thought of as easily tradable packages of capital, each having their own unique characteristics and structure. Thewide array of financial instruments in today's marketplace allows for the efficient flow of capital amongst the world's investors. Several financial instruments are available in the Indian money market. These are government securities, or G-sec, preference shares, commercial papers, equity shares, certificate of deposits, call money market and industrial securities. These can be categorised as given in subsequent paras.

6. Money Market The money market can be defined as a market for short-term money and financial assets that are near substitutes for money. The term short-term means generally a period up to one year and near substitutes to money is used to denote any financial asset which can be quickly converted into money with minimum transaction cost. The various Money Market Instruments are : a) Call / Notice-Money Market. The loans made in the call money market are mainly short term in nature. Call money market mainly deals with the interbank markets. Those banks that are suffering from a short-term cash deficit borrow cap from the call money market. The interest rate varies with the market rate and depends upon the banking system. b) Inter-Bank Term Money of Maturity Inter-bank market for deposits beyond 14 days is referred to as the term money market. The entry restrictions are the same as those for Call/Notice Money except that, as per existing regulations, the specified entities are not allowed to lend beyond 14 days. c) Treasury Bills Treasury Bills are short term (up to one year) borrowing instruments of the union government. It is an IOU of the Government. It is a promise by the Government to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e. less than one year). They are issued at a discount to the face value, and on maturity the face value is paid to the holder. The rate of discount and the corresponding issue price are determined at each auction. d) Certificate of Deposits These are negotiable instrument and issued in de-materialized form or as a Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time. Banks have the freedom to issue CDs depending on their requirements. An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments viz.,term money, term deposits, commercial papers and intercorporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet. e) Commercial Paper These are issued mainly by the corporate businessmen to fund their working capital needs. Commercial Papers are issued generally for short-term maturities. Commercial papers are not secure and subject to market risks, so those corporate bodies that have a good credit history will only be able to use this financial instrument

7. Capital Market Instruments The capital market consists of the long term period (>one year) financial instruments. In the equity segment Equity shares, preference shares, convertible preference shares, non-convertible preference shares etc and in the debt segment debentures, zero coupon bonds, deep discount bonds etc. a) Preference Shares These carry a fixed dividend rate and a special right to dividends over the private equity holders. Currently, all the preference shares in the Indian market are redeemable, that is, they have a fixed period of maturity. Therefore, sometimes they are termed as `hybrid variety’. b) Equity Shares It is a "high return risk" instrument. Equity shares don't have any fixed return rate and thereby, no period of maturity. c) Industrial Securities Normally the big corporate bodies are used to issue this to fulfill their long-term requirements regarding working capital. The debentures, equity shares fall under this category.

8. Hybrid instruments Thesehave both the features of equity and debenture. This kind of instruments is called as hybrid instruments. Examples are convertible debentures, warrants etc.

Financial Markets

9. A financial market is a market in which people and entities can trade financial securities, commodities, and other fungible items of value at low transaction costs and at prices that reflect supply and demand. Securities include stocks and bonds, and commodities include precious metals or agricultural goods.Thereare both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded). Markets work by placing many interested buyers and sellers, including households, firms, and government agencies, in one "place", thus making it easier for them to find each other. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy in contrast either to a command economy or to a non-market economy such as a gift economy.

10. Theactors in Indian Financial Market include Regulators, Stock Exchanges, Commodities Exchanges and the Depositories.The regulators include: a) Securities and exchange board of India (SEBI) that governs the Equity markets and Depositories. b) Forward Market Commision (FMC) that governs Commodities markets. c) Reserve Bank of India (RBI) that governs Banks and Fixed Income Money Markets.

11. The three regulatory bodies don’t interfere in one anothersarea , though the regulatory frame work of SEBI and RBI overlap to some extent.The two stock exchanges in India, governed by SEBI, National Stock Exchange (NSE) and Bombay Stock Exchange (BSE), contribute almost 99.9% turnover in the market. Other exchanges like Delhi Stock Exchange don’t have significant turnover and are almost dead.

12. The Depositories takes care of the share certificates andcommoditiesin Dematerialized (DEMAT) form. The two depositories in Indian market areNational Securities Depositories Limited (NSDL) and Central Depositories Services Limited (CDSL).

13. The Commodities Market is governed byForward Market Commission (FMC).The two prominent Commodities exchanges in India areMulti Commodity Exchange (MCX)and National Commodities & Derivatives Exchange (NCDEX). Reserve Bank of India (RBI)govern banks and money markets in India. The trading platform for money markets is Negotiated Dealing System (NDS).Trading in money markets is dominated by Institutional players and thus retail investors can participate only through Liquid Mutual funds.

Financial Intermediaries

14. A financial intermediary is a financial institution that connects surplus and deficit agents. The classic example of a financial intermediary is a bank that transforms bank deposits into bank loans.Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities. As such, financial intermediaries channel funds from people who have extra money (savers) to those who do not have enough money to carry out a desired activity (borrowers).Money needs to be circulated for an economy to be productive. If all savings are hoarded, the surpluses of the community will not be available for investments and this in turn would lead to economic stagnation. Financial intermediaries play an important economic function by facilitating a productive use of the community's surplus money. There are various types of financial intermediaries and their structure comprises of both organized and unorganized sectors. The dominance in terms of financial flows handled by these sectors differs from country to country.

15. In India, the players in the unorganized sector are: Money lenders. Indigenous bankers. Chit funds Nidhis or mutual benefit funds, Self Help Groups In the current scenario, there is no estimate of the volume of business handled by the unorganized sector. While the volume of business handled in the urban sector may be small, their role in rural India is very significant. One of the negative effects of the sway of the unorganized sector is that it reduces the efficacy of a country's monetary policy. A lot of initiatives have been undertaken over the years both by central and state governments to reduce the adverse impact. Some of these initiatives are:

a) All India Development Financial Institutions [DFIs] b) State level Financial Corporations [SFCs] c) Insurance Companies Mutual Funds [MFs] d) Non Banking Finance Corporations [NBFCs]

16. All India Development Financial Institutions The following are the various institutions covered under all India DFIs: Industrial Finance Corporation of India [IFCI] Industrial Development Bank of India [IDBI], which merged with IDBI Bank in 2004 Industrial Credit and Investment Corporation of India [ICICI], which merged with ICICI Bank in 2002 Industrial Investment Bank of India [IIBI]. The former Industrial Reconstruction Corporation of India was converted into Industrial Reconstruction Corp of India [IRCI] and was later converted into IIBI in 1995 Small Industries Development Bank of India [SIDBI], which is a wholly owned subsidiary of IDBI curved out through an act of parliament in 1990. 17. State Level Financial Corporations These are state level bodies that mainly concentrate on industrial development in a state. They are legal bodies created under the State Finance Corporations Act, 1951 and are funded through an issue of shares in which the state governments, banks, financial institutions, and private investors participate. SFCs are also permitted to raise funds through the issue of bonds and debentures. The main focus of SFCs is financing the local industrial units, which are usually small and medium units, situated in backward regions of the state.

18. Insurance Companies Insurance companies concentrate on fulfilling the insurance needs of the community, both for life and non-life insurance. With the globalization of the Indian economy, a large number of private players have entered into this field, offering products that allow investors to select the kind of policies to suit their financial planning needs. Many of these organizations are formed as subsidiaries of banks that enable the banks to cross sell insurance products to their existing customers. Banks benefit by way of fee income through referrals and enhanced relationships with insurance companies for their banking needs.

19. Mutual Funds These organizations satisfy the needs of individual investors through pooling resources from a large number with similar investment goals and risk appetite. The resources collected are invested in the capital market and money market securities and the returns generated are distributed to investors. The fund managers of MFs are specialists in the fields of investment analysis and are able to diversify and even out risks through portfolio mix. MFs offer a wide variety of schemes, such as, growth funds, income funds, balanced funds, money market funds and equity related funds designed to cater to the different needs of investors.

20. Non-Banking Finance Corporations NBFCs are commonly known as finance companies and are corporate bodies, which concentrate mainly on lending activities in a well defined area. The Reserve bank of India [RBI] Amendment Act, 1997 defines an NBFC as a financial institution or non banking institution, which has its principal business of receiving deposits under any scheme or arranging and lending in any manner. There are 4 broad categories of NBFCs: Finance Companies, Leasing Companies, Loan finance companies and Investment finance companies

The Regulatory Environment

21. Financial sector in India has experienced a better environment to grow with the presence of higher competition. The financial system in India is regulated by independent regulators in the field of banking, insurance, mortgage and capital market. Government of India plays a significant role in controlling the financial market in India. Ministry of Finance, Government of India controls the financial sector in India. Every year the finance ministry presents the annual budget on 28th February. The Reserve Bank of India is an apex institution in controlling banking system in the country. It's monetary policy acts as a major weapon in India's financial market. Securities and Exchange Board of India (SEBI) is one of the regulatory authorities for India's capital market. The major financial regulatory authorities/institutions in India's financial market are: e) Securities and Exchange Board of India f) National Stock Exchange g) Bombay Stock Exchange (BSE) h) Reserve Bank of India i) Major Financial Institutions in India j) Foreign Investment Promotion Board k) Financial Regulatory Bodies In India

22. The financial system in India is regulated by independent regulators in the field of banking, insurance, capital market, commodities market, and pension funds. However, Government of India plays a significant role in controlling the financial system in India and influences the roles of such regulators at least to some extent. The following are five major financial regulatory bodies in India:-

a) Statutory Bodies via parliamentary enactments:

i. Reserve Bank of India Reserve Bank of India is the apex monetary Institution of India. It is also called as the central bank of the country. The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937. The Central Office is where the Governor sits and where policies are formulated. Though originally privately owned, since nationalization in 1949, the Reserve Bank is fully owned by the Government of India. It acts as the apex monetary authority of the country. The Central Office is where the Governor sits and is where policies are formulated. Though originally privately owned, since nationalization in 1949, the Reserve Bank is fully owned by the Government of India. The preamble of the reserve bank of India is as follows: "...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage." ii. Securities and Exchange Board of India – SEBI Act, 1992 Securities and Exchange Board of India (SEBI) was first established in the year 1988 as a non-statutory body for regulating the securities market. It became an autonomous body in 1992 and more powers were given through an ordinance. Since then it regulates the market through its independent powers. iii. Insurance Regulatory and Development Authority The Insurance Regulatory and Development Authority (IRDA) is a national agency of the Government of India and is based in Hyderabad (Andhra Pradesh). It was formed by an Act of Indian Parliament known as IRDA Act 1999, which was amended in 2002 to incorporate some emerging requirements. Mission of IRDA as stated in the act is "to protect the interests of the policyholders, to regulate, promote and ensure orderly growth of the insurance industry and for matters connected therewith or incidental thereto." b) Ministries of the Government of India Ministries of the government are also involved in policy making in the financial system. Of course, Ministry of Finance (MoF) is most prominently involved, through its representatives on the Boards of SEBI, IRDA and RBI. MoF and Ministry of Small Scale Industries have representatives on SIDBI Board, and Ministry of Urban Development is represented on the NHB Board. MoF representatives are also on Boards of public sector banks and DFIs. Forward Market Commission (FMC), regulates commodity exchanges and brokers. c) i. Forward Market Commission India (FMC) Forward Markets Commission (FMC) headquartered at Mumbai, is a regulatory authority which is overseen by the Ministry of Consumer Affairs, Food and Public Distribution, Govt. of India. It is a statutory body set up in 1953 under the Forward Contracts (Regulation) Act, 1952 This Commission allows commodity trading in 22 exchanges in India, out of which three are national level. ii. Pension Fund Regulatory and Development Aulthority PFRDA was established by Government of India on 23rd August, 2003. The Government has, through an executive order dated 10th October 2003, mandated PFRDA to act as a regulator for the pension sector. The mandate of PFRDA is development and regulation of pension sector in India. c) State governments The registrar of cooperatives, under the departments of agriculture, the state governments regulates the cooperative banking institutions in their respective states. The state government have also sometimes claimed a regulatory role in certain other cases. Though it never became an open battle, the Andhra Pradesh government’s Ordinance directing operations of Micro Finance Institutions (MFIs) – many of them NBFCs registered with and regulated by RBI – falls into this space. Such actions by state government have been matters of contention in the past as well, and some of them have gone to the courts as well. The court cases to clarify the RBI Vs. State government issue are still being heard in the Supreme Court, and a judgement from the Apex Court could help clarify this ambiguity.

23. Problems with the Present System An important implication of this system is the regulatory arbitrage emerging from it, because there are spaces in the financial system that are either regulated by multiple entities with little clarity on division of responsibilities, or are regulated by agencies that do not have the competence to regulate them effectively. An example of this is the regulation of district cooperative banks, which are supposed to be regulated by the RBI and by the registrar of cooperatives in their respective states. While the former has the expertise, it does not have the regulatory bandwidth to regulate these institutions, and the registrar of cooperatives have a more direct role in their regulation, but they typically do not have the expertise to regulate such deposit-taking entities. Similarly, when investment/pension products are offered by insurance companies, though the entity is regulated by the insurance regulator, the specific product should fall under the purview of the respective regulator (investment/fund management – SEBI, pension – PFRDA), which may be more capable of regulating the product, and may have developed more effective ways of regulating it in terms of capital, expenses and disclosure. Since the regulation is practically entity-based, the entities can enjoy regulatory arbitrage. The present also makes it difficult to create financial intermediaries that offer a range of financial services and benefit from economies of scope. An example is the regulation of financial services distribution, which has significant inter-regulator differences. So, it is almost impossible to create distribution agencies or front-end intermediaries that can offer a complete range of financial services to the clients.

24. There develops conflict of interest in the present system as in case of RBI which is not just the banking regulator, it is also the investment banker for the government and the monetary policymaker. The role of investment banker to the government may conflict with the role of banking regulator because banks buy a bulk of government securities. The monetary policy can help the banks in maintaining their health, and if the same agency is responsible for banking regulation and monetary policy, conflict of interest may arise, and the agency’s actions may turn out to be good for the banks but bad for the long-term development of the markets.

25. Then there is also the problem of coordination between various agencies. For managing systemic risks, regulatory coordination at the level of financial system is crucial. In India’s financial system, unless the FSDC plays an active role, the inter-agency coordination mechanisms are quite weak. Though it is clear that the regulatory mechanism needs to see some changes to avoid regulatory arbitrage, gaps, costs, and coordination problems, the exact nature of these changes is not obvious.

The Way Forward

26. As the economy grows in complexity and generates new demands, the quantum of resource mobilization required, places the financial sector in a vital position for promoting efficiency and momentum. It intermediates in the flow of funds from those who want to save a part of their income to those who want to invest in productive assets. The efficiency of intermediation depends on the width, depth and diversity of the financial system. Till about two decades ago, a large part of household savings was either invested directly in physical assets or put in bank deposits and small savings schemes of the Government. Since the late eighties however, equity markets started playing an important role. Other markets such as the medium to long-term debt market and short term money market remained relatively segmented and underdeveloped. Thus there is dramatic transformation of the stock market segment but the considerably more limited progress in other segments of the markets. In other words, one could broadly say that while India has done well in terms of creating efficient equity and equity derivatives, development in the banking sector services, bond markets, retail access to finance, and general business environment leaves much to be desired.

27. At present the structure of the financial sector is such that while the different sub-sectors are highly stratified within the sub-sectors, particularly those which do not any more belong to the State sector, there is a high proliferation of constituents of varying levels of size and efficiency. These sub-sectors are commercial banking, investment banking, development banking, asset management, securities trading and distribution, insurance and NBFCs. The current trend worldwide and the present debate within the country, suggests that the end of stratification between sectors and consolidation within sub-sectors would be inevitable. Deregulation of the sector and the lowering of entry barriers would speed up this process. Unification in the shape of cross-over between banking and insurance are already evident and the larger of the constituents are expected to adopt this strategy. However regional and niche players will continue to be relevant. The wide area covered by the financial sector in terms of an array of products and geographical reach makes regulation critical and both institutional regulation and self-regulation assume importance. The regulatory system today is far more conscious and better equipped, institutionally and legally, to demand and enforce necessary disclosures and compliance with laid norms for protection of the users of the system as well as the credibility and efficacy of the system itself. The aim would be to achieve international standards in this area within the shortest possible time frame. 28. An area, which requires considerable streamlining, is the lack of free flow of information within the financial system regarding the credit worthiness of borrowers and solvency of institutions. The high level of NPAs can in some measure be traced to this lacuna. Unless information sharing and early warning systems are instituted, the dangers to the financial system will get multiplied as the level of complexity of financial transactions in the economy increases. The institutionalization of such an information system has been recognized as a high priority area requiring legislative action to make it credible. The setting up of the Credit Information Bureau is a beginning in this process. In the field of technology based banking, information technology and electronic funds transfer system have emerged as the twin pillars of modern banking development. Products offered by banks have moved way beyond conventional banking and access to these services have become round the clock. This, indeed, is a revolution in Indian banking but some systemic changes are urgently required. Cyber laws and other procedures which are commensurate with modern technology based banking have to be put in place immediately and sufficient regulatory mechanism has to be instituted so that the fast strides in banking automation does not go on undesirable lines. Corporate governance in banks and financial institutions has assumed great importance in India and there is still some ground to cover to making all banking institutions safe, sound and efficient. It is necessary that institutions, which form a part of the financial system, have internal management, governance and accountability structures, which measure up to the highest standards. Some of the issues, which need to be debated, are those of compatibility of corporate governance with public ownership of banks and making the system accountable to economic institutions and regulators. It is also imperative that there is complete alignment between the goals of the management of the banks and the goals of shareholders. 29. Some specific areas wherein the Government can take action to improve the situation are :- a) Life Insurance Co.’s Minimum investment required in respect of approved securities (GOI, State Government & Securities granted by either GOI or State Government) should be reduced. Minimum investment requirement should be investment grade only i.e. BBB –which is followed in United Kingdom. IRDA (Insurance Regulatory And Development Authority) should allow insurance funds to trade in Govt. securities (currently they are required to hold until maturity) to improve liquidity and depth to secondary bond market. b) Pension Firms In order to accelerate the flow of pension funds into infrastructure, Upper limit for investment in Government securities or Government guaranteed securities or gilt funds be reduced. PFRDA should allow pension funds to trade in Govt. securities (currently they are required to hold until maturity) to improve liquidity and depth to secondary bond market. c) Foreign Institutional Investors Income Tax Department, Ministry of Finance should do away with or decrease withholding tax rate to encourage investments in bonds. Same has been done to attract off-shore funds into IDF (Infrastructure Debt Funds) by reducing withholding tax on interest payments on the borrowings from 20% to 5%. Republic of Korea had also scrapped this tax leading to threefold increase in FII investment. d) Rationalizing Stamp Duty There should be a uniform low rate across all states and that the maximum amount payable should be capped. Fix stamp duties based on tenor and issuance value to encourage public offerings of corporate debt. Department of Revenue (DOR) and State Govts need to act on it. e) Removal of TDS on Corporate Bonds TDS was viewed as a major impediment to the development of the Government securities market and was abolished when the RBI pointed out to the Government how TDS was making Government securities trading inefficient and cumbersome. Same could be done for corporate bonds as also been suggested by CII. f) Creation of Market Makers in Corporate Bond Market There is a need to set up institutions that will perform the function of buying/ selling bonds. (By creating a network of dealers which provide two-way quotes). As India already has an established system of Primary Dealers, it should utilize the same for good corporate bond. Dr. C. Rangarajan, Chairman PMEAC has also suggested that there is need to set up dedicated institutions like DFHI and Securities Trading Corporation for the purpose of development of corporate bond market. g) Risk Mitigation Steps To address the risks associated with investment in corporate bonds, GOI had introduced CDS (Credit Default Swaps), IRF (Interest Rate Futures) and Repos on corporate bonds but they have not taken off. Initiatives should be taken to popularize these instruments.

30. The various steps taken by the Government to meet the challenges of a complex financial architecture have ensured that a new face of the Indian financial sector is emerging to culminate into a strong, transparent and resilient system. The situation however is quite dynamic and there would be changes, which we are unable to anticipate now. It is clear, however, that the financial sector players of the future will emerge larger in size, technologically better equipped and stronger in capital base. The regulatory as well as the self-regulatory mechanisms will match up to the best worldwide thereby ensuring that the health of the Indian financial system is not only preserved but improved upon and its ability to withstand shocks, which are inevitable with global integration, remains strong.