Unit2 - Subjective Questions

Indian Capital Market:
The Indian Capital Market is a market for long-term debt and equity shares. It is where savings and investments are channeled between suppliers of capital (retail investors, institutional investors) and those in need of capital (businesses, government).

Significance in Economic Development:

• Capital Formation: It mobilizes idle savings from households and channels them into productive corporate investments, aiding in gross capital formation.
• Economic Growth: By providing long-term capital for infrastructure and industrial projects, it accelerates the pace of economic growth.
• Liquidity: It provides an exchange mechanism (Stock Exchanges) that offers liquidity to investors, allowing them to buy and sell securities easily.
• Price Discovery: It helps in the valuation of financial instruments through the forces of demand and supply.
• Foreign Investment: A robust capital market attracts Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI), boosting foreign exchange reserves.

Objectives of SEBI:
SEBI was established as a statutory body in 1992 with the basic objective to protect the interests of investors in securities and to promote the development of, and to regulate the securities market.

Primary Objectives:

1. Protection of Investors: To protect the rights and interests of investors, especially retail investors, by providing adequate, accurate, and authentic information and guarding them against malpractices.
2. Prevention of Malpractices: To prevent fraudulent and unfair trade practices like insider trading, market manipulation, and price rigging.
3. Promotion of Fair Practices: To promote a code of conduct and fair practices among intermediaries like brokers, merchant bankers, and mutual funds.
4. Regulation of Securities Market: To regulate the operations of stock exchanges and other securities markets to ensure they function efficiently and transparently.
5. Developmental Role: To develop the capital market through education, research, and introduction of new financial instruments.

SEBI performs three key categories of functions:

1. Regulatory Functions:

• Registration and regulation of brokers, sub-brokers, and other market players.
• Registration and regulation of collective investment schemes and Mutual Funds.
• Regulation of stock exchanges and any other securities market.
• Conducting audits and inspections of stock exchanges and intermediaries.
• Levying fees or other charges for carrying out the purposes of the SEBI Act.

2. Developmental Functions:

• Promoting investor education and training of intermediaries.
• Encouraging fair trade practices and reducing systemic risks.
• Conducting research and publishing information useful to all market participants.
• Permitting internet trading through registered stockbrokers.

3. Protective Functions:

• Prohibiting Insider Trading: Penalizing company officials who trade their company's securities based on unpublished price-sensitive information.
• Checking Price Rigging: Preventing the unnatural manipulation of prices of securities.
• Promoting Fair Practices: Ensuring that no fraudulent or unfair trade practices are allowed in the market.
• Financial Education: Educating investors to help them make informed decisions.

Impact of the 2008 Global Financial Crisis on Indian Capital Market:
The 2008 crisis, originating from the US subprime mortgage collapse, had a severe contagion effect globally, including India.

• Massive Sell-offs: Foreign Institutional Investors (FIIs) aggressively pulled out funds from the Indian stock market to meet liquidity requirements in their home countries. This led to a massive stock market crash.
• Index Plunge: The BSE Sensex plummeted from its peak of over 21,000 in January 2008 to below 9,000 by November 2008, eroding billions in investor wealth.
• Liquidity Crunch: The money market experienced extreme tightness. Banks were reluctant to lend to each other due to trust deficits, causing short-term interest rates to spike.
• Primary Market Freeze: Initial Public Offerings (IPOs) dried up completely as companies postponed their capital-raising plans due to poor market sentiment and lack of demand.
• Rupee Depreciation: The massive outflow of dollars led to a sharp depreciation of the Indian Rupee against the US Dollar.

Covid-19 Impact on Indian Capital Market:

1. Initial Crash (Q1 2020):

• The announcement of the global pandemic and subsequent nationwide lockdowns caused panic selling.
• In March 2020, the BSE Sensex and NSE Nifty crashed by roughly 30-40% from their January peaks.
• High volatility was observed, triggering lower circuit breakers multiple times.
• Massive FPI outflows occurred as investors flocked to safe-haven assets.

2. Policy Interventions:

• RBI injected massive liquidity, slashed repo rates, and provided loan moratoriums.
• SEBI tightened short-selling norms and revised margin requirements to curb extreme volatility.

3. V-Shaped Recovery:

• Post the initial crash, the market witnessed a sharp 'V-shaped' recovery fueled by global liquidity, stimulus packages, and the opening up of the economy.
• There was a massive surge in retail investor participation, with millions of new Demat accounts opened.
• Sectors like IT and Pharmaceuticals saw unprecedented rallies due to changing business and healthcare dynamics.

Recent SEBI Guidelines for Investor Protection:

1. Margin Pledge System: SEBI introduced a new system where shares do not leave the investor's demat account when pledged for margin. Instead, a lien is marked in favor of the broker, preventing brokers from misusing client securities.
2. Upfront Margin Requirements: SEBI mandated the collection of upfront margins for both cash and derivatives segments to reduce systemic risk and prevent over-leveraging by retail investors.
3. T+1 Settlement Cycle: India became one of the first major markets to transition to a T+1 settlement cycle, reducing settlement risk and providing faster liquidity to investors.
4. Categorization of Mutual Funds: SEBI standardized the categories of mutual funds (Large Cap, Mid Cap, etc.) to ensure that investors can accurately compare schemes and understand the risks involved.
5. SCORES 2.0: Revamping the SEBI Complaints Redress System (SCORES) for faster and more efficient resolution of investor grievances against listed companies and intermediaries.
6. Stricter Norms for IPOs: Capping the usage of IPO proceeds for unidentified inorganic growth and increasing the lock-in period for anchor investors to prevent extreme price volatility post-listing.

The differences between the Primary and Secondary markets are:

• Nature of Securities:
  • Primary Market: Deals with new securities that are issued for the first time (New Issue Market).
  • Secondary Market: Deals with existing, already outstanding securities.
• Buying/Selling Parties:
  • Primary Market: Securities are exchanged directly between the issuing company and the investors.
  • Secondary Market: Securities are exchanged between investors. The issuing company is not directly involved.
• Capital Formation:
  • Primary Market: Directly promotes capital formation as funds flow from savers to businesses.
  • Secondary Market: Indirectly promotes capital formation by providing liquidity and marketability to existing securities.
• Price Determination:
  • Primary Market: The price is determined by the management of the issuing company.
  • Secondary Market: The price is determined by the demand and supply forces in the market.
• Location:
  • Primary Market: Has no fixed geographical location.
  • Secondary Market: Has a specified physical or virtual location (e.g., BSE, NSE).

Companies can raise capital in the primary market through several methods:

1. Initial Public Offering (IPO): The process by which an unlisted company offers its shares to the public for the first time to raise capital.
2. Further/Follow-on Public Offer (FPO): When an already listed company makes a fresh issue of shares to the public to raise additional funds.
3. Rights Issue: An offer made to existing shareholders to buy additional shares of the company in proportion to their current holdings, usually at a discounted price.
4. Private Placement: The sale of securities to a relatively small number of select investors (like mutual funds, insurance companies, high net worth individuals) rather than the general public.
5. Preferential Allotment: Issuing shares to a select group of individuals or companies at a predetermined price. It is a subset of private placement.
6. Offer for Sale (OFS): Promoters or large shareholders sell their existing shares to the public through the exchange platform. No new shares are created, so capital does not go to the company.
7. Qualified Institutional Placement (QIP): A method used by listed companies to raise capital by issuing equity shares or convertible securities to Qualified Institutional Buyers (QIBs).

Nature and Characteristics of the Indian Money Market:

1. Short-Term Funds: It is a market purely for short-term funds with a maturity period ranging from overnight to one year.
2. High Liquidity: Instruments traded are highly liquid and can be converted into cash quickly with minimal loss of value.
3. Wholesale Market: It is largely a wholesale market characterized by high-volume transactions. Retail participation is minimal.
4. Over-The-Counter (OTC) Trading: Transactions mostly take place over the telephone or electronic platforms rather than on a formal exchange floor.
5. Major Participants: The principal players are the RBI, commercial banks, financial institutions, mutual funds, and large corporates.
6. Sub-markets: It is not a single homogeneous market but a collection of sub-markets like the call money market, bill market, treasury bill market, etc.
7. Role of RBI: The Reserve Bank of India is the central node, regulating the market and using it to implement monetary policy.

Functions of the Money Market:

• Equilibrating Mechanism: It provides an equilibrating mechanism to iron out short-term surpluses and deficits of funds among institutions.
• Financing Trade and Industry: It helps in financing domestic and international trade through instruments like commercial bills. It provides working capital to industries.
• Implementation of Monetary Policy: The money market is the primary conduit through which the central bank's monetary policy interventions (like repo rate changes) are transmitted to the broader economy.
• Profitable Investment: It allows commercial banks and institutions to park their temporary surplus funds in short-term instruments to earn interest while maintaining liquidity.
• Non-Inflationary Govt Borrowing: It provides a mechanism for the government to raise short-term funds (via Treasury Bills) to bridge temporary budgetary gaps without resorting to printing money, which would be inflationary.

Benefits of a Well-Developed Money Market:

1. Promotes Economic Growth: By ensuring that short-term funds are allocated efficiently to trade and industry, it supports uninterrupted production and supply chains.
2. Effective Central Banking: A deep money market helps the central bank influence short-term interest rates effectively, thereby controlling money supply and inflation.
3. Development of Capital Market: Short-term interest rates in the money market serve as a benchmark for pricing long-term bonds in the capital market.
4. Helps Commercial Banks: Banks can operate with lower cash reserves if there is a highly liquid money market where they can borrow instantly (Call Money) to meet Cash Reserve Ratio (CRR) requirements.
5. Financial Stability: By providing avenues for institutions to manage short-term liquidity crunches, it prevents localized liquidity issues from turning into systemic financial crises.

1. Treasury Bills (T-Bills):

• Issuer: Issued by the Reserve Bank of India on behalf of the Central Government.
• Purpose: To meet the short-term liquidity requirements of the government.
• Tenor: They are issued in three maturities: 91-day, 182-day, and 364-day.
• Nature: They are zero-coupon bonds issued at a discount to their face value and redeemed at par. They are considered the safest money market instrument (risk-free).
• Yield Formula: The yield is calculated as:
  
  Where = Face Value, = Issue Price, and = Days to maturity.

2. Commercial Paper (CP):

• Issuer: Unsecured promissory notes issued by highly rated corporate entities, primary dealers, and all-India financial institutions.
• Purpose: To meet short-term working capital needs as a cheaper alternative to bank loans.
• Tenor: Can be issued for maturities between a minimum of 7 days and a maximum of up to one year from the date of issue.
• Nature: Like T-Bills, they are usually issued at a discount to face value. Since they are unsecured, only companies with strong credit ratings can issue them.

1. Certificate of Deposit (CD):

• Definition: CDs are negotiable, unsecured promissory notes issued in dematerialized form or as a Usance Promissory Note.
• Issuers: Scheduled commercial banks and select All-India Financial Institutions.
• Investors: Issued to individuals, corporations, companies, and trusts.
• Tenor: For banks, the maturity ranges from 7 days to 1 year. For financial institutions, it ranges from 1 to 3 years.
• Purpose: Used by banks to raise bulk deposits when credit demand is high and deposit growth is sluggish.

2. Call Money Market:

• Definition: The market for very short-term funds, where lending and borrowing happen overnight.
• Notice Money: If the funds are borrowed for 2 to 14 days, it is termed Notice Money.
• Participants: Mostly commercial banks and cooperative banks. It is an inter-bank market.
• Purpose: Primarily used by banks to maintain their daily Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) requirements mandated by the RBI.

Organizational Structure of RBI:
The Reserve Bank's affairs are governed by a central board of directors, appointed by the Government of India in keeping with the Reserve Bank of India Act, 1934.

1. Central Board of Directors:

• Official Directors: Comprises the Governor (Chief Executive) and not more than four Deputy Governors.
• Non-Official Directors: Nominated by the Government, including 10 directors from various fields and 2 government officials.
• Local Boards: 4 directors representing the four local boards (Mumbai, Kolkata, Chennai, New Delhi).

2. Local Boards:

• Four local boards represent the West, East, South, and North regions of India.
• Their function is to advise the Central Board on local matters and represent the territorial and economic interests of local cooperative and indigenous banks.

3. Internal Organization:

• The RBI operates through various specialized departments (e.g., Department of Currency Management, Monetary Policy Department, Department of Banking Regulation).

Core Functions of the RBI:

1. Monetary Authority: The RBI formulates, implements, and monitors the monetary policy to maintain price stability while keeping in mind the objective of economic growth.
2. Issuer of Currency: It has the sole right to issue currency notes (except one-rupee notes) and coins. It ensures an adequate supply of clean and genuine notes.
3. Banker to the Government: It manages government banking transactions, issues new loans on behalf of the Central and State governments, and manages the public debt.
4. Banker's Bank: Commercial banks maintain their current accounts with the RBI. The RBI provides financial assistance to banks in times of need, acting as the 'lender of last resort'.
5. Controller of Credit: It controls the credit created by commercial banks using quantitative tools (CRR, SLR, Repo Rate) and qualitative tools (margin requirements, moral suasion) to control inflation.
6. Manager of Foreign Exchange: It manages the Foreign Exchange Management Act (FEMA), 1999, to facilitate external trade and payment and promote orderly development of the foreign exchange market in India.
7. Regulator and Supervisor: It sets the parameters of banking operations within which the country's banking and financial system functions.

RBI as a Regulator:
The RBI derives its regulatory powers from the Banking Regulation Act, 1949, and the RBI Act, 1934.

• Licensing: Every entity wishing to commence banking operations in India must obtain a license from the RBI.
• Prudential Norms: The RBI prescribes broad parameters of banking operations, such as capital adequacy ratio (Basel norms), income recognition, asset classification, and provisioning for Non-Performing Assets (NPAs).
• Reserve Requirements: It mandates the maintenance of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) to ensure banks' solvency and liquidity.
• Corporate Governance: The RBI regulates the appointment of top management in private banks and lays down guidelines for board-level committees.
• Inspection and Auditing: The RBI conducts regular onsite inspections and offsite surveillance of banks to ensure compliance with its directives and to protect depositors' interests.
• Amalgamation and Liquidation: It oversees the merger, reconstruction, or liquidation of weak banks to maintain systemic stability.

RBI's Response to the Covid-19 Crisis:
To mitigate the economic impact of lockdowns, the RBI took unprecedented monetary and regulatory steps:

1. Monetary Policy Measures (Liquidity Infusion):

• Policy Rate Cuts: The Repo rate was slashed to historic lows (4.0%) to reduce borrowing costs.
• Cash Reserve Ratio (CRR) Cut: CRR was temporarily reduced to free up primary liquidity in the banking system.
• Targeted Long-Term Repo Operations (TLTRO): Introduced to ensure liquidity reaches specific stressed sectors like NBFCs and microfinance institutions.

2. Regulatory Measures (Relief to Borrowers):

• Loan Moratorium: Permitted all lending institutions to grant a 6-month moratorium on payment of all term loan installments.
• Asset Classification: Paused the downgrading of accounts into Non-Performing Assets (NPAs) during the moratorium period.
• Restructuring Framework: Announced a one-time restructuring window for Covid-19 stressed corporate and retail loans without classifying them as NPAs.

3. Support for Financial Markets:

• Conducted special Open Market Operations (OMOs) to manage government bond yields.
• Provided a special liquidity facility for mutual funds to ease redemption pressures.

Comparison: Capital Market vs Money Market:

1. Time Horizon:
   • Capital Market: Market for medium and long-term funds (maturity > 1 year).
   • Money Market: Market for short-term funds (maturity up to 1 year).
2. Instruments Used:
   • Capital Market: Equity shares, preference shares, debentures, bonds.
   • Money Market: Treasury Bills, Commercial Paper, Certificate of Deposit, Call Money.
3. Risk and Return:
   • Capital Market: Higher risk (especially equity) but offers higher expected returns.
   • Money Market: Very low risk (often government-backed or highly rated corporate debt) but offers relatively lower returns.
4. Liquidity:
   • Capital Market: Moderate liquidity. While shares can be sold on exchanges, large block sales can impact price.
   • Money Market: Extremely high liquidity. Instruments can be easily discounted or traded.
5. Regulator:
   • Capital Market: Regulated primarily by SEBI.
   • Money Market: Regulated primarily by the Reserve Bank of India (RBI).
6. Purpose:
   • Capital Market: Used for fixed capital requirements like setting up plants or expansion.
   • Money Market: Used for meeting working capital and short-term liquidity needs.

Repo Rate (Repurchase Rate):

• Definition: It is the rate at which the RBI lends short-term money to commercial banks against approved securities.
• Impact on Liquidity: When the RBI wants to increase liquidity and boost economic activity, it lowers the repo rate, making borrowing cheaper for banks. This leads to cheaper loans for the public. Conversely, to curb inflation, it increases the repo rate, sucking liquidity out of the market.

Reverse Repo Rate:

• Definition: It is the rate at which the RBI borrows money from commercial banks. In practice, it is the rate banks earn when they park their surplus funds with the RBI.
• Impact on Liquidity: When the RBI increases the reverse repo rate, banks are incentivized to park more funds with the central bank rather than lending to the public, thereby reducing market liquidity. Lowering the rate encourages banks to lend more to businesses and individuals.

Complementary Roles of SEBI and RBI:
While they have distinct jurisdictions, SEBI and RBI work together to ensure systemic stability.

1. Division of Regulation:

• RBI governs the banking sector, the money market, foreign exchange, and payment systems.
• SEBI governs the securities market, stock exchanges, mutual funds, and primary issuances.

2. Overlapping Interfaces:
Many entities, like commercial banks, operate in both spaces. Banks issue capital (SEBI regulated) and take deposits/lend (RBI regulated). Bank-sponsored mutual funds fall under SEBI, but the parent bank is under RBI. They coordinate via the Financial Stability and Development Council (FSDC) to avoid regulatory arbitrage.

3. Crisis Management:
During crises (e.g., 2008 crash, Covid-19):

• RBI acts to ensure the banking system has enough liquidity to fund the economy.
• SEBI acts to curb market manipulation, restrict short selling, and adjust margin requirements to prevent stock market collapses.

4. Policy Transmission:
RBI's monetary policy sets interest rates in the money market. These short-term rates ultimately influence the pricing of long-term bonds and equities in the capital market, regulated by SEBI. Thus, their coordination is vital for a smooth transmission of economic policies.