UNIT-1

FINANCIAL SYSTEM IN INDIA

INTRODUCTION
The economic development of a nation is reflected by the progress of the various economic units,
broadly classified into corporate sector, government and household sector. There are areas or
people with surplus funds and there are those with a deficit. A financial system or financial
sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to
the areas of deficit. The word ‘system’ in the term ‘Financial System’ implies a set of complex
and closely connected or intermixed instructions, agents, practices, markets, transactions, claims
and liabilities in the economy. Finance is the study of money, its nature, creation, behaviour,
regulations and administration. Therefore, Financial System includes all those activities dealing
in finance, organised into a system. The financial system consists of financial institutions,
financial markets, financial instruments and the services Indian Financial System 8 provided by
the financial institutions.
MEANING OF FINANCIAL SYSTEM
India has a financial system that is controlled by independent regulators in the sectors of
insurance, banking, capital markets and various services sectors.
Thus, a financial system can be said to play a significant role in the economic growth of a
country by mobilizing the surplus funds and utilizing them effectively for productive purposes.
FEATURES OF INDIAN FINANCIAL SYSTEM:
 • It plays a vital role in economic development of a country.
 • It encourages both savings and investment.
 • It links savers and investors.
 • It helps in capital formation.
 • It helps in allocation of risk.
 • It facilitates expansion of financial markets.

Components of Indian Financial System

There are four main components of the Indian Financial System. This includes:

1. Financial Institutions
2. Financial Assets/intruments
3. Financial Services
4. Financial Markets
1. Financial Institutions

The Financial Institutions act as a mediator between the investor and the borrower. The
investor’s savings are mobilised either directly or indirectly via the Financial Markets.

The main functions of the Financial Institutions are as follows:

 A short term liability can be converted into a long term investment

 It helps in conversion of a risky investment into a risk-free investment
 Also acts as a medium of convenience denomination, which means, it can match a small
deposit with large loans and a large deposit with small loans
The best example of a Financial Institution is a Bank. People with surplus amounts of money
make savings in their accounts, and people in dire need of money take loans. The bank acts as an
intermediate between the two.

The financial institutions can further be divided into two types:

 Banking Institutions or Depository Institutions – This includes banks and other credit
unions which collect money from the public against interest provided on the deposits
made and lend that money to the ones in need
 Non-Banking Institutions or Non-Depository Institutions – Insurance, mutual funds
and brokerage companies fall under this category. They cannot ask for monetary deposits
but sell financial products to their customers.
Further, Financial Institutions can be classified into three categories:

 Regulatory – Institutes that regulate the financial markets like RBI, IRDA, SEBI, etc.
 Intermediates – Commercial banks which provide loans and other financial assistance
such as SBI, BOB, PNB, etc.
 Non Intermediates – Institutions that provide financial aid to corporate customers. It
includes NABARD, SIBDI, etc.

2. Financial Instruments

The products which are traded in the Financial Markets are called Financial Assets. Based on the
different requirements and needs of the credit seeker, the securities in the market also differ from
each other.

Some important Financial Assets have been discussed briefly below:

 Call Money – When a loan is granted for one day and is repaid on the second day, it is
called call money. No collateral securities are required for this kind of transaction.
  Notice Money – When a loan is granted for more than a day and for less than 14 days, it
is called notice money. No collateral securities are required for this kind of transaction.
 Term Money – When the maturity period of a deposit is beyond 14 days, it is called term
money.
 Treasury Bills – Also known as T-Bills, these are Government bonds or debt securities
with maturity of less than a year. Buying a T-Bill means lending money to the
Government.
 Certificate of Deposits – It is a dematerialised form (Electronically generated) for funds
deposited in the bank for a specific period of time.
 Commercial Paper – It is an unsecured short-term debt instrument issued by
corporations.

3. Financial Services

Services provided by Asset Management and Liability Management Companies. They help to
get the required funds and also make sure that they are efficiently invested.

The financial services in India include:

 Banking Services – Any small or big service provided by banks like granting a loan,
depositing money, issuing debit/credit cards, opening accounts, etc.
 Insurance Services – Services like issuing of insurance, selling policies, insurance
undertaking and brokerages, etc. are all a part of the Insurance services
 Investment Services – It mostly includes asset management
 Foreign Exchange Services – Exchange of currency, foreign exchange, etc. are a part of
the Foreign exchange services
The main aim of the financial services is to assist a person with selling, borrowing or purchasing
securities, allowing payments and settlements and lending and investing.

4. Financial Markets

The marketplace where buyers and sellers interact with each other and participate in the trading
of money, bonds, shares and other assets is called a financial market.

The financial market can be further divided into four types:

 Capital Market – Designed to finance the long term investment, the Capital market
deals with transactions which are taking place in the market for over a year. The capital
market can further be divided into three types:
(a)Corporate Securities Market
 (b)Government Securities Market

(c)Long Term Loan Market

 Money Market – Mostly dominated by Government, Banks and other Large Institutions,
the type of market is authorised for small-term investments only. It is a wholesale debt
market which works on low-risk and highly liquid instruments. The money market can
further be divided into two types:
(a) Organised Money Market

(b) Unorganised Money Market

 Foreign exchange Market – One of the most developed markets across the world, the
Foreign exchange market, deals with the requirements related to multi-currency. The
transfer of funds in this market takes place based on the foreign currency rate.
 Credit Market – A market where short-term and long-term loans are granted to
individuals or Organisations by various banks and Financial and Non-Financial
Institutions is called Credit Market

Role of Indian Financial system

 Lower transaction costs
 Reduce risk
 Provide liquidity.

Indian Financial System Functions

The Indian financial system has several functions that help to meet the financial needs of
individuals and businesses. Here are some of the key functions of the Indian financial system:
 Mobilization of Savings: The Indian financial system helps to mobilize savings from
various sectors of the economy and channel them towards productive investments. This is
achieved through various financial intermediaries such as banks, mutual funds, and
insurance companies.
 Allocation of Credit: The Indian financial system also plays a key role in allocating credit
to different sectors of the economy. Banks and other financial institutions provide loans
and credit facilities to businesses and individuals to help them meet their financial needs.
 Payment System: The financial system provides a safe and efficient payment mechanism
to facilitate transactions between different individuals and businesses. This is achieved
through various payment systems such as NEFT, RTGS, and IMPS.
  Risk Management: The financial system helps to manage risks associated with financial
transactions. Financial intermediaries such as insurance companies provide risk
management products such as life insurance, health insurance, and property insurance.
 Price Discovery: The Indian financial system also helps in the discovery of prices of
financial assets such as stocks, bonds, and commodities. This is achieved through various
financial intermediaries such as stock exchanges and commodity exchanges.
 Economic Development: The financial system plays a critical role in the economic
development of the country. It provides financial resources for investment in
infrastructure, industries, and other productive sectors of the economy.
 Financial Inclusion: The Indian financial system also strives to promote financial
inclusion by providing access to financial services to individuals and businesses in
remote and underdeveloped areas of the country.

Development of Financial System in India

 India has experienced a prolonged period of strong economic growth since it embarked
on major structural reforms and economic liberalization in 1991, with real GDP growth
averaging about 6.6 percent during 1991–2019. Millions have been lifted out of poverty.
 With a population of 1.4 billion and about 7 percent of the world economic output (in
purchasing power parity terms), India is the third largest economy—after the US and
China.
 The various Financial Institutions help balance the economic growth of the country and
mobilise the flow of debit and credit in the country. With the help of rural development,
the overall financial system of the country can be improved.

Narasimham Committee report (1991)

 It was established to give reforms pertaining to the financial sector of India including the
capital market and banking sector.
 Some of its major recommendations have been mentioned below:
 It recommended reducing the cash reserve ratio (CRR) to 10% and the
statutory liquidity ratio (SLR) to 25% over the period of time.
 It suggested fixing at least 10% of the credit for priority sector lending to
marginal farmers, small businesses, cottage industries, etc.
 In order to provide required independence to the banks for setting the interest
rates themselves for the customers, it recommended de-regulating the interest
rates.
Financial system and Economic development
 A financial system consists of individuals like borrowers and lenders and institutions like
banks, stock exchanges, and insurance companies actively involved in the funds and
assets transfer.
 It gives investors the ability to grow their wealth and assets, thus contributing to
economic development.
It serves different purposes in an economy, such as working as payment systems, providing
savings options, bringing liquidity to financial markets, and protecting investors from
unexpected financial risks
Financial reforms in India

Reforms in the Banking Sector

 Reduction in CRR and SLR has given banks more financial resources for lending to the
agriculture, industry and other sectors of the economy.
 The system of administered interest rate structure has been done away with and RBI no
longer decides interest rates on deposits paid by the banks.
 Allowing domestic and international private sector banks to open branches in India, for
example, HDFC Bank, ICICI Bank, Bank of America, Citibank, American Express, etc.
 Issues pertaining to non-performing assets were resolved through Lok adalats, civil
courts, Tribunals, The Securitisation And Reconstruction of Financial Assets and the
Enforcement of Security Interest (SARFAESI) Act.
The system of selective credit control that had increased the dominance of RBI was removed so
that banks can provide greater freedom in giving credit to their customers

Reforms in the Debt Market

 The 1997 policy of the government that included automatic monetization of the fiscal
deficit was removed resulting in the government borrowing money from the market
through the auction of government securities.
 Borrowing by the government occurs at market-determined interest rates which have
made the government cautious about its fiscal deficits.
 Introduction of treasury bills by the government for 91 days for ensuring liquidity and
meeting short-term financial needs and for benchmarking.
 To ensure transparency the government introduced a system of delivery versus payment
settlement.
Reforms in the Foreign Exchange Market
 Market-based exchange rates and the current account convertibility was adopted in
1993.
 The government permitted the commercial banks to undertake operations in foreign
exchange.
 Participation of newer players allowed in rupee foreign currency swap market to
undertake currency swap transactions subject to certain limitations.
  Replacement of foreign exchange regulation act (FERA), 1973 was replaced by
the foreign exchange management act (FEMA), 1999 for providing greater freedom to
the exchange markets.
 Trading in exchange-traded derivatives contracts was permitted for foreign
institutional investors and non-resident Indians subject to certain regulations and
limitations.

Impact of Various Reforms in the Financial Sector

 It increased the resilience, stability and growth rate of the Indian economy from around
3.5 % to more than 6% per annum.
 A resilient banking system helped the country deal with the Asian economic crisis of
1977-98 and the Global subprime crisis.
 The emergence of private sector banks and foreign banks increased competition in the
banking sector which has improved its efficiency and capability.
 Better performance by stock exchanges of the country and adoption of international best
practices.
 Better budget management, fiscal deficit, and public debt condition have improved after
the financial sector reforms.
Limitations or weaknesses of Indian financial system
o Lack of Co-ordination between different Financial Institutions : There are a large number
of financial intermediaries. Most of the vital financial institutions are owned by the
Government. At the same time, the Government is also the controlling authority of these
institutions. In these circumstances, the problem of co-ordination arises. As there is
multiplicity of institutions in the Indian financial system, there is a lack of co-ordination in
the working of these institutions.
o Monopolistic Market Structures : In India, some financial institutions are so large that they
have created a monopolistic market structure in the financial system. For instance, a major
part of life insurance business is in the hands of LIC. The UTI has more or less monopolised
the mutual fund industry. The weakness of this large structure is that it could lead to
inefficiency in their working or mismanagement or lack of effort in mobilising savings of the
public and so on. Ultimately, it would retard the development of the financial system of the
country itself.
o Dominance of Development Banks in Industrial Financing : The development banks
constitute the backbone of the Indian financial system occupying an important place in the
capital market. The industrial financing today in India is largely through the financial
institutions created by the Government, both at the national and regional levels. These
development banks act as distributive agencies only, since, they derive most of their funds
from their sponsors. As such, they fail to mobilise the savings of the public. This would be
a serious bottleneck which stands in the way of the growth of an efficient financial system
 in the country. For industries abroad, institutional finance has been a result of
institutionalisation of personal savings through media like banks, LIC, pension and
provident funds, unit trusts and so on. But they play a less significant role in the Indian
financial system, as far as industrial financing is concerned. However, in recent times
attempts are being made to raise funds from the public through the issue of bonds, units,
debentures and so on. It will go a long way in forging a link between the normal channels
of savings and the distributing mechanism.
o Inactive and Erratic Capital Market : The important function of any capital market is to
promote economic development through mobilisation of savings and their distribution to
productive ventures. As far as industrial finance in India is concerned, corporate customers
are able to raise their financial resources through development banks. So, they need not go
to the capital market. Moreover, they don't resort to capital market, since it is very erratic
and inactive. Investors too prefer investments in physical assets to investments in financial
assets. The weakness of the capital market is a serious problem in our financial system.
o Imprudent Financial Practice : The dominance of development banks has developed
imprudent financial practice among the corporate customers. The development banks
provide most of the funds in the form of term loans. So there is a preponderance of debt in
the financial structure of corporate enterprises. This predominance of debt capital has made
the capital structure of the borrowing concerns uneven and lopsided. To make matters
worse, when corporate enterprises face any financial crisis, these financial institutions
permit a greater use of debt than is warranted. It is against the traditional concept of a sound
capital structure.

However, in recent times all efforts have been taken to activate the capital market. Integration is
also taking place between different financial institutions. For instance, the Unit Linked Insurance
Schemes of the UTI are being offered to the public in collaboration with the LIC. Similarly, the
refinance and rediscounting facilities provided by the IUBI aim at integration. Thus, the Indian
financial system has become a developed one