Understanding resource mobilisation through capital markets

Mobilisation of Resources can be either for short term or for long term. Economy consists of huge number of enterprises and individuals, requirements of all of them differ. Some have surplus cash to save, while some other needs cash. Some firms/individuals wants to make good there short term liquidity requirements, some wants money for long term capital investment.

So distinction can be made as to period for which one intends to lend or borrow. It means the financial market is categorized into money market and capital markets. In Money market, period involved for funds movement is 1 year or less, while in capital markets period is generally more than 1 year.

Banks basically caters to money market and mobilizes resources from savers to borrowers. It plays significant role in capital markets, as it lends for capital investment purposes. As economy of the country grows, highly specialized institutions comes up which caters exclusively to capital needs and banks continues its money market business. These institutions are known as Capital Market intermediaries.

Capital market intermediaries are like insurance companies, housing finance companies, pension funds, and investment funds etc. which mobilize savings and fund long term investments. Person having surplus money for long term may be willing to ‘lend’ or to ‘invest’. This forms distinction between debt and equity. In former, lender will get fixed return and in latter investor will get share of his profit.

These are invested through different type of intermediaries as per interest of lender, may be mutual fund, debt fund, stock market etc. In financial market, financial assets are created such as debenture, shares, bonds etc.

Financial Assets represent claim of their holder over certain asset with certain quantity. This claim arises because of a contract between two parties e.g. lender and borrower or buyer and seller.

In the first place, these are created when fresh money is raised in the market (either through debt or equity). Instruments issued could be traded like anything else and they have their market.

The distinctions between primary and secondary markets are that Markets in which fresh funds are raised are primary and in which financial assets are traded are called Secondary markets.

What are Financial Markets?

Financial market is a market where financial instruments are exchanged or traded and helps in determining the prices of the assets that are traded.
These facilitate trade in financial assets by providing platform for coming together of buyers and sellers or Borrowers or Lenders.

Financial markets classified as:

• Debt and equity markets
• Money market and capital market
• Primary market and secondary market

Capital Markets

Primary capital market

• Whenever a company raises fresh capital or debt, it does so by ‘initial public offer’ (IPO). Already listed company can again raise capital by ‘follow on public offer’ (FPO).
• Secondary capital market
• Shares which were issued in primary market remains listed on stock exchanges and are traded.
• Share prices move in accordance with Market Sentiment, Economic and Political stability, and fundamentals of particular company.

Stock Exchanges

• Both these activities are facilitated by Stock exchanges.
• In layman terms stock exchanges are ‘markets’ (or mandis) where prospective buyer and seller meets and item traded is Shares, debentures, bonds etc.
• In early days, there was physical interface between two parties; there were mediators in stock exchanges, which for a commission used to negotiate the deal.
• Lot of buyers would come and make bids for purchase and on other hand there would be sellers with financial assets, attempting to sell at highest possible price.
• When difference between selling and buying bid is eliminated, deal is done.
• Mediators used to shout bids for their clients. This was known as open outcry system.

Bombay Stock Exchange (BSE)

• It is the oldest and the largest stock exchange in India.
• Historically, it traded for two hours in a day with an open outcry system.
• The exchange was managed in the interests of individual members, a majority of who had inherited their seats.
• A large proportion of stocks listed on the exchange were not actively traded.
• There was minimum supervision from the exchanges and speculation (satta) was rampant.
• It was in 1992 that in pursuance of LPG reforms that the Stock Exchanges were reformed.
• These reforms were on the back of Legal provisions and technology.
• One landmark legal reform was passage of Securities and Exchange Board of India Act, 1992, which created an apex independent regulator for capital markets.
• Earlier, everything was under Finance ministry, which resulted in consistent interference.
• Apart from this, earlier companies have to get their issue price approved by finance ministry.
• With reforms, this control was also done away with.
• Apart from this, Transactions were now settled in a separate ‘Clearing House’ which earlier was done mutually between members.
• Perhaps, most effective reform was ’dematerialization of Securities’ which means conversion of securities from physical to electronic form.
• In those days there were physical proofs such as Share Certificates which has to be transferred in name of purchaser. This involved lot of time, efforts and also, stamp duty.
• In electronic form, securities (share, debentures etc.) are held by ‘depositories’ on behalf of actual owners.
• Two depositories in India are NSDL and CDSL. So trade is handled by Stock Exchanges which have designated brokers like Karvx, Parsavnath etc.
• These brokers have account with depositories and interface with prospective buyers and sellers.
• A person willing to trade in securities has to open a ‘demat account’ in Depository with help of broker. As soon as he buys any security, it is transferred to this account.
• Now there is highly sophisticated electronic and online trading system in plane.
• There is real time transfer of market, industry and stock specific information across the country which removes information asymmetry and ensure level playing field.

Corporate Governance (CG)

What is corporate governance?

• CG concept holds that company should not ignore interest of its any stakeholder. Main stakeholders are investors, employees, government and society at large.
• Investor’s interest: Better Returns, Transparency & accountability in business, secure future of company.
• Employees Interest: Regular salaries, good working conditions, Career progress potential and social status.
• Interest: Regular payment of taxes, Compliance with laws & rules, Non indulgence in anti-national activities.
• Society’s Interest: generation of employment, less pollution, efficient utilization of scarce resources, Healthy & affordable products etc.
• SEBI’s role in safeguarding interest of investors and curbing malpractices is significant from point of view of Corporate Governance.
• Apart from this Companies act, 2013 too gives sound stress on CG – It provides for appointment of Independent directors, Regulates remuneration of directors, Internal Audit Committee, increases responsibility and penalties of auditors and provides that at least 1 director should be woman.
• New companies act also introduced mandatory Corporate Social Responsibility clause. Every company having net worth of rupees five hundred crore or more, or turnover of rupees one thousand crore or more or a net profit of rupees five crore or more during any financial year shall constitute a Corporate Social Responsibility Committee of the Board consisting of three or more directors, out of which at least one director shall be an independent director.
• They also need to formulate a CSR policy which should be continuously monitored. Company should spend for CSR, minimum, 2% of its average net profit during previous three years.
• Two main committees for corporate governance in past were – Kumar Manglam Birla Committee in 1999 and N.R. Narayan Murthy Committee in 2002.

Mutual Funds

• Different shares in the market carry different kind and degree of risks.
• So investors instead of putting all eggs in one basket, diversifies its portfolio.
• Investors attempts to minimize his risk and maximize return by investing in both debt and equity and further within equity, investor picks up various sectors – infra, textile, IT, Cement, Housing, banking etc.
• A normal investor often faces information constraints and fails to get an adequate portfolio.
• For this purpose there are ‘Asset Management Companies (AMC)’ which forms a fund by issuing units to the public. These units are just like any other instrument – shares or debentures. Public purchases these units and money reaches AMC.
• Now this AMC is manned with financial market experts and they will invest this money in different sectors so as to maximize returns and minimize risk.
• As profit from different investment flows value of units of mutual fund increases. These units are also traded on stock exchanges.
• The mutual fund industry in India was started in 1963 with the formation of Unit Trust of India (UTI), at the initiative of the government of India and Reserve Bank.
• The history of mutual funds in India can be broadly divided into different phases.
• In the first phase UTI has enjoyed the status of monopoly in the mutual fund industry.
• In the second phase some public sector mutual funds set up by the public sector banks and Life Insurance Corporation of India (LIC) and General Insurance Corporation of India (GIC) were launched besides the UTI.
• In the third phase, which started in 1993, the government allowed private players to offer mutual fund schemes giving the Indian investors a wider choice of fund families.

Corporate Debt/bond Market in India

• It is aware that resource for investment can be either mobilized in form of either Equity or Debt.
• Foregone discussion was for equity. Any business prefers to get financed first from internal sources like profit from its own operation, or capital infused by its owners.
• Second comes the debt and equity is preferred only if debt is unavailable. This is because equity gets ‘share of profit’ in return, while debt is entitled only to fixed interest. Normally, former is significantly higher than latter.
• So all over the world cooperate bond markets are well developed.
• In this corporate raise equity, not by issuing shares, but by debentures or bonds, on which investors/lenders will get fixed rate of interest.
• In India government bond market is well developed and it has been financing its fiscal deficit by such bonds, but corporate bond market is quite laggard.
• In India, the Government bond market has experienced a steady growth over the years due to the need to finance the fiscal deficit.
• The Government bond market, which is around 39.5 per cent of GDP in end-2010 in India compares favourably to most other Asian countries.
• The corporate bond market on the other hand is just 1.6 per cent of GDP in end-2010 and small in relation to the economy’s size.
• From 2008 to 2010 corporate bond market in India in value terms grew from $7.85 billion to $24.99 billion.
• In comparison to other countries such as South Korea ($380.62 billion) and China ($ 522.09 billion), the Indian corporate bond market appears to be under-developed.
• The under development of the corporate bond market in India is not incidental and is mainly attributable to the structure of the Indian financial system and regulatory structure.
• Currently corporate and business get majority (almost all) of the lending from banks. Banks are exposed to numerous other risks. If bank’s credit is exposed to a bad company (say kingfisher) than any default by that company (in repayment) can cause harm to depositor, who otherwise wouldn’t have opted to get exposed to this bad company.
• So Corporate bond market provides investors option to choose their risk and return. It also leaves finance with bank to lend to more socially productive ventures.
• Last but not least, a company with good reputation can get cheap finance for its expansion as this is directly from public and ‘middleman’ bank is eliminated.
• By same logic, investor will also get somewhat better deal. For corporate debt market to develop, it is imperative that regulatory mechanism is strengthened at very first place.

Mobilisation of small savings in investment

• Foregoing discussion was related mobilization of savings under which central objective of savers is just to invest and increase their wealth.
• There are other forms of savings under which small denominations of savings gets together to form significant investment figures.
• These are mainly Insurance, Provident fund and pension Savings (also called contractual savings).
• These have an important social security angle, but here focus is on resource mobilization through them.
• These funds have long maturity (repayment) period so they are better placed to cater need of projects with long gestation periods like infrastructure.
• But in India, the investment patterns of these funds are highly regulated with a bias towards investment in Government securities.
• There is need to deregulate these long-term fund sources and formulate prudential norms for such financing.
• Insurance sector is somewhat contributing to private sector, but pension and provident savings are completely government controlled, so the will be discussed in next article along with government finance.
• Savings through these three forms 20-25% of total household savings, so efficient mobilization becomes crucial.

Insurance

• Insurance is service in which individual economic risk is spread over large number of people.
• Any loss that can be quantified in money can be insured.
• For e.g. Life Insurance provides risk cover on life of a person.
• Life cannot be quantified in itself, but economic hardships on survivors of a deceased breadwinner can be undoubtedly quantified in money terms, so this way life insurance can be done.

How individual economic risk is spread over large number of people?

• In insurance large number of people pay premium and their risk gets covered.
• In case of any mishappening, under which claim can be invoked as per legal agreement; person will get compensated by Insurance company.
• Not all covered vehicles will meet an accident, nor all covered persons will die.
• But everyone certainly has risk of dying or getting trapped into an accident.
• So premium from all people under risk is used to pay a person who really met accident or relatives of person who died.
• Insurance is highly profitable and cash rich business.
• Premium is collected and claims are to be paid when there is risk materialized.
• The insurance sector has been an important source of low cost funds of long-term maturities all over the world.
• In the Indian context, however, the insurance companies, particularly in life insurance, apart from covering risk are also committed to repayment of the principal with interest although with long maturities and thereby tend to act as investment funds.
• One of the reasons that this has happened is that the average premium charged by the insurance companies in India tends to be relatively high due to obsolete and rigid actuarial practices and inefficient operations.
• This is the reason Life Insurance Corporation is one of the richest and omnipresent government companies.
• Insurance industry is generally classified into Life Insurance Business and General Insurance. Former was nationalized in 1950’s and latter in 1970’s.
• After LPG reforms there have been increasing involvement of privates sector.
• A watershed moment came in 1999 when Insurance Regulatory and Development Authority act was passed which establish IRDA.
• This independent authority remains at apex of Insurance business. This was necessary because government was keen on promoting private sector participation, for which independent and efficient regulators are prerequisite.
• An ordinance recently has been promulgated to allow FDI upto 49% in insurance sector. This is expected to bring much needed forex, Human Resource and differentiated products in the sector.
• Capital markets, as name suggests, mobilize savings towards productive capital assets.
• High investment in primary market will suggest high fixed capital formation, which in turn will have all around impact on employment creation, tax collection and eventually higher standard of living. However, capital markets at times can squeeze savings from large public to a handful of sectors.
• This results in income inequalities. As was seen in last decade, that much growth was due to services sector and much of the resources got concentrated into that sector.
• Government through its policy interventions has to make sure that any growth is inclusive of all sects, regions, classes of the country, it is only then it can be sustainable.
• Otherwise it will receive a backlash from disadvantaged people, which has strong implications for political and economic stability of the country.

Expected Questions:
1.What reforms were undertaken in India to revive its Stock Exchanges? Explain how they help in mobilization of resources.
2.What is importance of corporate debt market?
3.Do you think government should facilitate development of a burgeoning Corporate Bond market? Why?
4.How does Insurance helps in mobilization of small savings? Should FDI allowed in Insurance sector at time when domestic industry is nascent?

Syllabus:
General Studies P-II