Structure of Financial System Finance Essay

The financial system is the backbone of every country and is a symbol of economic strength of that country. The financial system acts as a transformer of present into to better future. A better future of the economy can be secured only by a sound and effective financial system. Financial system in simple terms can be defined as a set of all activities related to financial institutions, financial markets, financial services and financial instruments (see figure 1.1. The main function of financial system is to facilitate the allocation of financial resources. This allocation is supported by increasing household savings which will result in increase in the investments in the corporate sector, by transferring of funds from one firm to another, by increasing consumption of households etc.

Figure 1.1: Structure of Financial System

Source: Bhole, L.M. (2010). Financial Institution & Market, Structure, Growth & Innovation. Tata Mc Graw Hill Publishing Co Ltd., New Delhi In the financial system, the financial markets play a very important role in resource mobilization. A financial market facilitates the sale and purchase of financial securities (shares, debentures etc.), commodities (metals, agriculture products) and other items. It can further be classified into two parts - Capital Market and Money Market. Money market facilitates the short term fund requirement (one year or less) of the firms through various instruments like Treasury Bills, Commercial Papers, Repurchase Agreements, whereas the capital market is for long term instruments (more than one year). The capital market has a larger role in the development of every economy as it not only encourages savings but at the same time also boost direct investment in the Industry. Capital market deals in the long term sources to be raised through bonds, debentures and stocks. The capital market can further be split into primary market and secondary market. Primary market is the one where new securities are bought and sold for the first time and the funds with the companies actually increase whereas in secondary market the shares which are already listed are dealt in and there is no additional resource mobilization for the companies. The secondary market provides easy liquidity, transferability and continuous price formation of securities and facilitates investors to buy and sell the shares with ease (Fortune India, 1990).

INDIAN CAPITAL MARKET

Indian capital market is one of the oldest capital markets of Asia. The history of Indian Capital Market dates back to the British rule period, when the shares of East India Company were traded in India. There were only two stock exchanges in Bombay and Calcutta till the end of 19th century. There has been a huge transformation since then. With the history of socialistic pattern and strict control over private participation in economy since independence till 1990, the Indian capital market has witnessed a major shift in the focus after 1990. The growth of Indian Capital Market started in 1990s with the major reforms that were carried in the Indian Economy. Indian Capital Market started its transformation from a young market to a comparatively mature and advanced market with the major changes in the way it was being governed and regulated. The writing on the wall started in 1980s but it was during the 1990s that the process actually picked the pace. The reforms in the financial sector capital market started with the abolition of the Controller of Capital Issues Act in 1992 and introduction of SEBI Act has given the momentum with which IPO market has been growing.

DEVELOPMENTS AND GROWTH IN INDIAN PRIMARY MARKET

The most preferred source of raising funds for every corporate in India is the primary market. In primary market, the funds can be raised through Shares, Debentures, Bonds etc. A direct link is established between the companies and the investor whenever the funds are raised through primary market, which is beneficial to both the parties in terms of confidence in each other and the returns that both the parties get. This is the reason that the funds mobilization from the primary market has been increasing since 1993-94 with few exceptions (refer table 1.1). Table 1.1 shows the growth that the Primary market in India has witnessed since 1993-94. The growth is clearly visible in the initial years and the trend continued till 1994-95. However, beginning with 1995 there was a fall in the fund raising from the primary market. Although number of issues of shares increased from 1692 in 1994-95 to 1725 in 1995-96 but the total amount reduced to 20,804 crores from 27,633 crores. This falling trend continued till 2002-03, when a new lifeline was provided to the primary market and the confidence of the industry as well as the investors was restored and both the parties returned to the primary market fold. The total funds mobilized increased from Rs. 23,272 crores in 2003-04 to Rs. 87,029 crores in 2007-08. In 2008-09, the world economy witnessed one of the severe financial crises of all times. Although the impact on Indian economy was less as compared to other economies, but still it took its toll on the securities market. In 2008-09, the funds raised fell sharply to Rs. 16,220 crores from Rs. 87,209 crores in 2007-08. But with the immediate intervention of all the concerned authorities (Government, SEBI, RBI etc.) the negative impact was restricted to one financial year only and there was a turnaround in 2009-10.

Table 1.1: Resources Mobilized from the Primary Market

(Amount in Rs. Crore) Year Total Category - wise Issuer Type Public Rights Listed IPOs No. Amt. No. Amt. No. Amt. No. Amt. No. Amt. 1993-94 1,143 24,372 773 15,449 370 8,923 451 16,508 692 7,864 1994-95 1,692 27,633 1,342 21,045 350 6,588 453 11,061 1,239 16,572 1995-96 1,725 20,804 1,426 14,240 299 6,564 368 9,880 1,357 10,924 1996-97 884 14,284 753 11,565 131 2,719 167 8,326 717 5,959 1997-98 111 4,570 62 2,862 49 1,708 59 3,522 52 1,048 1998-99 58 5,587 32 5,019 26 568 40 5,182 18 404 1999-00 93 7,817 65 6,257 28 1,560 42 5,098 51 2,719 2000-01 151 6,108 124 5,378 27 729 37 3,385 114 2,722 2001-02 35 7,543 20 6,502 15 1,041 28 6,341 7 1,202 2002-03 26 4,070 14 3,639 12 431 20 3,032 6 1,039 2003-04 57 23,272 35 22,265 22 1,007 36 19,838 21 3,434 2004-05 60 28,256 34 24,640 26 3,616 37 14,507 23 13,749 2005-06 139 27,382 103 23,294 36 4,088 60 16,446 79 10,936 2006-07 124 33,508 85 29,796 39 3,710 47 5,002 77 28,504 2007-08 124 87,029 92 54,511 32 32,518 39 44,434 85 42,595 2008-09 47 16,220 22 3,582 25 12,637 25 12,637 21 2,082 2009-10 76 57,555 47 49,236 29 8,319 34 30,359 39 24,696

Source: SEBI Handbook 2010

The funds mobilization has always been more from the equities as compared to other instruments (Table 1.2). However there were certain exception years (1996-97, 1998-99, 2000-01 and 2002-03) when the funds raised through equities was less as compared to Bonds, Compulsorily Convertible Preference Shares (CCPS) and other instruments. In 1996-97 maximum funds have been raised through CCPS whereas in remaining years i.e. 1998-99, 2000-01 and 2002-03 the maximum funds have been raised through bonds.

Table 1.2: Resources Mobilized from the Primary Market

(Amount in Rs. Crore) INSTRUMENT WISE EQUITIES CCPS BONDS OTHERS AT PAR AT PREMIUM Year No. Amt. No. Amt. No. Amt. No. Amt. No. Amt. 1993-94 608 3,808 383 9,220 1 2 9 1,991 142 9,351 1994-95 942 5,529 651 12,441 7 124 0 0 135 9,538 1995-96 1,181 4,958 480 9,727 8 145 6 2,086 63 3,888 1996-97 697 3,441 148 4,412 10 5,400 27 886

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1997-98 64 271 33 1,610 3 10 4 1,550 10 1,128 1998-99 20 197 20 660 3 78 10 4,450 6 202 1999-00 30 786 52 3,780 0 0 10 3,200 2 51 2000-01 84 818 54 2,408 2 142 10 2,704 1 36 2001-02 7 151 8 1,121 0 0 16 5,601 4 670 2002-03 6 143 11 1,314 0 0 8 2,600 2 13 2003-04 14 360 37 18,589 0 0 6 4,324 0 0 2004-05 6 420 49 23,968 0 0 5 3,867 0 0 2005-06 10 372 128 27,000 0 0 0 0 1 10 2006-07 2 12 119 32,889 0 0 2 356 1 249 2007-08 7 387 113 79,352 2 5,687 2 1,603 0 0 2008-09 5 96 40 14,176 1 448 1 1,500 0 0 2009-10 1 9 71 54,866 1 180 3 2,500 0 0

Source: SEBI Handbook 2010

In 2010-11, 91 companies accessed the primary market as against 76 in 2009-10. The total amount mobilized during 2010-11 was Rs 67,609 crores compared to Rs. 57,555 crores mobilized during 2009-10. With the entering of large number of public sector companies in the IPO market, the number of Initial Public Offerings (IPOs) have also increased to 53 in 2010-11 from 39 in 2009-10. In 2009-10 and 2010-11, the share of public sector in the funds mobilization was more as compared to private sector. But there was a fall in the number of rights issue from 23 to 29 and also in the funds raised through the Qualified Institutions' Placement Mode (QIP) to Rs. 25,861 crores (from 50 issues) against Rs. 42,729 crores (from 62 issues) during the same period. [1]

INITIAL PUBLIC OFFERINGS

An Indian company can issue shares through Public Issue, Right Issue, Bonus Issue and Private Placement.

Figure 1.2: Types of Issues

Public issue is the most popular way of raising finance directly through the public i.e., primary market. The IPOs have their existence from the historical era but IPO market in India has been developing since the transformation of Indian economic structure after the economic reforms in the form of liberalization of the Indian economy. IPO has become one of the most preferred methods of raising funds for various new companies and existing companies. An Initial Public Offering (IPO) is the sale of stock by a company that is made to the public immediately after the formation of the company. It can be used by either small or large companies to raise expansion capital and become publicly traded enterprises. Investment Banking firms assist companies that undertake an IPO and also act as an underwriter to help them correctly assess the value of their shares, that is, the share issue price. A company can issue securities in the following three ways: 1. Public issue 2. Right issue 3. Private placement Public issue is the most preferred and important source of raising funds by the company. It is not only in the interest of the company to raise funds through IPOs rather it is generally a win-win situation for all the parties involved. Normally there are three parties involved in the process of IPO - The Company, The Vendors (Investment Bankers) and The Investors. IPO is the safest form of raising funds for any company. It is one way of expanding ownership. Although, the main objective of the company in issuing IPO is to raise funds but at the same time it becomes the responsibility of the company to create atmosphere for immediate return to the investors by facilitating increase in market price of the shares and future returns to the shareholders. The Vendors act as an intermediary between the company and the investors. The primary interest of the vendors in an IPO is to get immediate returns in the form of commission but at the same time they are also interested in creating a market for them by ensuring the full sale of shares and to be seen as a successful intermediary. Investors are the main affected party as they are investing their amount and are the real risk bearers. The investors will always like the value of their shares to go up and will seek higher possible return on their investment.

Figure 1.3: Various IPO Objectives

Source: Geddes, 2003, "IPOs and Equity Offerings", Butterworth-Heinemann Publications

PROCEDURE FOR ISSUING AN IPO

The process of issuing an IPO starts with the appointment of the Merchant Bankers who do the primary work for issuing the IPO. They try to propose a price which will be accepted by the market by studying the market environment. The task of appointing agents, registrar, banks etc. is facilitated by Merchant Bankers. As already explained tAs the Merchant Bankers are the intermediaries between the company and the investors, so practically all the functions of issuing IPO are either performed by them or they act as advisors for other functions. Sometimes a single Merchant Bank is hesitant to take all the risk, especially when the size of the issue is very big. In such cases they for a group of similar bankers and divides the risk amongst them. The Merchant Bankers after doing the analysis and discussion with the company prepares an offer document which is than filed with SEBI. After receiving a confirmation from SEBI the prospectus is finally issued and the applications are invited from the investors. The offer normally remains open from 3-7 days. After the closing of the issue, the merchant bankers scrutinize the applications and then finally decide on the issue of the shares. The successful investors are informed of the allotment and amount is refunded to the unsuccessful investors.

REGULATORY FRAMEWORK

The IPO market in India is growing as a large number of companies are issuing equity shares in the capital market. Since 1990 reforms, the Indian IPO market went through a dynamic phase of policy changes, reforms and streamlining. Among these reforms and transforms, one of the most significant developments was the substitution of Controller of Capital Issues (CCI) by a free pricing mechanism. CCI had the regulatory control on all capital issues in Indian market. CCI was the authority which actually cleared the issue price set as the offer price of such issue. The CCI's formula was used to compute the fair price of equity in the light of accounting information (Shah, 1995) [2] 1.3 Schedules - Disclosure and Investor Protection Guidelines, 2000 enables the Central Government to exercise the jurisdiction over (a) stock exchanges through a process of recognition and continued supervision, (b) contracts in securities, and (c) listing of securities on stock exchanges. market expectations and economic environment prevailing at that particular point of time. F A is appointed as by the issuer company of IPO. Ais prepared in consultation with . W, the final prospectus is filed with the registrar of companies. One day before the opening of the public issue through fixed price method, private placement and t On the 2nd day from the closure of the issue, is to that portion will be As per the statutory requirements, is to be done for the shares in n. Table 1.4: Difference between Book Building and Fixed pricing https://www.bseindia.com/bookbuilding/about.asp Jagannathan et. al. The been considered as a when there was a the e was suffering from a downturnIt was after 2002 when the primary market recovered from this downturn but the investors had already lost their confidence as they suffered huge losses since they had bought shares in the boom period. The confidence of the investors was only restored in 2003 when wthe improvement in the market.

1.5

2008-09 45 14,670 2009-10 67 25,298 2010-11 70 24,830 RBI But in 2008 the financial crisis took its toll on the primary market also with the number of IPOs decreased to 45 in 2008-09. . The market showed a sign of recovery with the number of IPOs increasing since 2009.

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1.4POi (Kaustia, 2004) The type of industry to which that particular company belongs also affects the degree of underpricing of the IPOs. The IPOs of the sectors from which the market has greater expectations are tend to be more underpriced as compared to the IPOs of the sectors for which the demand is comparatively less. (Henrick, 2012) (Hail and Leuz, 2006)It can also be concluded (Shi, Pukthuanthong & Walker, 2007) IPOs have been the most preferred source of raising funds by companies. The companies always try to fix a fair price for the shares but generally end up pricing IPO at a lower price in order to attract investors. This safe play or rather conservative approach adopted by the companies generally result in underpricing of IPOs. The above discussion brings into light the possible reasons which cause underpricing. A large number of studies have been published regarding underpricing of IPOs and on the role of various factors on underpricing in IPOs in isolation in emerging markets. An attempt is required to be made to

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