Businesses raise and use investment funds from the financial system (the

stock, bond or money market), funds which have been saved by individuals.
In turn these investments in capital equipment, in research and
development, in new products and new markets, etc. provide growth prospects
for the companies and income and capital gains prospects to the individuals
that have invested in these companies by buying their stock or debt
securities. Here we will preview the major objectives of business and provide
the basic theoretical explanations of why different profit potentials exist in
different sectors of the economy.

The Financial System

It doesn’t take much to convince anyone that the financial sector (or system)
is vital for the smooth functioning of the economy since it helps money to
be channeled efficiently from savers (or surplus units) to prospective
borrowers (or deficit units). In this way, the financial system makes it easier
(1) for firms to obtain financing for profitable investments opportunities
(investments in new technology, capital equipment, or for acquisition of
other companies), and (2) for individuals to borrow against future income
(e.g., to pay for university, to buy a house or car, etc). This fundamental
intermediation function of the financial system is presented graphically in
Figure 1.1.

Without financial markets and institutions, borrowers would have to borrow

directly from savers. In such a case it is easy to imagine that not much
borrowing would take place since it would be very difficult for people in
need to borrow to find other people able and willing to lend the same
amounts and with exactly the same terms (time, interest rate, collateral, etc).
In other words, we need to have “a double coincidence of wants”. Therefore,
we can easily conclude that a well-functioning financial system is necessary
for a well-functioning economy. A schematic structure of the financial
system is provided in Figure 1.2.

Financial Institutions
Financial institutions are firms that provide access to financial markets,
both to savers who want to place their savings in financial instruments and
to borrowers who want to borrow from banks or issue debt securities. Among
other services, financial institutions allow individuals to earn a return on
their money while at the same time avoid (or at least reduce) risk. Financial
institutions are called financial intermediaries (businesses that connect
savers with borrowers) since they serve as middlemen between individuals,
firms, and financial markets.

Components of Financial System

A financial system refers to a system which enables the transfer of money
between investors and borrowers. A financial system could be defined at an
international, regional or organization level. The term “system” in
“Financial System” indicates a group of complex and closely linked
institutions, agents, procedures, markets, transactions, claims and liabilities
within a economy.

Five Basic Components of Financial System

 Financial Institutions
 Financial Markets
 Financial Instruments (Assets or Securities)
 Financial Services
 Money
Financial Institutions
Financial institutions facilitate smooth working of the financial system by
making investors and borrowers meet. They mobilize the savings of investors
either directly or indirectly via financial markets, by making use of
different financial instruments as well as in the process using the services
of numerous financial services providers.
They could be categorized into Regulatory, Intermediaries, Non-
intermediaries and Others. They offer services to organizations looking for
advises on different problems including restructuring to diversification
strategies. They offer complete array of services to the organizations who want
to raise funds from the markets and take care of financial assets for example
deposits, securities, loans, etc.

Figure 1.3: Five Basic Components of Financial System

Financial Markets
A financial market is the place where financial assets are created or
transferred. It can be broadly categorized into money markets and capital
markets. Money market handles short-term financial assets (less than a year)
whereas capital markets take care of those financial assets that have
maturity period of more than a year. The key functions are:

1. Assist in creation and allocation of credit and liquidity.

2. Serve as intermediaries for mobilization of savings.
3. Help achieve balanced economic growth.
4. Offer financial convenience.
 One more classification is possible: primary markets and secondary markets.
Primary markets handles new issue of securities in contrast secondary
markets take care of securities that are presently available in the stock
market.
Financial markets catch the attention of investors and make it possible for
companies to finance their operations and attain growth. Money markets
make it possible for businesses to gain access to funds on a short term basis,
while capital markets allow businesses to gain long-term funding to aid
expansion. Without financial markets, borrowers would have problems
finding lenders. Intermediaries like banks assist in this procedure. Banks
take deposits from investors and lend money from this pool of deposited
money to people who need loan. Banks commonly provide money in the form
of loans.

Financial Instruments
This is an important component of financial system. The products which are
traded in a financial market are financial assets, securities or other type of
financial instruments. There is a wide range of securities in the markets
since the needs of investors and credit seekers are different. They indicate a
claim on the settlement of principal down the road or payment of a regular
amount by means of interest or dividend. Equity shares, debentures, bonds,
etc are some examples.

Financial Institutions and their roles

Financial institutions play a pivotal role in every economy. They are
regulated by a central government organization for banking and non-
banking financial institutions. These institutions help in bridging the gap
between idle savings and investment and its borrowers, i.e., from net savers
to net borrowers.
Following are the list of roles performed by Financial Institutions –

1. Regulation of Monetary Supply

2. Banking Services
3. Insurance Services
4. Capital Formation
5. Investment Advice
6. Brokerage services
7. Pension Fund Services
8. Trust Fund Services
9. Financing the Small and Medium Scale Enterprises
10. Act as A Government Agent for Economic Growth

Let us discuss each one of them in detail –

#1 – Regulation of Monetary Supply
Financial institutions like the central bank help in regulating the money
supply in the economy. They do it to maintain stability and control
inflation. The central bank applies various measures like increasing or
decreasing repo rate, cash reserve ratio, open market operations, i.e., buying
and selling government securities to regulate liquidity in the economy.
#2 – Banking Services
Financial institutions, like commercial banks, help their customers by
providing savings and deposit services. They provide credit facilities like
overdraft facilities to the customers for catering to the need for short-term
funds. Commercial banks also extend several kinds of loans like personal
loans, education loans, mortgage or home loans to their customers.
#3 – Insurance Services
Financial institutions, like insurance companies, help to mobilize savings
and investment in productive activities. In return, they provide assurance to
investors against their life or some particular asset at the time of need. In
other words, they transfer their customer’s risk of loss to themselves.
#4 – Capital Formation
Financial institutions help in capital formation, i.e., increase in capital
stock like the plant, machinery, tools and equipment, buildings, means of
transport and communication, etc. They do so by mobilizing the idle savings
from individuals in the economy to the investor through various monetary
services.
#5 – Investment Advice
There are a number of investment options available at the disposal of
individuals as well as businesses. But in the current swift changing
environment, it is very difficult to choose the best option. Almost all
financial institutions (banking or non-banking) have an investment
advisory desk that helps customers, investors, businesses to choose the best
investment option available in the market according to their risk
appetite and other factors.
#6 – Brokerage services
These institutions provide their investors access to a number of investment
options available in the market that ranges from stock, bonds (common
investment alternative) to hedge funds, and private equity investment
(lesser-known alternative).
#7 – Pension Fund Services
Financial institutions, through their various kinds of investment plans,
help the individual in planning their retirement. One such investment
options is a pension fund, where the individual contributes to the pool of
investment set up by employers, banks, or other organizations and get the
lump sum or monthly income after retirement.
#8 – Trust Fund Services
Some financial organization provides trust fund services to their clients.
They manage the client’s assets, invest them in the best option available in
the market, and take care of its safekeeping as well.
#9 – Financing the Small and Medium Scale Enterprises
Financial institutions help small and medium scale enterprises set up
themselves in their initial days of business. They provide long-term as well
as short-term funds to these companies. The long-term fund helps them in
the formation of capital, and short-term funds fulfill their day to day needs
of working capital.
#10 – Act as A Government Agent for Economic Growth
Financial institutions are regulated by the government on a national level.
They act as a government agent and help in the growth of the nation’s
economy as a whole. For example, to help out an ailing sector, financial
institutions, as per the guidelines from the government, issue selective credit
line with lower interest rates to help the sector overcome the issues it is
facing.
Conclusion
Financial institutions are the backbone of the economy. Without the help of
these institutions, the economy will go down and will not be able to stand
up. Due to their pivotal role in the development and growth of the economy,
the government regulates these institutions through the central bank,
insurance regulators, pension fund regulators, and so on. Over the years,
their role has expanded from accepting and lending funds to larger areas of
services.

Role of Financial Institutions

A financial system consists of financial institution, financial market and
financial instrument. The mix of financial institutions, financial market
financial instrument called it financial structure. Commercial Bank,
Development financial institutions, Mutual funds, Insurance company,
Investment companies, and Stock exchange s are part of the formal financial
system, which is India regulated by the securities and exchange board of
India and the Reserve bank of India. Commercial Bank, which is also
include foreign bank and private bank are the predominant segment. Co-
operative banks, which are organized on the UNIT banking principle, are
mainly rural based although there are urban co-operative banks also
operative in urban areas. Additionally NBIFS, government owned post office
also mobilizes deposits, but they do not undertake landing activity. Besides,
there is an extensive network of all India and state development banks
catering to agriculture, industry, housing and exports. Also there exicts
several financial institutions like UTI, LIC, GIC and its subsidiaries mutual
fund, investment and loan companies and equipment leasing and hire
purchase companies, that are engaged in mobilizing resources and providing
financial services in medium as well as long term investment. The National
Bank for Agriculture and Rural Development (NABARD), the Industrial
Bank of India (IDBI), Export-Import Bank (EXIM) and the National Housing
Bank (NHB) has been established to serve as apex banks in their specific
area of responsibilities and concern. The four important term-lending
institution namely IDBI (Which was converted in to commercial bank) ICICI
(which was merge with ICICI Bank) IFCI (which has ceased operation) and
IRBI dominate the term –landing market and provide medium and long
term – financial assistance to corporate sector.

Importance and Needs of Financial Institutions in India

Indian Financial System is dynamic system. It is important to consider its
role in the economic development of the country, has received very good
momentum. By mid-2008, when it was shut down of banks in countries,
such as the US considered when pursuing global streak. Today has seen
increased several times day by day co- operative banks, private banks, and
public sector bank is a sign of progress in financial system. Compare with
develop countries, our country industrial sector, trade commercial sector and
agriculture sector, which manage the financial native in India. Much
progress has given rise to a variety of industrial organization such as a
financial institutions like IDBI ,IFCI, ICICI, IRBI, STCI, LIC, GIC, SCICI,
HUDCO, NHB, as well as state level institution work. R.R.B., Land
Development Bank, NABARD, Co- operative Bank is also working constantly
to have the path of progress.
The financial system is a barometer of economic development, its
sophistication being adjusted by the number of financial institutions, the
depth of the various financial instruments, the degree of freedom accorded
to market participants, the type of financial services, their availability,
their quality and cost. Countries with stable well developed economics. They
are characterized by not just a strong banking system but an equally vigorous
non-banking system. The innovativeness of financial system is judged by
financial engineering a process that generates new product and new service
that re-price risk. It is no wonder then that the financial system is so
important to the efficient functioning of an economy.
Some important points are follows:
 It accelerates the rate and volume of saving provision of various
financial instruments.
 It helps economic development and raising the standard of living the
people.
 It helps to promote the development of weaker section of the society
through rural development banks and co-operative societies.
 It protects the interest of investors and ensures smooth financial
transaction through regularity bodies such as RBI, SEBI etc.
 It helps corporate customer to make better financial decision by
providing effective financial as well as advisory service.

Types of Financial Institutions and Its Role

Financial institution is those organizations that are involved in providing
various types of financial services to their customers. The financial
institutions are controlled and supervised by the rules and regulations
delineated by the government authorities. The financial institutions of India
play a major role in the economy of the country. Financial institution in
India has been incorporated for a definite purpose. These institutions
include the Reserve Bank of India, Commercial bank, Investment Bank,
Insurance Companies, Management Investment companies, IDBI, IFCI, SIDBI,
NABARD, ICICI. A financial institution is an establishment that conducts
financial transaction such as an investments loan and deposits. Almost
everyone deals with financial institutions on a regular basis. Everything
from depositing money to taking out loans and exchanging currencies must
be done through financial institutions.

Reserve Bank of India

The Reserve bank of India is the nerve centre of the monetary system of the
country. It is the central bank of the country and it started operating since
1st April 1935, subsequent to the RBI Act in 1934 under private
shareholders institutions. The Reserve Bank of India is empowered to control,
regulate guide and supervise the financial system of the country through its
monetary and credit policy. The RBI has served function of perform.
Traditionally, it is the banker’s bank and banker to state and central
governments. It is also a banker to the commercial bank , state co- operative
bank and financial institutions of the country. It is the only bank engaged
in the issue of legal tender currency. The RBI has also played a role in the
country agriculture sector. It is conducted and All India Rural Credit Review
in1968 to study the problems of rural credit. It provides agriculture credit
through state Co-operative banks to Co-operative banks for short-term
purpose for marketing of crops.
Commercial Banks
Commercial bank accepts deposit and provides security and convenience to
its customers. Part of the original purpose of banks was to offer customer safe
keeping for their money. By keeping physical cash at home or in a wallet,
there are risks of loss due to theft and accident, not to mention the loss of
possible income from interest. With banks, consumers no longer need to keep
large amounts of currency on hand; transaction can be handled with checks,
debits cards on credit cards, instead. Commercial banks also make loans that
individuals and business use to buy goods or expand business operation,
which in turn leads to more deposited funds that make their way to banks.
If banks can lend money at a higher interest rate than they have to pay for
funds and operating costs, they make money.
Investment Banks
An investment banks typically a private company that provides various
finance related and other services to individuals. Corporation and
government, such as raising financial capital by underwriting or acting as
the client's agent in the issuance of securities. An investment bank may also
ass its companies involved in mergers and acquisitions and provide
ancillary service such as a market making, trading of derivatives and equity
securities and FICC service. (Fixed income instrument, currency and
commodities). The two main line of business in investment banking are
called the sell side and buy side. The sell side trading securities for cash or
for the other securities. The buy side involved the provision of advice to
institutions that buy investment service.
Insurance Companies
The insurance company offer protection against losses. They deal in life
insurance, marine insurance, and vehicle insurance and so on. The
insurance company collects the little saving of the investors and then
reinvests those saving in the market. The insurance companies foreign
insurance companies after the liberalization process. This step has been
incorporated to expand the Indian insurance market and make it
competitive.
Industrial Bank of India
IDBI was established in 1964. IDBI was a wholly owned subsidiary of RBI
up to February 1976 and was made on autonomous corporation fully owned
by the government of India. The IDBI is the apex institutions and providing
financial assistance on consortium basis the major function co-ordination
between the various institutions is looked after by the bank. It also provides
refinance facility to the eligible financial institutions including term loans.
IDBI finance new project / expansions/ diversification/ modernization of
project. It provides refinance facility to the primary lending institutions i.e.
SFC/SIICS/ SIDC/ Commercial bank etc.
Small Industrial Development Bank of India
SIDBI has been set by the Government of India with his headquarters in
Lucknow, Utter Pradesh. As the principle financial institutions for
promotion, financing and development of industries in the small scale sector
and to coordinate function of the institutions engaged in similar activities.
Industrial Finance Corporation of India
IFCI was established 1st July 1948, as the first financial institution in
country to cater to the long term finance need of the industrial sector. The
newly established DFI was provided access to low – cost funds through the
centre bank SLR which is turn enable to provide loan and advance to
corporate borrowers at concessional rates. IFCI remain solely responsible for
implementation of the government industrial policy initiatives. It
contributes to the modernization of Indian industry, export promotion,
import substitution, entrepreneurship development.
National Bank for Agriculture & Development Bank of India
NABARD is established as a development Bank, in term of the Preamble of
the act for providing and regulating credit and other facilities for the
promotion and development of agriculture, small scale industries, cottage
and village industries, handicraft and other rural craft and other allied
economy activities in rural areas with a view to promoting integrating rural
development and securing prosperity of rural areas fund for matters
connected therewith or incidental there to.
ICICI Bank
ICICI Bank was originally promoted in 1994 by ICICI Limited, a financial
institution, and was it wholly owned subsidiary. ICICI Banks in India second
largest bank. ICICI bank offer a wide range of banking products and
financial services to corporate and retail customers through a variety of
delivery channels and through its specialized and affiliates in the areas of
investment banking., life and non-life insurance, venture capital ,assets
management and information technology.

List of Financial Institutions in India

 Industrial Development Bank of India (IDBI)
 Industrial Finance Corporation of India (IFCI)
 Export – Import Bank of India (Exim Bank)
 Industrial Investment Bank of India
 National Bank for Agriculture and Rural Development (NABARD)
 Small Industries Development Bank of India (SIDBI)
 National Housing Bank (NHB)
 Unit Trust of India (UTI)
 Life Insurance Corporation of India (LIC)
 General Insurance Corporation of India (GIC)
 Risk Capital and Technology Finance Corporation Ltd. (RCTC)
 Technology Development and Information Company of India
Ltd.(TDICI)
 Tourism Finance Corporation of India Ltd. (TFCI)
 Shipping Credit and Investment Company of India Ltd. (SCICI)
 Discount and Finance House of India Ltd. (DFHI)
 Securities Trading Corporation of India Ltd. (STCI)
 Power Finance Corporation Ltd.
 Rural Electrification Corporation Ltd.
 Indian Railways Finance Corporation Ltd.
  Infrastructure Development Finance Co. Ltd.
 Housing and Urban Development Corporation Ltd. (HUDCO)
 Indian Renewable Energy Development Agency Ltd. (IREDA)

Role of Foreign Direct Investment:

WHY FDI?
Why do countries want FDI? There are strong reasons why MNCs are
welcomed to invest in foreign countries.
1. Traditionally, foreign investment is seen as a way of filling in gaps
between the domestically available supplies of savings, foreign
exchange, government revenue, and human capital skills and the
desired level of these resources necessary to achieve growth and
development targets. If domestic savings are inadequate to generate
enough investments, foreign capital is expected to fill the gap between
targeted or desired investment and locally mobilised savings.
Often, the foreign exchange earnings generated from exports and
foreign aid fall short of targeted requirements. This is typically called
the trade deficit or gap. An inflow of FDI cannot only alleviate part or
all of the deficit on the balance of payments current account but can
also function to remove that deficit over time, if the MNCs can generate
a net positive inflow of export earnings.
There can be gap between targeted government tax revenues and locally
raised taxes. By taxing MNCs profits and participating financially in
their local operations, governments of developing countries are
expected to be able to mobilise public financial resources for
development projects.
There is also a gap in management, entrepreneurship, technology, and
skill presumed to be partly or wholly filled by the local operations of
MNCs. Not only do multinationals provide financial resources and
new factories to poor countries, but they also supply a "package of
needed resources, including managerial experience, entrepreneurial
abilities, and technological skills that can then be transferred to their
local counterparts by means of training programmes and the process
of learning by doing. In addition, MNCs can educate local managers
about how to establish contacts with foreign banks, locate alternative
sources of supply, diversify market outlets, and become better
acquainted with international marketing practices. Besides, MNCs
 bring with them the most sophisticated technological knowledge about
production processes while transferring modern machinery and
equipment to capital-starved developing countries. It is assumed that
some of this knowledge leaks out to the broader economy when
engineers and managers leave to start their own enterprises. Such
transfers of knowledge, skills, and technology are assumed to be both
desirable and productive for the recipient nations.

2. Factories set up by MNCs act as nucleus of growth. An industrial

enterprise established by a foreign company gives birth to several other
enterprises which would supply inputs to the parent company. It is
not that only a few surrounding firms are the beneficiaries. An entire
industry, steel for example, may get a boost. It has been estimated that
every dollar of FDI increases domestic investment by 80 per cent of the
amount of FDI.

3. FDI can generate healthy competition in the recipient countries. When

FDI assumes the form of greenfield projects, the result is the creation of
new enterprises, adding to the number of players in the market. By
implication, this can increase the level of competition in a host
country. Intense competition enhances consumer choice, tends to bring
down prices and shall boost economic welfare of consumers. Increased
competition tends to stimulate capital investments by firms in plant,
equipment, and R&D, in order to gain competitive advantage over
their rivals. All these tend to result, in the long run, in increased
productivity, innovations and greater economic growth.
But when MNCs buy out popular local brands/companies, benefits
from the expected competition will not result. For example, Coca Cola
bought over the dominant domestic brand Thumps Up, and the then
Hindustan Lever (now Hindustan Unilever) acquired Tomco, the
largest domestic rival and the second largest firm in the industry, and
the largest cosmetics company, Lakme. Such acquisitions do not add to
any additional benefits to the economy.

4. Too often, location advantages attract FDI. The location-specific

advantages in particular, include natural resources such as oil and
other minerals, which are by nature specific to certain locations. A
 firm must undertake FDI to exploit such endowments. This explains
the FDI undertaken by many of the world's oil companies, which had
to invest where oil was located. Another example is the valuable
human resource, such as low-cost highly skilled labour force. The cost
and skill of labour varies from country to country. A Canadian
medium-sized plant is thinking in terms of renovating a plant near
Warsaw in Poland as the price of labour in that country is fairly low.
Other nearby countries have lower wage rates, but Warsaw, the
company's specific choice, has a cadre of well trained factory workers
who could be transferred to the renovated factory. Similarly, one major
benefit of locating plants in Mexico is the highly skilled labour force
that can be hired at fairly low wage rates. Additionally,
manufacturing firms located in Mexico report high productivity
growth rates and quality performance. France has been the target of
much MNC activity. Daimler-Chrysler has recently built a new
factory in France because of its faith in the workers' productivity and
work ethic. Additionally, France's recent economic growth has
impressed many MNCs.
Hyundai, the automobile giant from South Korea, has chosen Chennai
in India for its new car manufacturing plant. Skilled labour at low
wages; location of auto parts manufacturers such as Wheels India, Brakes
India, Sundaram Fasteners, Sundaram Brakes, Bimetal Bearings, Tafe,
and India Pistons in and around Chennai; guaranteed power supply:
cheap land and proximity to sea port have attracted the plant to the
capital city of Tamil Nadu.
The argument that location-specific advantages attract FDI is propounded
by the British economist John Dunning. Dunning believes that market
imperfections make licensing and exporting difficult and thereby
rendering FDI an obvious choice to globalisation.

5. FDI often depends on a country's political attempts to reduce security

risks. For example, Chinese state-owned petroleum companies have
been investing abroad so as to minimise its dependence on foreign
companies for oil supplies. The move may also help China hold down
prices on the petroleum it receives.
There is one more political motive behind FDI. During the early 1980s,
the US government instituted various incentives to increase the
profitability of US investments in Caribbean countries that were
unfriendly to Cuba's Castro regime. The US wanted to strengthen the
economies of those friendly nations through the growth of the FDI and
make it difficult for unfriendly leftist governments to gain control. But
with the end of the Civil war, the US ended investment incentives in the
Caribbean region, and much investment was diverted to Mexico because
of NAFTA.

6. It is the poor countries that deserve FDI more than any others. Poverty
is prevalent, notwithstanding globalisation, world becoming flat and
millennium agenda. Following statistics speak for themselves:
• 12,000 children die every day from poverty-related diseases.
Underweight children number over 150 million.
• A typical house in a village buys a bucket of drinking water at 2. About
1.2 billion people live on less than $1 a day.
• The average income of the 20 richest countries was 15 times that of the
20 poorest countries in 1960. It is now 30 times the average of the 20
poorest countries.
• Average life expectancies in many African countries have fallen from
over 60 years to below 40 years because of AIDS. Over 95 per cent of AIDS
victims are in the poor countries. The poorest 40 per cent of the 15-19
years age group of the populations of India, Pakistan, Mali, and Benin
averaged 0 years of schooling.
How to alleviate poverty? Aid from international institutions and rich
countries can be a temporary measure, Economic growth ushered in by
increased investment can be a permanent solution.
What Jeffrey Sachs, Special Adviser to the then Secretary General Kofi
Annan on the Millennium Development Goals, told a press briefing on
Sept 22, 2004 is telling, "Many of the poorest countries are simply being
bypassed by globalisation, and the promises of the rich countries are not
being fulfilled. We need more globalisation that reaches poor countries,
and more successful globalisation, not less. The kind of globalisation that
the poorest countries are feeling is brain drain. They are not seeing the
inflow of foreign investment." Sachs added that FDI would be the strongest
engine of growth in the developing world.