management of financial institutions project

7/31/2019 Management of Financial Institutions Project

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PROJECT

ON

The Role of Financial Institutions in

Long Run Economic Growth

Sri Shared Institute of Indian Management-Research

7, Institutional Area, Phase-II, Vasant Kunj, New Delhi -110070

Website : www.srisiim.org

( 2010-2012 )

Submitted To: Submittedby:

Prof. DevRaj Deepak Singh(108)

H.R.Praveen(111)

Sanjeev Roy(145)


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DECLARATION

We,Deepak Singh, H.R. Praveen and Sanjeev Roy student of PGDM (2010-12) hereby declare

that we have completed this project on The Role of Financial Institutions in Long Run

Economic Growth The information submitted is true to the best of our knowledge.

Deepak Singh

H.R.Praveen

Sanjeev Roy

(PGDM 2010-12)


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THE ROLE OF FINANCIAL INSTITUTIONS IN

LONG RUN ECONOMIC GROWTH

INTRODUCTION

The recent economic difficulties in Southeast Asian economies are often linked to

the financial sector in these countries. The business and popular press around the

world are replete with stories connecting the economic crisis with difficulties in the

financial sectors in these economies. The connection between the troubled

banking sector and the economic slowdown is especially stressed. Asian

economies that have been less impacted by the economic crisis, for example

Taiwan, are often characterized as having more stable financial institutions then

their neighbors. Yet this is not the first time financial difficulties have been

linked with poor macroeconomic performance. Many today believe the Great

Depression of the 1930s was made much more sever by problems in the banking

sector specifically and financial markets inefficiencies in general. More recently

the dramatic economic slowdown in the 1980s in the state of Texas in the United

States are often linked to the banking and savings and loan crisis that gripped the

state at the same time. This raises the question, what is the link between financial

institutions and the macroeconomic performance of an economy?

Economists hold dramatically different views regarding this question. From a

much earlier time, Bagehot (1873), and Schumpeter (1911) argued that an efficient

financial system greatly helped a nations economy to grow. As Ross Levine has

pointed out it was Schumpeters contention that well-functioning banks spurred


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area. The implications, however, are clear; the poor do save but not in financial

institutions. These low savings in turn makes it difficult for entrepreneurs in the

economy to borrow funds in economically disadvantaged areas. Due to this

difficulty in borrowing experienced by entrepreneurs the economy will experience

a low level of investment. Thus, even though savings is taking place in the

economy, the savings is not being used efficiently since it is not making its way

into the hands of deficit units. If the savings could make their way to the

entrepreneur the resulting investment would have positive spillover effects for the

entire economy. The positive spillover effects from investment to economic growth

are well known. If investment in physical capital creates new knowledge, then as

Romer (1986, 1987) has shown there will be a spillover from each persons

investments to knowledge that is useful for all the other agents in the economy.

Economies that already have high capital will have the highest returns for new

investment.

Higher levels of investment led to positive spillovers increasing the returns to and

incentives for higher levels of investment. However, in economically

disadvantaged areas with a lack of financial institutions a low level of investment

results due to the lack of incentive for investment. This low level of investment

results in slower or no economic growth thus retarding the growth of financial

institutions in the economy. This relationship can be shown using Figure 1 below.

An economy that begins with a lack of financial institutions will thus suffer from alow savings rate. This low savings rate will lead to a low level of investment.

Finally, this low level investment will result in slow or no economic growth,

further retarding the growth of financial institutions. Then the pattern repeats its

self.


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Lack of Financial Institutions

Low Savings Slow or No Growth

Low Business Investment

Figure 1

There also may be other poverty traps stemming for the lack of financial

institutions. Consider the role of information costs. With a lack of financial

institutions, the information costs for savers and borrows are extremely high.

Thus, these high information costs may also be reducing the level of business

investment and furthering slowing economic growth. Figure 2 shows this

compounding effect from suffering from a lack of financial institutions. The lack

of financial institutions result in a low savings rate, but also in increased

information costs. Both the low savings and high information costs reduce overall


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levels of business investment. This lower level of investment slows any economic

growth that the economically disadvantaged economy may be experiencing. As in

figure 1 the slower economic growth retards expansion of financial institutions and

thus the cycle starts over.

Lack of Financial Institutions Higher information costs

Low Savings Slow or No Growth

Low Business Investment

Figure 2


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ROLE OF BANKS AND FINANCIAL INSTITUTIONS IN

ECONOMY

Money lending in one form or the other has evolved along with the history of the

mankind. Even in the ancient times there are references to the moneylenders.Shakespeare also referred to Shylocks who made unreasonable demands in casethe loans were not repaid in time along with interest. Indian history is also replete

with the instances referring to indigenous money lenders, Sahukars and Zamindars

involved in the business of money lending by mortgaging the landed property of

the borrowers.

Towards the beginning of the twentieth century, with the onset of modern industry

in the country, the need for government regulated banking system was felt. The

British government began to pay attention towards the need for an organizedbanking sector in the country and Reserve Bank of India was set up to regulate the

formal banking sector in the country. But the growth of modern banking remained

slow mainly due to lack of surplus capital in the Indian economic system at that

point of time. Modern banking institutions came up only in big cities and industrial

centres. The rural areas, representing vast majority of Indian society, remained

dependent on the indigenous money lenders for their credit needs.

Independence of the country heralded a new era in the growth of modern banking.

Many new commercial banks came up in various parts of the country. As the

modern banking network grew, the government began to realize that the bankingsector was catering only to the needs of the well-to-do and the capitalists. The

interests of the poorer sections as well as those of the common man were being

ignored.

In 1969, Indian government took a historic decision to nationalize 14 biggest

private commercial banks. A few more were nationalized after a couple of years.

This resulted in transferring the ownership of these banks to the State and the

Reserve Bank of India could then issue directions to these banks to fund the

national programmers, the rural sector, the plan priorities and the priority sector atdifferential rate of interest. This resulted in providing fillip the banking facilities

to the rural areas, to the under-privileged and the downtrodden. It also resulted in

financial inclusion of all categories of people in almost all the regions of the

country.

However, after almost two decades of bank nationalization some new issues


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operate his bank account without actually visiting the bank premises. The facility

of ATMs and the credit/debit cards has revolutionized the choices available with

the customers. The banks also serve as alternative gateways for making payments

on account of income tax and online payment of various bills like the telephone,

electricity and tax. The bank customers can also invest their funds in various stocks

or mutual funds straight from their bank accounts. In the modern day economy,

where people have no time to make these payments by standing in queue, the

service provided by the banks is commendable.

While the commercial banks cater to the banking needs of the people in the cities

and towns, there is another category of banks that looks after the credit and

banking needs of the people living in the rural areas, particularly the farmers.

Regional Rural Banks (RRBs) have been sponsored by many commercial banks in

several States. These banks, along with the cooperative banks, take care of the

farmer-specific needs of credit and other banking facilities.

FutureTill a few years ago, the government largely patronized the small savings schemes

in which not only the interest rates were higher, but the income tax rebates and

incentives were also in plenty. The bank deposits, on the other hand, did not entail

such benefits. As a result, the small savings were the first choice of the investors.

But for the last few years the trend has been reversed. The small savings, the bank

deposits and the mutual funds have been brought at par for the purpose of

incentives under the income tax. Moreover, the interest rates in the small savingsschemes are no longer higher than those offered by the banks.

Banks today are free to determine their interest rates within the given limits

prescribed by the RBI. It is now easier for the banks to open new branches. But the

banking sector reforms are still not complete. A lot more is required to be done to

revamp the public sector banks. Mergers and amalgamation is the next measure on

the agenda of the government. The government is also preparing to disinvest some

of its equity from the PSU banks. The option of allowing foreign direct investment

beyond 50 per cent in the Indian banking sector has also been under consideration.

Banks and financial intuitions have played major role in the economic

development of the country and most of the credit- related schemes of the

government to uplift the poorer and the under-privileged sections have been

implemented through the banking sector. The role of the banks has been important,

but it is going to be even more important in the future


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Role of Specialised Financial Institutions

SFI

Need for and importance of Specialized Financial Institutions (SFIs)

SFIs are institutions set up mainly by the government for providing medium and

long-term financial assistance to industry. As these institutions provide

developmental finance, that is, finance for investment in fixed assets,they are also

known as development banks or development financial institutions. These

institutions receive funds for their financing operations primarily from the

government or other public institutions. These institutions also raise funds from the

capital market.

Need for SFIs

The need for establishing SFIs arose mainly because of the following reasons:-

1. It was difficult for industry in general to procure sufficient long term funds in

the capital markets. There were no other institutions to supply long-term finance to

industry. Traditionally, only short term finance could be availed from commercial

banks. SFIs were established to ensure that industry get sufficient long-term funds

and in the desired sectors in accordance with planned priorities.

2. Certain particular sections of the industry faced greater difficulties than others in

procuring long-term finance. These included

(a) Small and medium sized concerns,

(b) new concerns set up by new entrepreneurial groups,

(c) specific industries, such as cotton and jute, which required funds for

modernization,

(d) concerns involved in innovation and new technological developments,

(e) concerns requiring extra-ordinarily large amounts of finance with a long

gestation period,

(f) concerns in backward regions.


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7. These institutions have been helpful in the establishment of concerns which

required extra-ordinarily large amounts of finance for their projects with a long

gestation period.

20.4 Types of Specialized Financial Institutions

Specialized financial institutions may be divided into the following types:

(a) All India Development Banks

1. Industrial Development Bank of India (IDBI)58 :: Business Studies

2. Small Industries Development Bank of India (SIDBI)

3. Industrial Finance Corporation of India (IFCI)

4. Industrial credit and Investment corporation of India (ICICI)

5. National Bank for Agriculture and Rural Development

(NABARD)

6. Industrial Investment Bank of India Ltd. (previously, Industrial Reconstruction

Bank of India)

(b) State-level Institutions

1. State Financial Corporations (SFCs)

2. State Industrial Development Corporations (SIDC)

3. State Industrial Investment Corporations (SIIC)

( c ) Investment institutions

1. Unit Trust of India (UTI)

2. Life Insurance Corporation of India (LIC)

3. General Insurance Corporation (GIC)

20.5 Objectives and Functions of Industrial Finance


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Industrial Development Bank of India (IDBI)

These institutions along with ICICI (discussed in the next section) met the

financial needs of different sectors of industry, showed a steady growth in their

operations and contributed substantially to the industrial development of theeconomy. However need was felt for a central coordinating agency to be ultimately

concerned with all problems relating to long and medium term financing of

industry and to act as an apex industrial financing and developmental agency.

The Industrial Development Bank of India was set up in July 1964 as wholly

owned subsidiary of the Reserve Bank of India. The purpose waste enable the new

institution to benefit from the financial support and experience of RBI. After a

decade of its working, it was delinked forbid in 1976, when its ownership was

transferred to the Government of India. The purpose was to allow RBI to

concentrate on its central banking function and allow IDBI to grow into a

developmental agency. After the public issue of equity shares and sale of a part of

Governments shareholding in July 1995, Governments shareholding in IDBI has

been reduced to 72.14%.

IDBI is now the principal financial institution for co-coordinating the working of

institutions engaged in financing, promoting or developing industry, assisting the

development of such institutions and providing credit and other facilities for the

development of industry. Thus the role of IDBI may be stated as under:

( 1 ) As an apex financial institution, it coordinates the working of otherfinancial

institutions.

( 2 ) It assists in the development of other financial institutions.

( 3 ) It provides credit to large industrial concerns directly.

( 4 ) It undertakes other activities for the development of industry.

Objectives

The main objectives of IDBI is to serve as the apex institution for termfinance for

industry in India. Its objectives include-64 :: Business Studies


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( 1 ) Co-ordination, regulation and supervision of the working of other financial

institutions such as IFCI , ICICI, UTI, LIC, Commercial Banks and SFCs.

( 2 ) Supplementing the resources of other financial institutions and thereby

widening the scope of their assistance.

( 3 ) Planning, promotion and development of key industries and diversifications of

industrial growth.

( 4 ) Devising and enforcing a system of industrial growth that conforms to

national priorities.

Function

The IDBI has been established to perform the following functions-

( 1 ) To grant loans and advances to IFCI, SFCs or any other financial institution

by way of refinancing of loans granted by such institutions which are repayable

within 25 year.

( 2 ) To grant loans and advances to scheduled banks or state co-operative banks by

way of refinancing of loans granted by such institutions which are repayable in 15

years.

( 3 ) To grant loans and advances to IFCI, SFCs, other institutions, scheduledbanks, state co-operative banks by way of refinancing of loans granted by such

institution to industrial concerns for exports.

( 4 ) To discount or rediscount bills of industrial concerns.

( 5 ) To underwrite or to subscribe to shares or debentures of industrial concerns.

( 6 ) To subscribe to or purchase stock, shares, bonds and debentures of other

financial institutions.

( 7 ) To grant line of credit or loans and advances to other financial institutions

such as IFCI, SFCs, etc.

( 8 ) To grant loans to any industrial concern.


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( c ) The income of the trust is divided among the unit holders or shareholders of

the trust after meeting management expenses.

( 2 ) Closed-end Investment Trusts

The distinguishing characteristics are as under -

(a) These Trusts do not continuously sell their shares or units;

(b) They also do not buy back their shares or units;

( c ) The shares or units of the trust are listed on stock exchanges and can be

bought and sold like shares of any other company;

(d) The market value of shares or units of these trusts depends upon the market

forces of demand and supply;

( e ) Such institutions can also raise loans to make investments;

( f ) They may plough back a part of their profits.

20.9 Unit Trust of India (U.T.I)

The Unit Trust of India is a statutory public sector investment institution

Established under the Unit Trust of India Act, 1963. It began functioning

on Ist July, 1964. It commenced its operations with an initial capital of

Rs.5 crores contributed as follows -

Reserve Bank of India ............... Rs.2.5 crore

Life Insurance Corporation............ Rs.75 Lakhs

State Bank of India.................. Rs.75 Lakhs68:: Business Studies

Scheduled Banks and other financial institutions............. Rs. 1 crore

With the amendment of the Public Financial Institutions Laws, the contribution

made by RBI to the initial capital and the control exercised by it are vested in the

IDBI with effect from 16th Feb.1976.


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UNIT TRUST OF INDIA ( UTI)

The Unit Trust of India is an investment trust. It mobilizes the savings of people

through sale of units. The savings as collected are invested in the shares and

debentures of profit-making companies. The income received by the trust by wayof interest and dividend is passed on to the unit holders by way of dividend after

meeting management expenses of the trust.

The small savers get benefit by participating in the investment schemes of UTI

and thus in the industrial prosperity of the country. Investment through UTI results

in lower risk of loss and higher return on investments due to professional

management by U.T.I.

What are units?

The total investment made by UTI in industrial securities (shares, debentures and

bonds) is divided into smaller parts called units. The Unit Trust of India sell units

under different schemes and also buys back its own units at the purchase price

fixed by it from time to time. Units have a face value of Rs.10 each.

Objectives

The main objectives of UTI are as under -

( i ) To encourage savings of people belonging to middle and low income

Groups;

(ii) To mobilize savings from the small savers;

(iii) To channelize savings to industrial growth;

(iv) To allow investors to participate in the prosperity of the industries.

Functions

The main functions of UTI are as follows -Role of specialized Financial

Institutions::

( i ) To mobilize the savings of the community through sale of units;


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(ii) To invest the savings so mobilized in corporate securities such as

Shares and debentures, etc;

(iii) To serve unit holders along the length and breadth of the country;

(iv) To underwrite the issue of shares and debentures.

Intext

Industrial Credit and Investment Corporation ofIndia

(ICICI)

Industrial Credit and Investment Corporation of India was established as a joint

stock company in the private sector in 1955. Its share capital was contributed by

banks, insurance companies and foreign institutions including the World Bank. Its

major shareholders now are Unit Trust of India, Life Insurance Corporation of

India and General Insurance Corporation and its subsidiaries. They together hold

approximately 50%of the paid up share capital of ICICI.70 ::

Objectives

The ICICI has been established to achieve the following objectives:

(I) To assist in the formation, expansion and modernization of industrial units in

the private sector;

(ii) To stimulate and promote the participation of private capital (both Indian and

foreign) in such industrial units;

(iii) To furnish technical and managerial aid so as to increase production and

expand employment opportunities;

(iv) To assist in the development of the capital market through its underwriting

activities.

Functions


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ICICI has promoted the following institutions in recent years, showingwidening

scope of activities of ICICI:

1. ICICI Securities and Finance Co. Ltd.

2. ICICI Asset Management Co. Ltd.

3. ICICI Investors Services Ltd.

4. ICICI Banking Corporations Ltd.

5. Credit Rating Information Services of India Ltd. (CRISIL)

6. Technology Development and Information Company of India Ltd.

(TDICI)

7. Programmed for the Advancement of Commercial Technology.

8. Programme for Acceleration of Commercial Energy Research

Financial Institutions :

The IFCI which was established in 1948, provides financial assistance to industrial

concerns for a period not exceeding 25 years. It also guarantees loans raised by

industrial concerns in the open market and underwrites issues of shares and

debentures. It grants financial assistance to industrial concerns in the corporate and

cooperative sectors. State Financial Corporation (SFCs) have been established by

State governments under State Financial Corporation Act, 1951. There are at

present 18 SFCs. These corporations grant assistance to industrial concerns for a

maximum period of 20 years. Financial assistance can be granted to industrial

concerns in corporate or co-operative sectors as well as sole proprietary or

partnership concern. Financial assistance is granted to medium and small sizeconcerns. Most of the financial assistance is in the form of term loans. Maximum

financial assistance that may normally be granted to a single industrial concern is

Rs. 60lakhs. The paid up share capital and free reserves of the industrial concern

seeking financial assistance should not exceed Rs 3 crore.


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The IDBI was established in 1964, to regulate, supervise and coordinate

the activities of other financial institutions. It supplements the financial Role of

specialized Financial Institutions :: 73resources of other financial institutions. It

also provides loan directly to industrial concerns. It guarantees loans and deferredpayments. It discounts and rediscounts bills of industrial concerns, refinances loans

granted bother financial institution, promotes industries and provides merchant

banking services.

The UTI was established in 1964 to stimulate and pool together the savings of

people by selling its units to investors in different parts of the country. It invests its

funds in shares and debentures of other industrial concerns and pays dividends to

the holders of its units.

The ICICI was formed in 1955 to provide assistance to industrial units in the

private sector. However the activities of ICICI have widened no-win scope. Joint

sector, public sector as well as co-operative sector industrial units are eligible for

financial assistance from ICICI. It is empowered to provide any amount of

financial assistance to business units. But normally, it provides such assistance in

the range of Rs. 5lakhs and Rs. 1 crore.


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management of financial institutions project

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