Indian Financial System
The financial system enables lenders and borrowers to exchange funds. 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.
Table of Contents
The period from the mid-1960s to the early 1990s was characterized by government-controlled interest rates, industrial licensing and controls, dominant public sector, and limited competition. This led to the emergence of an economy characterised by uneconomic and inefficient production systems with high costs.
This inefficient allocation and use of resources resulted in high capital-output ratios. Despite a rise in saving rates, there was greater dependence on assistance from abroad to meet urgent situations.
The Indian government, therefore, initiated deregulation in the 1980s by relaxing the entry barriers, removing restrictive clauses in the Monopolies and Restrictive Trade Practices (MRTP) Act, allowing expansion of capacities, encouraging modernization of industries, reducing import restrictions, raising the yield on long-term government securities, and taking measures to help the growth of the money market.
These measures resulted in relatively high growth in the second half of the 1980s, but its pace could not be sustained. Further, the government initiated economic reforms in June 1991 to provide an environment of sustainable growth and stability.
The deregulation of industry, liberalization of foreign exchange markets and convertibility of currency require an efficient financial system.
Hence, the steps to improve the financial system were an integral part of the economic reforms initiated in 1991. The improved financial system is expected to increase the efficiency of resource mobilization and allocation in the real economy, which, in turn, would induce a higher rate of economic growth.
In the 1990s, there was a paradigm shift in development from a state-dominated to a market-determined strategy. This shift was a result of the government’s failure in achieving a higher growth rate. On the one hand, the government could not generate resources for investment or public services; on the other, there was an erosion in public savings.
Thus, a failure of the government’s restrictive and regulating policies and a need to adopt a market-determined strategy of development were the causes for undertaking reforms in the financial system. These reforms aimed at improving the operational and allocative efficiency of the financial system. Further, they targeted at increasing competitive efficiency in the operation of the system, making it healthy and profitable and imparting to it operational flexibility and autonomy for working efficiently.
The reforms primarily aimed at the structural transformation in the financial system to improve efficiency, stability, and integration of various components of the financial system. Some of the structural changes initiated are free pricing of financial assets, relaxation of quantitative restrictions, and removal of barriers to entry, new methods and instruments of trading, and greater participation and improvement in the clearing, settlement, and disclosure practices.
Now, India’s financial sector is integrating with that of the rest of the world. The interest rates have been freed, the statutory provisions have been reduced and prudential norms have been strengthened for players in the financial sector.
Reforms have altered the organisational structure, ownership pattern, and domain of operations of financial institutions and infused greater competition. Presently the Indian financial system is composed of banks, non-banking financial companies and financial markets.
Types of Financial System
These are the main points types of financial system lets discuss them in detail:
Financial Institutions
Financial Institutions are business organizations serving as a link between savers and investors and so help in the credit allocation process. In simple, Financial Institutions are the institutions that offer financial services for their clients or members.
The most probable service is financial intermediation. The institutions include banks, trust, companies, insurance companies and investment dealers.
Features of Financial Institutions
An understanding of the above meaning and definition provides the following salient features of financial institutions:
- It is an institution as well as intermediary.
- It channelizes savings fund into investment fund.
- It creates financial assets such as deposits, loans, securities etc.
- It includes banking and non-banking institutions.
- It includes both organized and unorganized institutions.
- Established with a clear operating function.
- Regulated by the government and regulating authority.
- It accepts deposits.
- It provides commercial loans, real estate loans and mortgage loans.
- Financial institutions keep money flowing through the economy among consumers, businesses and government.
Types of Financial Institutions
Types of financial institutions can be classified into two categories:
- Banking Institutions (Reserve Bank of India)
- Non-banking Institutions
Banking Institutions (Reserve Bank of India)
Indian banking industry is subject to the control of the Central Bank. The RBI as the apex institution organises, runs, supervises, regulates and develops the monetary system and the financial system of the country. The main legislation governing commercial banks in India is the Banking Regulation Act, 1949.
The following are the types of banking institutions which are running their business in India:
- Cooperative Banks: These are established to safeguard the interest of its members. These are organized on a co-operative basis, accept deposits and lend money to the required members.
- Commercial banks: These are also called as business banks. The following are the types of commercial banks.
- Public sector.
- Private sector.
- Regional Rural Banks (RRB`s)
- Foreign banks.
Non-banking Institutions
These are the financial institutions that provide banking services without meeting the legal definition of a bank. The non-banking financial institutions also mobilize financial resources directly or indirectly from the people. They lend the financial resources mobilized. The non-banking institutions are classified into organized and unorganized financial institutions.
The following are examples of non-banking institutions:
- Provident and pension fund.
- Small Saving organization.
- Life Insurance Corporation (LIC).
- General Insurance Corporation (GIC).
- Unit Trust of India (UTI).
- Mutual funds.
- Investment Trust, etc.
Non-banking financial institutions can also be categorized as investment companies housing companies, leasing companies, hire purchase companies, specialized financial institutions (EXIM Bank), Investment Institutions, State level institutions etc.
The non-banking institutions may be categorized broadly into two groups:
- Organised Non – Banking Financial Institutions.
- Unorganised Non – Banking Financial Institutions.
Financial Market
Financial markets are another component of the financial system. Efficient financial markets are essential for speedy economic development. The vibrant financial market enhances the efficiency of capital formation. It facilitates the flow of savings into investment.
Financial markets are the backbone of the economy. This is because they provide monetary support for the growth of the economy. Financial markets refer to any marketplace where buyers and sellers participate in the trading of assets such as shares, bonds, currencies, and other financial instruments.
A financial market may be further divided into capital market and money market. The capital market deals in long term securities having a maturity period of more than one year. The money market deals with short term debt instruments having a maturity period of less than one year.
Functions of financial markets are:
- To facilitate creation and allocation of credit and liquidity.
- To serve as intermediaries for mobilisaton of savings.
- To assist the process of balanced economic growth.
- To provide financial convenience.
- To cater to the various credit needs of the business houses.
Types of Financial Markets
These organised markets can be further classified into two they are:
- Capital Market
- Money Market
Capital Market
The capital market is one of the significant aspects of every financial market. Broadly speaking the capital market is a market for financial assets which have a long or indefinite maturity. The capital market instruments mature for the period above one year. It is also called as long term securities market.
It is an institutional arrangement to borrow and lend money for a longer period of time. It consists of financial institutions like IDBI, ICICI, UTI, LIC etc. These institutions play the role of lenders in the capital market. Business units and corporates are the borrowers in the capital market.
The capital market is a market for financial assets which have a long or indefinite maturity. Generally, it deals with long term securities that have a maturity period of above one year.
Money Market
The money market is an organized financial market. It plays an important role in the Indian financial system. A money market is a market where money or its equivalent can be traded. It does not actually deal in cash or money. It actually deals with near money substitutes like trade bills, promissory notes and government papers drawn for a short period not exceeding one year.
The very feature of these instruments is they can be converted into cash readily without any loss and at low transaction cost. This market consists of financial institutions and dealers in money or credit who wish to generate liquidity.
Hence, the money market is a market where short term obligations such as treasury bills, commercial papers and bankers acceptances are bought and sold.
Financial Instruments
In any financial transaction, there should be a creation or transfer of financial assets. Hence, the basic product of any financial system is the financial asset. A financial asset is one that is used for production or consumption or for the further creation of assets.
One must know the distinction between financial assets and physical assets. Physical assets are not useful for further production of goods or for earning incomes. For instance, if a building is bought for residential purposes, it becomes a physical asset. If the same is bought for hiring it becomes a financial asset. Financial instruments are also called financial assets/securities.
Financial assets are intangible assets that receive value due to contractual transactions. Financial assets/instruments indicate a claim on the settlement of principal or payment of a regular amount of by means of interest or dividend. Equity shares, debentures, bonds etc., are some examples.
Financial instruments refer to those documents which represent financial claims on assets. As discussed earlier, financial asset refers to a claim to claim to the repayment of a certain sum of money at the end of a specified period together with interest or dividend. Examples: Bill of exchange, Promissory Note, Treasury Bill.
Characteristics of Financial Instruments
Characteristics of financial instruments: the important characteristics of financial instruments are as follows:
- Liquidity: financial instruments provide liquidity. These can be easily and quickly converted into cash.
- Marketing: financial instruments facilitate easy trading on the market. They have a ready market.
- Collateral value: financial instruments can be pledged for getting loans.
- Transferability: financial instruments can be transferred from one person to another.
- Maturity period: the maturity period of financial instruments may be short term, medium term or long term.
- Transaction cost: financial instruments involve buying and selling cost. The buying and selling costs are called transaction costs.
- Risk: financial instruments carry risk. Equity based instruments are riskier in comparison to debt based instruments because the payment of dividend is uncertain. A company may not declare dividend in a particular year.
- Future trading: financial instruments facilitate future trading so as to cover risks arising out of price fluctuations, interest rate fluctuations etc.
Types of Financial securities
Financial securities can be classified into:
- Primary Securities
- Secondary Securities
Primary Securities
These are securities directly issued by the ultimate investors to the ultimate savers. Eg. shares and debentures issued directly to the public.
Secondary Securities
These are securities issued by some intermediaries called financial intermediaries to the ultimate savers. Eg. Unit Trust of India and mutual funds issue securities in the form of units to the public and the money pooled is invested in companies.
Financial Services
Financial service refers to services that are financial in nature offered by financial industries to its customer. Its objective is to intermediate and facilitate financial transactions of individuals and institutional investors.
In other words, Financial Services are the products or services offered by institutions like banks, credit card companies, insurance companies, stock brokerage companies etc. Financial services are also called financial intermediation.
Financial intermediation is a process of mobilization of a surplus of people and allocation of mobilized funds to various needy groups (industries, companies, business people, individuals etc.) for economic development.
Types of Financial Services
Financial services provided by various financial institutions, commercial banks and merchant bankers can be broadly classified into two categories:
- Banking Services
- Foreign Exchange Services
- Investment Services
- Insurance Services
- Other Financial Services
Banking Services
The primary operations of banks include:
- Keeping money safe while allowing withdrawals when needed.
- Issuance of cheque books.
- Provide personal loans, commercial loans and mortgage loans.
- Issuance of credit cards and processing of credit card transactions and billing.
- Issuance of debit cards for use as a substitute for cheques.
- Allow financial transactions at branches or at Automatic Teller Machines (ATMs).
- Provide Electronic fund transfers between banks.
- Facilitation of standing orders and direct debits, so payments can be made automatically.
- Provide overdraft agreements.
- Notary service for financial and other documents.
- Provide wealth management and tax planning services.
- Provide credit card machine services and networks for business entities.
Foreign Exchange Services
Foreign exchange services are provided by many banks around the world. Foreign exchange services include:
- Currency Exchange: Clients can purchase and sell foreign currency bank notes.
- Wire Transfer: Clients can send funds to international banks abroad.
- Foreign Currency Banking: The transactions are done in foreign currency.
Investment Services
- Asset Management: The term usually given to describe companies which run collective investment funds.
- Hedge fund management: Hedge funds often employ the services “prime brokerage” divisions at major investment banks to execute their trades.
- Custody Services: Custody services and securities processing is a kind of “back-office” notes administration for financial services.
Insurance Services
It deals with the selling of insurance policies, brokerages, insurance underwriting or reinsurance.
Other Financial Services
- Intermediation or advisory services: These services involve stock brokers (private client services) and discount brokers. Stock brokers assist investors in buying or selling shares.
- Private Equity: Private equity funds are typically closed-end funds, which usually take controlling equity stakes in business that are either private or taken private once acquired. The most successful private equity funds can generate returns significantly higher than provided by the equity markets.
- Venture Capital: Venture capital is a type of private equity capital typically provided by professional, outside investors to new, high potential growth companies in the interest of taking the company to an IPO or trade sale of the business.
- Angel Investment: An angel investor or angel; is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity. A small but increasing number of angel investors organize themselves into angel groups or angel networks to share research and pool their investment capital.
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