JYOTINIVAS COLLEGE KORMANGALA AUTONOMOUS

MODULE I
FINANCIAL SYSTEM
An 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. A Financial System is a composition of various institutions,
markets, regulations and laws, practices, money manager, analysts, transactions
and claims and liabilities.

Financial system comprises of set of subsystems of financial institutions,

financial markets, financial instruments and services which helps in the
formation of capital. It provides a mechanism by which savings are transformed
to investment.
Financial System;

The word "system", in the term "financial system", implies a set of complex
and closely connected or interlinked institutions, agents, practices, markets,
transactions, claims, and liabilities in the economy. The financial system is
concerned about money, credit and finance - the three terms are intimately
related yet are somewhat different from each other. Indian financial system
consists of financial market, financial instruments and financial intermediation.

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Meaning of Financial System

A financial system functions as an intermediary between savers and

investors. It facilitates the flow of funds from the areas of surplus to the areas of
deficit. It is concerned about the money, credit and finance. These three parts are
very closely interrelated with each other and depend on each other.

A financial system may be defined as a set of institutions, instruments and

markets which promotes savings and channels them to their most efficient use. It
consists of individuals (savers), intermediaries, markets and users of savings
(investors).
In the worlds of Van Horne, “financial system allocates savings
efficiently in an economy to ultimate users either for investment in real
assets or for consumption”.
According to Prasanna Chandra, “financial system consists of a variety
of institutions, markets and instruments related in a systematic manner
and provide the principal means by which savings are transformed into
investments”.
Thus financial system is a set of complex and closely interlinked financial
institutions, financial markets, financial instruments and services which
facilitate the transfer of funds. Financial institutions mobilise funds from
suppliers and provide these funds to those who demand them. Similarly, the
financial markets are also required for movement of funds from savers to
intermediaries and from intermediaries to investors. In short, financial system is
a mechanism by which savings are transformed into investments.
Functions of Financial System

The financial system of a country performs certain valuable functions for

the economic growth of that country. The main functions of a financial system
may be briefly discussed as below:
1. Saving function: An important function of a financial system is to mobilise
savings and channelize them into productive activities. It is through financial
system the savings are transformed into investments.
2. Liquidity function: The most important function of a financial system is to
provide money and monetary assets for the production of goods and services.
Monetary assets are those assets which can be converted into cash or money
easily without loss of value. All activities in a financial system are related to
liquidity-either provision of liquidity or trading in liquidity.
3. Payment function: The financial system offers a very convenient mode of
payment for goods and services. The cheque system and credit card system are

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the easiest methods of payment in the economy. The cost and time of
transactions are considerably reduced.
4. Risk function: The financial markets provide protection against life, health
and income risks. These guarantees are accomplished through the sale of life,
health insurance and property insurance policies.

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5. Information function: A financial system makes available price-related

information. This is a valuable help to those who need to take economic and
financial decisions. Financial markets disseminate information for enabling
participants to develop an informed opinion about investment, disinvestment,
reinvestment or holding a particular asset.
6. Transfer function: A financial system provides a mechanism for the transfer
of the resources across geographic boundaries.
7. Reformatory functions: A financial system undertaking the functions of
developing, introducing innovative financial assets/instruments services and
practices and restructuring the existing assts, services etc, to cater the emerging
needs of borrowers and investors (financial engineering and re engineering).
8. Other functions: It assists in the selection of projects to be financed and also
reviews performance of such projects periodically. It also promotes the process of
capital formation by bringing together the supply of savings and the demand for
investible funds.
Role and Importance of Financial System in Economic Development

1. It links the savers and investors. It helps in mobilizing and allocating the
savings efficiently and effectively. It plays a crucial role in economic development
through saving-investment process. This savings – investment process is called
capital formation.
2. It helps to monitor corporate performance.
3. It provides a mechanism for managing uncertainty and controlling risk.
4. It provides a mechanism for the transfer of resources across geographical
boundaries.
5. It offers portfolio adjustment facilities (provided by financial markets and
financial intermediaries).
6. It helps in lowering the transaction costs and increase returns. This will
motivate people to save more.
7. It promotes the process of capital formation.
8. It helps in promoting the process of financial deepening and broadening.
Financial deepening means increasing financial assets as a percentage of GDP
and financial broadening means building an increasing number and variety of
participants and instruments.
In short, a financial system contributes to the acceleration of economic
development. It contributes to growth through technical progress.

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Structure of Indian Financial System

Financial structure refers to shape, components and their order in the

financial system. The Indian financial system can be broadly classified into
formal (organised) financial system and the informal (unorganised) financial
system. The formal financial system comprises of Ministry of Finance, RBI, SEBI
and other regulatory bodies. The informal financial system consists of individual
money lenders, groups of persons operating as funds or associations, partnership
firms consisting of local brokers, pawn brokers, and non-banking financial
intermediaries such as finance, investment and chit fund companies.

The formal financial system comprises financial institutions, financial

markets, financial instruments and financial services. These constituents or
components of Indian financial system may be briefly discussed as below:

I. Financial Institutions

Financial institutions are the participants in a financial market. They are

business organizations dealing in financial resources. They collect resources by
accepting deposits from individuals and institutions and lend them to trade,
industry and others. They buy and sell financial instruments. They generate
financial instruments as well. They deal in financial assets. They accept deposits,
grant loans and invest in securities.

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Financial institutions are the business organizations that act as mobilises

of savings and as purveyors of credit or finance. This means financial institutions
mobilise the savings of savers and give credit or finance to the investors. They
also provide various financial services to the community. They deal in financial
assets such as deposits, loans, securities and so on.
On the basis of the nature of activities, financial institutions may be
classified as: (a) Regulatory and promotional institutions, (b) Banking
institutions, and (c) Non-banking institutions.
1. Regulatory and Promotional Institutions:

Financial institutions, financial markets, financial instruments and

financial services are all regulated by regulators like Ministry of Finance, the
Company Law Board, RBI, SEBI, IRDA, Dept. of Economic Affairs, Department of
Company Affairs etc. The two major Regulatory and Promotional Institutions in
India are Reserve Bank of India (RBI) and Securities Exchange Board of India
(SEBI). Both RBI and SEBI administer, legislate, supervise, monitor, control and
discipline the entire financial system. RBI is the apex of all financial institutions
in India. All financial institutions are under the control of RBI. The financial
markets are under the control of SEBI. Both RBI and SEBI have laid down
several policies, procedures and guidelines. These policies, procedures and
guidelines are changed from time to time so as to set the financial system in the
right direction.
2. Banking Institutions:

Banking institutions mobilise the savings of the people. They provide a

mechanism for the smooth exchange of goods and services. They extend credit
while lending money. They not only supply credit but also create credit. There are
three basic categories of banking institutions. They are commercial banks, co-
operative banks and developmental banks.
3. Non-banking Institutions:

The non-banking financial institutions also mobilize financial resources

directly or indirectly from the people. They lend the financial resources mobilized.
They lend funds but do not create credit. Companies like LIC, GIC, UTI,
Development Financial Institutions, Organisation of Pension and Provident
Funds etc. fall in this category. Non-banking financial institutions can be
categorized as investment companies, housing companies, leasing companies,
hire purchase companies, specialized financial institutions (EXIM Bank etc.)
investment institutions, state level institutions etc.

Financial institutions are financial intermediaries. They intermediate

between savers and investors. They lend money. They also mobilise savings.

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II. Financial Markets

Financial markets are another part or component of 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 bridge one set of financial
intermediaries with another set of players. Financial markets are the backbone of
the economy. This is because they provide monetary support for the growth of
the economy. The growth of the financial markets is the barometer of the growth
of a country’s economy.

Financial market deals in financial securities (or financial instruments)

and financial services. Financial markets are the centres or arrangements that
provide facilities for buying and selling of financial claims and services. These are
the markets in which money as well as monetary claims is traded in. Financial
markets exist wherever financial transactions take place. Financial transactions
include issue of equity stock by a company, purchase of bonds in the secondary
market, deposit of money in a bank account, transfer of funds from a current
account to a savings account etc.

The participants in the financial markets are corporations, financial institutions,

individuals and the government. These participants trade in financial products in
these markets. They trade either directly or through brokers and dealers.
In short, financial markets are markets that deal in financial assets and credit
instruments.
Functions of Financial Markets:

The main functions of financial markets are outlined as below:

1. To facilitate creation and allocation of credit and liquidity.

2. To serve as intermediaries for mobilisation of savings.

3. To help in the process of balanced economic growth.

4. To provide financial convenience.

5. To provide information and facilitate transactions at low cost.

6. To cater to the various credits needs of the business organisations.

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Classification of Financial Markets:

There are different ways of classifying financial markets. There are mainly five
ways of classifying financial markets.

1. Classification on the basis of the type of financial claim: On this basis,

financial markets may be classified into debt market and equity market.
Debt market: This is the financial market for fixed claims like debt
instruments.
Equity market: This is the financial market for residual claims, i.e., equity
instruments.
2. Classification on the basis of maturity of claims: On this basis, financial
markets may be classified into money market and capital market.
Money market: A market where short term funds are borrowed and lend is
called money market. It deals in short term monetary assets with a maturity
period of one year or less. Liquid funds as well as highly liquid securities are
traded in the money market. Examples of money market are Treasury bill
market, call money market, commercial bill market etc. The main participants in
this market are banks, financial institutions and government. In short, money
market is a place where the demand for and supply of short term funds are met.
Capital market: Capital market is the market for long term funds. This
market deals in the long term claims, securities and stocks with a maturity
period of more than one year. It is the market from where productive capital is
raised and made available for industrial purposes. The stock market, the
government bond market and derivatives market are examples of capital market.
In short, the capital market deals with long term debt and stock.
3. Classification on the basis of seasoning of claim: On this basis, financial
markets are classified into primary market and secondary market.
Primary market: Primary markets are those markets which deal in the new
securities. Therefore, they are also known as new issue markets. These are
markets where securities are issued for the first time. In other words, these are
the markets for the securities issued directly by the companies. The primary
markets mobilise savings and supply fresh or additional capital to business
units. In short, primary market is a market for raising fresh capital in the form of
shares and debentures.

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Secondary market: Secondary markets are those markets which deal in

existing securities. Existing securities are those securities that have already been
issued and are already outstanding. Secondary market consists of stock
exchanges. Stock exchanges are self regulatory bodies under the overall
regulatory purview of the Govt. /SEBI.

4. Classification on the basis of structure or arrangements: On this basis,

financial markets can be classified into organised markets and unorganized
markets.
Organised markets : These are financial markets in which financial
transactions take place within the well established exchanges or in the
systematic and orderly structure.
Unorganised markets: These are financial markets in which financial
transactions take place outside the well established exchange or without
systematic and orderly structure or arrangements.
5. Classification on the basis of timing of delivery: On this basis, financial
markets may be classified into cash/spot market and forward / future market.
Cash / Spot market: This is the market where the buying and selling of
commodities happens or stocks are sold for cash and delivered immediately after
the purchase or sale of commodities or securities.
Forward/Future market: This is the market where participants buy and sell
stocks/commodities, contracts and the delivery of commodities or securities
occurs at a pre-determined time in future.
6. Other types of financial market: Apart from the above, there are some other
types of financial markets. They are foreign exchange market and derivatives
market.
Foreign exchange market: Foreign exchange market is simply defined as a
market in which one country’s currency is traded for another country’s currency.
It is a market for the purchase and sale of foreign currencies.
Derivatives market: The derivatives are most modern financial instruments
in hedging risk. The individuals and firms who wish to avoid or reduce risk can
deal with the others who are willing to accept the risk for a price. A common
place where such transactions take place is called the derivative market. It is a
market in which derivatives are traded. In short, it is a market for derivatives.
The important types of derivatives are forwards, futures, options, swaps, etc.
III. Financial Instruments (Securities)

Financial instruments are the financial assets, securities and claims. They
may be viewed as financial assets and financial liabilities. Financial assets
represent claims for the payment of a sum of money sometime in the future
(repayment of principal) and/or a periodic payment in the form of interest or
dividend. Financial liabilities are the counterparts of financial assets. They
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represent promise to pay some portion of prospective income and wealth to

others.

Financial assets and liabilities arise from the basic process of financing. Some of
the financial instruments are tradable/ transferable. Others are non
tradable/non-transferable. Financial assets like deposits with banks, companies
and post offices, insurance policies, NSCs, provident funds and pension funds
are not tradable. Securities (included in financial assets) like equity shares and
debentures, or government securities and bonds are tradable. Hence they are
transferable. In short, financial instruments are instruments through which a
company raises finance.

The financial instruments may be capital market instruments or money

market instruments or hybrid instruments. The financial instruments that are
used for raising capital through the capital market are known as capital market
instruments. These include equity shares, preference shares, warrants,
debentures and bonds. These securities have a maturity period of more than one
year.

The financial instruments that are used for raising and supplying money in
a short period not exceeding one year through money market are called money
market instruments. Examples are treasury bills, commercial paper, call money,
short notice money, certificates of deposits, commercial bills, money market
mutual funds.

Hybrid instruments are those instruments which have both the features of
equity and debenture. Examples are convertible debentures, warrants etc.
Financial instruments may also be classified as cash instruments and
derivative instruments. Cash instruments are financial instruments whose value
is determined directly by markets. Derivative instruments are financial
instruments which derive their value from some other financial instrument or
variable.
Financial instruments can also be classified into primary instruments and
secondary instruments. Primary instruments are instruments that are directly
issued by the ultimate investors to the ultimate savers. For example, shares and
debentures directly issued to the public. Secondary instruments are issued by
the financial intermediaries to the ultimate savers. For example, UTI and mutual
funds issue securities in the form of units to the public.

Characteristics of Financial Instruments

The important characteristics of financial instruments may be outlined as below:

1. Liquidity: Financial instruments provide liquidity. These can be easily and

quickly converted into cash.

2. Marketing: Financial instruments facilitate easy trading on the market. They

have a ready market.

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3. Collateral value: Financial instruments can be pledged for getting loans.

4. Transferability: Financial instruments can be easily transferred from person to
person.
5. Maturity period: The maturity period of financial instruments may be short
term, medium term or long term.
6. Transaction cost: Financial instruments involve buying and selling cost. The
buying and selling costs are called transaction costs. These are lower.
7. Risk: Financial instruments carry risk. This is because there is uncertainty
with regard to payment of principal or interest or dividend as the case may be.
8. Future trading: Financial instruments facilitate future trading so as to cover
risks due to price fluctuations, interest rate fluctuations etc.
IV. Financial Services

The development of a sophisticated and matured financial system in the

country, especially after the early nineties, led to the emergence of a new sector.
This new sector is known as financial services sector. Its objective is to
intermediate and facilitate financial transactions of individuals and institutional
investors. The financial institutions and financial markets help the financial
system through financial instruments. The financial services include all activities
connected with the transformation of savings into investment. Important
financial services include lease financing, hire purchase, instalment payment
systems, merchant banking, factoring, forfaiting etc.

Growth and Development of Indian Financial System

At the time of independence in 1947, there was no strong financial

institutional mechanism in the country. The industrial sector had no access to
the savings of the community. The capital market was primitive and shy. The
private and unorganised sector played an important role in the provision of
liquidity. On the whole, there were chaos and confusions in the financial system.
After independence, the government adopted mixed economic system. A
scheme of planned economic development was evolved in 1951 with a view to
achieve the broad economic and social objective. The government started creating
new financial institutions to supply finance both for agricultural and industrial
development. It also progressively started nationalizing some important financial
institutions so that the flow of finance might be in the right direction. The
following developments took place in the Indian financial system:

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1. Nationalisation of financial institutions: RBI, the leader of the financial

system, was established as a private institution in 1935. It was nationalized in
1949. This was followed by the nationalisation of the Imperial bank of India.
One of the important mile stone in the economic growth of India was the
nationalisation of 245 life insurance Corporation in 1956. As a result, Life
st
Insurance Corporation of India came into existence on 1 September, 1956.
Another important development was the nationalisation of 14 major
commercial banks in 1969. In 1980, 6 more banks were nationalized. Another
landmark was the nationalisation of general insurance business and setting up
of General Insurance Corporation in 1972.

2. Establishment of Development Banks: Another landmark in the history of

development of Indian financial system is the establishment of new financial
institutions to supply institutional credit to industries. In 1949, RBI undertook
a detailed study to find out the need for specialized institutions. The first
development bank was established in 1948. That was Industrial Finance
Corporation of India (IFCI). In 1951, Parliament passed State Financial
Corporation Act. Under this Act, State Governments could establish financial
corporation’s for their respective regions. The Industrial Credit and Investment
Corporation of India (ICICI) were set up in 1955. It was supported by
Government of India, World Bank etc. The UTI was established in 1964 as a
public sector institution to collect the savings of the people and make them
available for productive ventures. The Industrial Development Bank of India

st
(IDBI) was established on 1 July 1964 as a wholly owned subsidiary of the
RBI. On February 16, 1976, the IDBI was delinked from RBI. It became an
independent financial institution. It co-ordinates the activities of all other
financial institutions. In 1971, the IDBI and LIC jointly set up the Industrial
Reconstruction Corporation of India with the main objective of reconstruction
and rehabilitation of sick industrial undertakings. The IRCI was converted into
a statutory corporation in March 1985 and renamed as Industrial
Reconstruction Bank of India. Now its new name is Industrial Investment Bank
of India (IIBI). In 1982, the Export-Import Bank of India (EXIM Bank) was set
up to provide financial assistance to exporters and importers. On April 2, 1990
the Small Industries Development Bank of India (SIDBI) was set up as a wholly
owned subsidiary of IDBI. The SIDBI has taken over the responsibility of

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administrating the Small Industries Development Fund and the National
Equity Fund.

3. Establishment of Institution for Agricultural Development: In 1963, the

RBI set up the Agricultural Refinance and Development Corporation (ARDC) to
provide refinance support to banks to finance major development projects,
minor irrigation, farm mechanization, land development etc. In order to meet
credit needs of agriculture and rural sector, National Bank for Agriculture and
Rural Development (NABARD) was set up in 1982. The main objective of the
establishment of NABARD is to extend short term, medium term and long term
finance to agriculture and allied activities.
4. Establishment of institution for housing finance: The National Housing
Bank (NHB) has been set up in July 1988 as an apex institution to mobilise
resources for the housing sector and to promote housing finance institutions.
5. Establishment of Stock Holding Corporation of India (SHCIL): In 1987,
another institution, namely, Stock Holding Corporation of India Ltd. was set up
to strengthen the stock and capital markets in India. Its main objective is to
provide quick share transfer facilities, clearing services, support services etc. to
investors.
6. Establishment of mutual funds and venture capital institutions: Mutual
funds refer to the funds raised by financial service companies by pooling the
savings of the public and investing them in a diversified portfolio. They provide
investment avenues for small investors who cannot participate in the equities
of big companies.
Venture capital is a long term risk capital to finance high technology
projects. The IDBI venture capital fund was set up in 1986. The ICICI and the
UTI have jointly set up the Technology Development and Information Company
of India Ltd. in 1988 to provide venture capital.
7. New Economic Policy of 1991: Indian financial system has undergone
massive changes since the announcement of new economic policy in 1991.
Liberalisation, Privatisation and Globalisation has transformed Indian economy
from closed to open economy. The corporate industrial sector also has
undergone changes due to delicensing of industries, financial sector reforms,
capital markets reforms, disinvestment in public sector undertakings etc.
Since 1990s, Government control over financial institutions has diluted in a
phased manner. Public or development financial institutions have been converted
into companies, allowing them to issue equity/bonds to the public. Government
has allowed private sector to enter into banking and insurance sector. Foreign
companies were also allowed to enter into insurance sector in India.

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Weaknesses of Indian Financial System

1. Lack of co-ordination among financial institutions: There are a large

number of financial intermediaries. Most of the financial institutions are owned
by the government. At the same time, the government is also the controlling
authority of these institutions. As there is multiplicity of institutions in the
Indian financial system, there is lack of co-ordination in the working of these
institutions.
2. Dominance of development banks in industrial finance: The industrial
financing in India today is largely through the financial institutions set up by
the government. They get most of their funds from their sponsors. They act as
distributive agencies only. Hence, they fail to mobilise the savings of the public.
This stands in the way of growth of an efficient financial system in the country.
3. Inactive and erratic capital market: In India, the corporate customers are
able to raise finance through development banks. So, they need not go to
capital market. Moreover, they do not resort to capital market because it is
erratic and inactive. Investors too prefer investments in physical assets to
investments in financial assets.
4. Unhealthy financial practices: The dominance of development banks has
developed unhealthy financial practices among corporate customers. The
development banks provide most of the funds in the form of term loans. So
there is a predominance of debt in the financial structure of corporate
enterprises. This predominance of debt capital has made the capital structure
of the borrowing enterprises uneven and lopsided. When these enterprises face
financial crisis, the financial institutions permit a greater use of debt than is
warranted. This will make matters worse.
5. Monopolistic market structures: In India some financial institutions are so
large that they have created a monopolistic market structures in the financial
system. For instance, the entire life insurance business is in the hands of LIC.
The weakness of this large structure is that it could lead to inefficiency in their
working or mismanagement. Ultimately, it would retard the development of the
financial system of the country itself.
6. Other factors: Apart from the above, there are some other factors which put
obstacles to the growth of Indian financial system. Examples are:

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a. Banks and Financial Institutions have high level of NPA.

b. Government burdened with high level of domestic debt.
c. Cooperative banks are labelled with scams.
d. Investors confidence reduced in the public sector undertaking etc.,

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