Unit 2: Indian capital market

Introduction to the Indian Capital Market

The capital market is a vital component of the Indian Financial System. It is a market for long-term debt and equity shares, where funds are mobilized from entities with surplus savings (households, institutions) and channeled to entities that require funds for productive long-term investments (corporations, government).

Key Features of the Indian Capital Market:

• Maturity Period: Deals in financial instruments with a maturity period exceeding one year (unlike the money market).
• Components: Broadly divided into the Gilt-edged market (government securities) and the Corporate Securities market (shares and debentures).
• Institutional Framework: Supported by a robust network of commercial banks, development financial institutions (DFIs), mutual funds, insurance companies, and foreign portfolio investors (FPIs).
• Significance: Promotes economic growth by facilitating capital formation, providing liquidity, and ensuring the efficient allocation of resources.

Primary and Secondary Financial Markets and Issuance

The capital market is structurally divided into two interdependent segments: the Primary Market and the Secondary Market.

1. Primary Market (New Issue Market)

The primary market deals with the issuance of new securities. It is the platform where corporations and the government raise fresh capital directly from investors.

• Methods of Issuance:
  • Initial Public Offering (IPO): The process by which an unlisted company issues shares to the public for the first time.
  • Follow-on Public Offer (FPO): Issuance of additional shares to the public by an already listed company.
  • Rights Issue: Offering new shares to existing shareholders in proportion to their current holding, usually at a discounted price.
  • Private Placement: Selling securities to a select group of investors (e.g., QIBs - Qualified Institutional Buyers) rather than the general public.
  • Offer for Sale (OFS): Existing promoters/shareholders sell their shares directly to the public to dilute their holdings.

2. Secondary Market (Stock Exchange)

The secondary market is where already issued securities are bought and sold among investors. The issuing company is not directly involved in these transactions.

• Key Institutions: National Stock Exchange (NSE) and Bombay Stock Exchange (BSE).
• Functions:
  • Provides liquidity and marketability to existing securities.
  • Aids in price discovery based on the forces of demand and supply.
  • Serves as an economic barometer for the country's financial health.
• Issuance/Trading Mechanism: Trading is done electronically through registered stockbrokers using dematerialized (Demat) accounts and trading accounts, overseen by depositories (NSDL, CDSL).

Securities and Exchange Board of India (SEBI)

Established in 1988 and given statutory powers in 1992 (through the SEBI Act, 1992), SEBI is the apex regulatory body for the securities market in India.

Objectives of SEBI

1. Investor Protection: To protect the interests of investors and guide them to make informed decisions.
2. Market Development: To promote the development of the securities market through education, research, and innovation.
3. Market Regulation: To regulate the business in stock exchanges and other securities markets to prevent fraud and malpractices.

Functions of SEBI

SEBI's functions are categorized into three broad areas:

1. Protective Functions:
   • Prohibiting insider trading (buying/selling securities by someone with non-public, price-sensitive information).
   • Checking price rigging (artificial manipulation of stock prices).
   • Promoting fair practices and a code of conduct in the securities market.
   • Educating investors.
2. Regulatory Functions:
   • Registering and regulating brokers, sub-brokers, and other market intermediaries.
   • Registering and regulating mutual funds, venture capital funds, and credit rating agencies.
   • Conducting audits and inspections of stock exchanges.
   • Regulating corporate takeovers and acquisitions.
3. Developmental Functions:
   • Training intermediaries of the securities market.
   • Promoting electronic and internet trading to improve efficiency.
   • Encouraging self-regulating organizations.

Recent Guidelines of SEBI for Investors' Protection

SEBI continuously updates its regulations to safeguard investors in a rapidly evolving digital landscape. Recent significant guidelines include:

• T+1 Settlement Cycle: India became one of the first major markets to transition to a Trade+1 (T+1) settlement cycle, ensuring investors receive their funds or shares within 24 hours of a trade, reducing counterparty risk.
• ASBA (Application Supported by Blocked Amount): Made mandatory for public issues. The investor's application money remains in their bank account and is only debited if shares are allotted, preventing delays in refunds.
• Margin Pledge System: Implemented a system where shares remain in the investor's demat account but are pledged to the broker for margin, protecting investors from broker defaults or misuse of client securities.
• SCORES 2.0: Revamping the SEBI Complaints Redress System (SCORES) to ensure faster resolution of investor grievances (mandating resolution within 21 days).
• Regulation of Finfluencers: Introducing strict guidelines to curb unregistered financial influencers from providing misleading stock tips or financial advice on social media.
• Risk-o-Meter for Mutual Funds: Mandating mutual funds to visually depict the risk level of schemes (Low to Very High) based on the current portfolio, updated monthly.

Capital Market Fluctuations During Crises

1. The 2008 Global Financial Crisis

• Trigger: The collapse of the US subprime mortgage market, leading to the bankruptcy of Lehman Brothers.
• Impact on India: Massive capital flight by Foreign Institutional Investors (FIIs) seeking safe havens. The BSE Sensex plummeted from over 21,000 in January 2008 to around 8,000 by late 2008. The Rupee depreciated sharply.
• Recovery & Response: The RBI injected massive liquidity and cut the repo rate significantly. SEBI tightened rules on participatory notes (P-Notes) and enhanced margin requirements to curb extreme volatility. The market recovered gradually over 2009-2010 driven by domestic stimulus and renewed foreign inflows.

2. The COVID-19 Pandemic (2020)

• Trigger: Global lockdowns halting economic activity.
• Impact on India: The market witnessed one of the fastest crashes in history in March 2020. The Sensex crashed by nearly 40% from its January peak, triggering multiple lower circuit breakers. Extreme panic selling and high VIX (Volatility Index).
• Recovery & Response: Unlike 2008, the recovery was a rapid "V-shape". This was driven by massive global liquidity (central bank printing), aggressive retail participation (millions of new Demat accounts opened), and rapid digital adoption by Indian companies. RBI and SEBI implemented coordinated measures (short-selling restrictions, dynamic price bands) to stabilize the market.

The Indian Money Market

While the capital market is for long-term funds, the money market is a market for short-term financial assets that are close substitutes for money.

Nature of Money Market in India

• Short-Term: Deals in funds with a maturity of up to one year.
• Dichotomous Structure: Divided into the organized sector (RBI, commercial banks, LIC, UTI) and the unorganized sector (indigenous bankers, money lenders).
• Wholesale Market: Primarily characterized by large-ticket transactions involving institutions rather than individual retail investors.

Functions and Benefits of Money Market

• Equilibrating Mechanism: Balances short-term demand and supply of funds.
• Focal Point for Central Bank Intervention: RBI uses the money market to conduct monetary policy (e.g., Open Market Operations).
• Liquidity Management: Allows commercial banks and corporations to park temporary surplus funds or borrow to meet short-term deficits.
• Non-inflationary Capital: Helps the government raise short-term funds (via T-bills) without printing new currency, thereby controlling inflation.

Money Market Instruments

1. Treasury Bills (T-Bills): Short-term borrowing instruments issued by the Government of India (via RBI) at a discount and redeemed at par. Maturities: 91-day, 182-day, 364-day.
2. Commercial Paper (CP): Unsecured promissory notes issued by highly rated corporate entities to meet working capital needs. Maturity: 7 days to 1 year.
3. Certificate of Deposit (CD): Unsecured, negotiable instruments issued by commercial banks and financial institutions against funds deposited for a specific time. Maturity: 7 days to 1 year.
4. Call and Notice Money: Market for extremely short-term funds. "Call money" is for 1 day (overnight). "Notice money" is for 2 to 14 days. Primarily used by banks to maintain Cash Reserve Ratio (CRR).
5. Commercial Bills: Short-term, negotiable, self-liquidating instruments used to finance trade (bills of exchange).

Reserve Bank of India (RBI)

The RBI is India's central bank, established on April 1, 1935, under the RBI Act, 1934, and nationalized in 1949.

Organization and Structure

• Central Board of Directors: The apex decision-making body, consisting of an official full-time Governor, up to four Deputy Governors, and non-official directors nominated by the Government of India.
• Local Boards: Four local boards headquartered in Mumbai, Kolkata, Chennai, and New Delhi to represent regional interests.
• Departments: RBI functions through various specialized departments (e.g., Monetary Policy Department, Department of Banking Regulation, Financial Markets Regulation Department).

Functions of RBI

1. Traditional/Central Banking Functions:
   • Monopoly of Note Issue: Sole authority to issue currency (except one-rupee notes and coins).
   • Banker to the Government: Manages government accounts, public debt, and advises on economic policies.
   • Banker's Bank and Lender of Last Resort: Maintains cash reserves of commercial banks and provides financial assistance during crises.
   • Controller of Credit/Monetary Policy: Manages inflation and growth using quantitative tools (Repo rate, CRR, SLR) and qualitative tools (margin requirements).
   • Custodian of Foreign Exchange Reserves: Manages the country's forex reserves and stabilizes the exchange rate of the Rupee.
2. Promotional/Developmental Functions: Promoting financial inclusion, establishing specialized institutions (NABARD, SIDBI), and developing financial markets.

RBI as a Regulator

RBI derives its regulatory powers primarily from the Banking Regulation Act, 1949 and the Foreign Exchange Management Act (FEMA), 1999.

• Licensing: Grants licenses for establishing new banks or opening new branches.
• Prudential Norms: Mandates capital adequacy norms (Basel III), income recognition, and asset classification (NPA norms) to ensure banks remain solvent.
• Corporate Governance: Approves the appointment of bank CEOs/MDs and audits the board's functioning.
• Inspection and Penalties: Conducts regular on-site and off-site surveillance of banks. It has the authority to impose heavy penalties or supersede bank boards in cases of severe mismanagement (e.g., YES Bank, PMC Bank).
• Payment Systems: Regulates digital payments, UPI, and wallets under the Payment and Settlement Systems Act, 2007.

Steps Taken by RBI to Deal with the COVID-19 Crisis

The RBI took unprecedented, proactive measures to cushion the Indian economy from the pandemic's shock in 2020-2021:

1. Monetary Easing (Rate Cuts):
   • Slashed the Repo Rate cumulatively by 115 basis points (to a historic low of 4.0%) to reduce borrowing costs and spur investment.
   • Reduced the Reverse Repo Rate to discourage banks from passively parking funds with RBI, forcing them to lend to the productive sectors.
2. Liquidity Infusion:
   • Targeted Long-Term Repo Operations (TLTROs): Provided long-term liquidity to banks specifically to invest in corporate bonds, commercial papers, and non-convertible debentures of specific sectors.
   • CRR Reduction: Cut the Cash Reserve Ratio by 100 basis points, releasing over ₹1.37 lakh crore into the banking system.
   • Special refinance facilities were provided to NABARD, SIDBI, and NHB to support rural economy, MSMEs, and housing.
3. Regulatory Forbearance and Relief:
   • Loan Moratorium: Allowed lending institutions to grant a 6-month moratorium on payment of all term loan installments, preventing mass defaults.
   • Asset Classification Standstill: Ruled that the moratorium period would not result in asset classification downgrades (i.e., loans would not be marked as Non-Performing Assets/NPAs).
   • Resolution Framework: Allowed a one-time restructuring of loans for stressed corporates and retail borrowers without classifying them as NPAs, provided strict conditions were met.
4. Dividend Distribution Ban: Directed banks not to make any dividend payouts for the financial year 2019-20 to conserve capital and absorb future losses.