The Financial System: Two Markets, One Job

Organised and unorganised

The organised sector is regulated: banks, non banking financial companies, insurers, mutual funds and the exchanges. Its rates are published, its instruments are standardised and its participants are licensed.

The unorganised sector is not: indigenous bankers, moneylenders, traders who lend to their suppliers, chit funds and unregistered lenders. Its rates are high, its documentation is minimal and its reach is precisely where the organised sector does not go.

The coexistence of the two is called dualism, and it is a defining feature of the Indian money market treated in [The Features and the Defects of the Indian Money Market]. It matters because a change in the policy repo rate reaches the organised sector immediately and the unorganised sector barely at all.

The two markets distinguished

This table is the whole purpose of the chapter and both topic 3.1 and topic 3.2 rest on it.

The one line that must be right. The dividing line is one year of original maturity, and it is not merely a textbook convention: section 45U(b) of the RBI Act 1934 defines money market instruments as including call or notice money, term money, repo, reverse repo, certificate of deposit, commercial usance bill, commercial paper "and such other debt instrument of original or initial maturity up to one year as the Bank may specify from time to time".

The regulators, in statute

The Reserve Bank of India, under the RBI Act 1934. Section 45W empowers it to regulate transactions in derivatives, money market instruments and securities. Its other functions, note issue, banker to the Government, banker to banks, monetary policy, are in [What Money Is, and Why Its Supply Is Measured] and [What Determines the Money Supply, and How the RBI Controls It].

The Securities and Exchange Board of India, under the SEBI Act 1992. Section 11(1) states its duty in a single sentence: to protect the interests of investors in securities and to promote the development of, and to regulate, the securities market. Those three objects, protection, development and regulation, are the frame of [Features of the Indian Capital Market and the Role of SEBI].

Why two regulators and not one. Because the two markets fail in different ways. The money market's characteristic risk is systemic: a bank that cannot meet its obligations tomorrow can bring down others, so its regulator must be able to lend to it. The capital market's characteristic risk is informational: an investor cannot tell a sound company from an unsound one, so its regulator's business is disclosure, fair dealing and the punishment of fraud. A central bank supplies liquidity; a securities regulator supplies information.

A worked example: one company, both markets

Konark Ceramics wants to build a second kiln costing 40 crore rupees, and it also needs 6 crore rupees for three months because a large buyer pays in 60 days while its own coal supplier requires payment in 15.

The long need goes to the capital market. It issues equity shares, or debentures repayable over seven years, or borrows a term loan. The money is used for a fixed asset, the horizon is years, the investor takes the risk that the kiln does not pay, and the issue is governed by the securities law that SEBI administers.

The short need goes to the money market. It issues commercial paper for 90 days, or its bank funds the gap and manages its own liquidity in the call money market and the repo market. The horizon is weeks, the risk is small, the rate is low, and the market is regulated by the Reserve Bank.

Why it must not confuse the two. Financing a seven year kiln with 90 day commercial paper would leave it needing to refinance twenty eight times, and a single refusal in a tight market would stop the kiln. That mismatch, borrowing short to lend or invest long, is exactly what makes financial crises, and it is why maturity transformation is done by regulated banks with a central bank behind them rather than by ordinary companies.

What beginners get wrong

"The money market deals in money and the capital market in capital." Both deal in loanable funds. The distinction is maturity, drawn at one year.

"The money market is a place." It has no physical location. It is a network of telephones and screens among banks, primary dealers and large institutions, and the Reserve Bank sits in the middle of it.

"The capital market is the stock exchange." The exchange is the secondary market for listed securities. The capital market also includes the primary market, where securities are first issued, and the debt market, which is much larger than the equity market by value.

"Households participate in the money market." Very rarely and only indirectly, through mutual funds. The minimum sizes are far beyond a household.

"One regulator would be simpler." The two markets fail in different ways and need different powers, which is the reason for the division.

Limits of the distinction

The boundary blurs. A treasury bill of 364 days is a money market instrument and a government security of 366 days is not, though they are almost the same thing to a buyer.

Institutions operate in both. A bank takes deposits and lends short, and also holds government securities and underwrites issues.

Regulatory perimeter disputes are real. Instruments that resemble both a deposit and a security have repeatedly raised the question of which regulator governs them, and Indian law has answered it case by case.

Quick revision

1. A financial system moves savings from surplus units to deficit units. Five functions: mobilisation of savings, allocation of capital, maturity transformation, risk transfer and pooling, and payment and liquidity.
2. Four components: institutions, markets, instruments and services, with regulators over them.
3. Organised and unorganised sectors coexist, which is dualism, and it weakens the transmission of monetary policy.
4. The dividing line between the markets is one year of original maturity, and it is statutory: section 45U(b) of the RBI Act 1934 defines money market instruments as call or notice money, term money, repo, reverse repo, certificate of deposit, commercial usance bill, commercial paper and other debt instruments of original maturity up to one year.
5. Money market: short term, low risk, low return, highly liquid, no exchange, for working capital and liquidity, regulated by the Reserve Bank.
6. Capital market: medium and long term, higher risk and return, organised exchanges for the secondary market, for fixed capital, regulated by SEBI.
7. SEBI Act 1992, section 11(1): to protect the interests of investors in securities, and to promote the development of and to regulate the securities market.
8. Two regulators because the two markets fail differently: systemic and liquidity risk in one, informational risk in the other.

Test yourself

1. What is a financial system and what functions does it perform? It is the set of institutions, instruments, markets, services and regulators through which savings are mobilised from those with a surplus and allocated to those who need funds. Its functions are the mobilisation of savings, gathering many small surpluses that individually could finance nothing; the allocation of capital to the uses that promise the best return; maturity transformation, since savers want liquidity and borrowers want long term funds, and an institution that accepts short deposits and makes long loans reconciles the two; the transfer and pooling of risk through insurance, guarantees and diversification; and the provision of a means of payment and of liquid stores of value. Its importance for a developing economy is that the absence of any of these functions shows up directly as high cost credit for poor households and small enterprises.

2. Distinguish the money market from the capital market. The money market deals in short term funds of original maturity up to one year, used for working capital and for managing temporary mismatches between receipts and payments; its instruments are call and notice money, term money, treasury bills, commercial paper, certificates of deposit, repos and commercial bills; its participants are the central bank, banks, primary dealers and large institutions; risk and return are low, liquidity is very high, there is no physical exchange, and it is regulated by the Reserve Bank of India. The capital market deals in medium and long term funds used for fixed capital; its instruments are equity and preference shares, debentures, bonds and mutual fund units; its participants include companies, the Government and retail and institutional investors; risk and return are higher, the secondary market operates on organised exchanges, and it is regulated by the Securities and Exchange Board of India.

3. Where is the boundary between the two markets drawn, and is it merely conventional? It is drawn at one year of original maturity, and it is not merely conventional in India because it is statutory. Section 45U(b) of the Reserve Bank of India Act 1934 defines money market instruments to include call or notice money, term money, repo, reverse repo, certificate of deposit, commercial usance bill, commercial paper and such other debt instrument of original or initial maturity up to one year as the Bank may specify. The boundary nevertheless blurs at the edge, since a treasury bill of 364 days and a government security of slightly longer tenor are nearly identical to a buyer, and many institutions operate in both markets.

4. What is meant by dualism in the Indian financial system, and why does it matter? Dualism is the coexistence of an organised sector, comprising regulated banks, non banking financial companies, insurers, mutual funds and exchanges, with an unorganised sector of indigenous bankers, moneylenders, trade creditors and unregistered lenders whose rates are high and whose documentation is minimal. It matters for two reasons. The unorganised sector serves precisely the borrowers the organised sector does not reach, so the households and enterprises paying the highest rates are the poorest. And because the unorganised sector is not connected to the central bank, a change in the policy rate is transmitted to the organised sector at once and to the unorganised sector hardly at all, which weakens monetary policy exactly where its effect would matter most.

5. Why does India have two principal financial regulators rather than one? Because the two markets fail in different ways and the powers needed to correct them differ. The characteristic danger of the banking and money market is systemic and liquidity risk: an institution unable to meet its obligations can bring down others through the payment system, so its regulator must be able to supply liquidity and act as lender of last resort, which only a central bank can do. The characteristic danger of the securities market is informational: an investor cannot distinguish a sound issuer from an unsound one, so the regulator's business is disclosure, fair dealing, the prevention of manipulation and the punishment of fraud. Section 11(1) of the SEBI Act 1992 states those objects directly, namely to protect the interests of investors in securities and to promote the development of and to regulate the securities market.

6. Why must a firm match the maturity of its funds to the maturity of its assets? Because funds raised for a short period must be repaid or refinanced at the end of it, whatever the state of the asset they financed. A firm that builds a plant with a seven year life using ninety day commercial paper has to refinance twenty eight times, and a single failure to refinance, which may reflect market conditions having nothing to do with the firm, stops the plant. Long lived assets are therefore financed with equity or long term debt, and short term needs such as the gap between paying a supplier and being paid by a buyer are financed in the money market. The deliberate mismatch of borrowing short and lending long is undertaken by banks, and it is precisely because that activity is risky that banks are regulated and have a central bank behind them.