MODULE 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. A Financial System is a composition of various institutions,
markets, regulations and laws, practices, money manager Etc.
Financial system is a concept derived from the wide concept of finance. The financial
system is a system that allows the transfer of money between savers and investors. It plays an
important role in global, national, regional, institutional and individual areas.

Meaning of financial system

A financial system is a set of institutions, such as banks, insurance companies, and stock
exchanges, that permit the exchange of funds. It facilitates the flow of funds from the areas
of surplus to the areas of deficit.

Definition
Prof. S.B. Gupta defines the financial system as “A set of institutional arrangements
through which financial surpluses available in the economy are mobilized”.

According to Robinson, the primary function of the system is “to provide a link between
savings and investment for the creation of new wealth and permit portfolio adjustment in the
composition of the existing wealth.

Features/Characteristics/Role of Financial System:

1. It plays a vital role in the economic development of a country.
2. It encourages both savings and investments.
4. It links both savers and investors.
5. It helps in mobilizing and allocating the savings efficiently and effectively.
6. It plays a crucial role in economic development through saving-investment process. This
savings-investment process is called capital formation. So, financial system helps in
capital formation.
7. It helps in bringing investments.
8. It facilitates expansion of financial markets.
9. It helps in allocation of funds.
10. It creates a bridge between investors and companies.
11. It helps in fiscal discipline and control of the economy.
12. It helps to monitor corporate performance.
13. It allows transfer of money between savers and borrowers.
Constituents / components of Financial System
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 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.
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
assets, 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.
 Structure of financial System
The formal Indian financial system consists of financial Institutions, financial market,
financial instruments and financial services.
There are four components of Indian financial system as shown in the chart. They are:
1. Financial Institutions.
2. Financial Markets.
3. Financial Instruments.
4. Financial Services.

Structure of
financial System

Financial Markets. Financial Instruments. Financial Services.

Financial Institutions.

Unorganized market Organized market

Term based Type based

Banking Non-banking
institutions institutions Capital market Money market

*Short term *Primary *Banking service

securities
*Primary market *Medium *Foreign exchange service
Commercial term *Secondary
Cooperative *Insurance services
banks *Secondary market securities
banks *Long term
*Other services
*Call money market a) Advisory services
*Provident and pension
fund. b) Venture capital
*Public sector *Treasury bills
*Life Insurance Corporation c) Angel investment
*Private sector d) Leasing
(LIC). *Commercial bills
*RRBs e) Hire purchase
*Foreign banks *General Insurance
*Commercial papers f) Consumer credit
Corporation (GIC).
*Unit Trust of India (UTI). *CDs
*Mutual funds. etc.

1. FINANCIAL INSTITUTIONS:
Financial institutions are the intermediaries who facilitate smooth functioning of the
financial system by making investors and borrowers meet. They mobilize savings of
the surplus units and allocate them in productive activities promising a better rate of
return. Financial institutions are also termed as financial intermediaries because they
act as middle between savers by accumulating Funds them and borrowers by lending
these funds.
 TYPES OF FINANCIAL INSTITUTIONS
Financial institutions can be classified into two categories:
A. Banking Institutions.
B. Non - Banking Financial Institutions.

A. Banking Institutions:
These are the type of financial institutions which involve in accepting public deposits
and lending the same to the needy customers. These are fundamentally established to
earn profit, secondarily to safeguard the interest of the members. The banking
institutions ensure that deposits accumulated from people are productively utilized.
The following are the types of banking institutions which are running their
business in India.
a) Commercial banks: A commercial bank is a kind of financial institution that carries
all the operations related to deposit and withdrawal of money for the general public,
providing loans for investment, and other such activities. These banks are profit-
making institutions and do business only to make a profit.
The following are the types of commercial banks.
i. public sector.
ii. Private sector.
iii. Regional Rural Banks (RRB`s)
iv. Foreign banks.
b) 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.

B. Non - Banking Financial 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.
The non-banking institutions are classified into organized and unorganized financial
institutions.
The following are examples of non-banking institutions:
a) Provident and pension fund.
b) Life Insurance Corporation (LIC).
c) General Insurance Corporation (GIC).
d) Unit Trust of India (UTI).
e) Mutual funds. etc.

2. FINANCIAL MARKETS:
Financial markets are another 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 are the backbone of the economy. This is because they
provide monetary Support for the growth of the economy.
Financial markets refer to any market place where buyers and sellers
participate in trading of assets such as shares, bonds, currencies, and other financial
instruments.

CLASSIFICATION OF FINANCIAL MARKETS:

a) UNORGANIZED FINANCIAL MAREKTS:
these are comprised with private money lenders, indigenous bankers, traders etc. they
lend money to the public from their own funds. The operations and activities of these
people are not regulated by the Reserve Bank of India or by any other controlling
authority. But still the Reserve Bank of India is trying to fold them to the class of
organized financial markets through its strategies.

b) ORGANIZED FINANCIAL MARKETS:

these are the markets strictly controlled and regulated by Reserve Bank of India and
other regulating authorities. They follow high degree of institutionalization and
instrumentalization. The organized financial markets are further classified into capital
market and money market.
i. 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 which have a maturity period of
above one year. Capital market classified into 2 types
• Primary market
In the primary market, companies sell new stocks and bonds to
the public for the first time, such as with an initial public offering
(IPO).
• Secondary market
The place where formerly issued securities are traded is known as
Secondary Market.

ii. MONEY MARKET

The money market is a component of the economy that provides short-term
funds. The money market deals in short-term loans, generally for a period of a
year or less. It 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.
Money market instruments include
1. Call money market
2. Treasury bills
3. Commercial bills
4. Commercial papers
5. CDs
3. FINANCIAL INSTRUMENTS.
Financial instruments refer to those documents which represents financial claims on assets.
financial asset refers to a 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 etc
CLASSIFICATION OF FINANCIAL INSTRUMENTS:
A. Term financial instruments:
these are the tradable financial assets and exchanged on term basis. These are again classified
into short term, medium term and long-term securities.
1. Short term securities: This category include securities with maturity of one year or
less.
2. Medium term securities: This category includes securities with maturity from 1 to 5
years.
3. Long term securities: this includes securities with maturity longer than those of
short and medium term.

B. Type based securities: under this classification financial securities are classified
into primary and secondary
1. Primary Securities
These are securities directly issued by the ultimate investors to the ultimate savers. Eg.
shares and debentures issued directly to the public.
2. 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.

4. FINANCIAL SERVICES:
It refer to services provided by the banks and financial institutions in a
financial system.
IMPORTANT TYPES OF FINANCIAL SERVICES:
There are so many financial services that the financial market offers. The most important
ones are as follows:
a) Banking services:
The primary operations of banks include:
o Keeping money safe while allowing withdrawals when needed.
o Issuance of cheque books.
o Provide personal loans, commercial loans and mortgage loans.
o Issuance of credit cards and processing of credit card transactions and billing.
o Issuance of debit cards for use as a substitute for cheques.
o Allow financial transactions at branches or at Automatic Teller Machines
(ATMs)
o Provide Electronic fund transfers between banks.
o Provide overdraft agreements. 
o Notary service for financial and other documents.
 o Provide wealth management and tax planning services.
o Provide credit card machine services and networks for business entities.
o Bills discounting
o Merchant banking

b) Foreign Exchange Services:

Foreign exchange services are provided by many banks around the world. Foreign
exchange services include:
o Currency Exchange: Clients can purchase and sell foreign currency bank
notes.
o Wire Transfer: Clients can send funds to international banks abroad.
o Foreign Currency Banking: The transactions are done in foreign currency.
c) Insurance Services:
It deals with the selling of insurance policies, brokerages, insurance underwriting or
the reinsurance.
d) 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.
• Venture Capital
Entrepreneurs need investments for their start-up companies. The
investments or the capital that these entrepreneurs receive from
wealthy investors is called Venture Capital and the investors are
called Venture Capitalists.
• 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.
• Leasing: Leasing is a financial arrangement where one party, known as the
lessor, allows another party, known as the lessee, to use an asset, such as
equipment, vehicles, machinery, real estate, or other property, for a specified
period of time in exchange for regular payments. These payments, often
referred to as lease payments or rent, are made by the lessee to the lessor over
the duration of the lease agreement.
• Hire purchase: It is used for purchasing expensive assets like vehicles,
machinery, or equipment. It is a type of installment purchase agreement that
allows a buyer, often referred to as the hirer or purchaser, to acquire an asset
over time while initially only making a down payment. The hirer then makes
regular installment payments to the seller, who retains ownership of the asset
until the final installment is paid.
• Consumer credit: It refers to a type of credit or borrowing that is extended to
individuals or households for personal, family, or household purposes. It
allows consumers to make purchases, pay for services, or cover expenses
when they do not have the immediate cash or funds to do so. Consumer credit
 can take various forms, and it plays a significant role in modern economies by
facilitating consumer spending and enabling people to access goods and
services.

Financial Concepts
Investment
An investment is a financial asset bought with the idea that the asset will provide income
further or will later be sold at a higher cost price for a profit

Return
Return also called return on investment, is the amount of money you receive from an
investment.
*A return is the change in price of an asset, investment.
*A positive return represents a profit, while a negative return marks a loss.

Portfolio
The term “portfolio” refers to any combination of financial assets such as stocks, bonds and
cash. Portfolios may be held by individual investors or managed by financial professionals,
banks and other financial institutions.

Asset Allocation
Asset allocation refers to an investment strategy in which individuals divide their investment
portfolios between different diverse asset classes to minimize investment risks.

Net worth
Net worth is an individual or company's total assets, minus any liabilities or debts. Net worth
presents an easy way to measure a person or company’s financial standing.
Net worth Formula= Total Assets – Total liabilities

Nominal interest rate

Nominal interest is calculated on the original principal only. it does not take into account
inflation.
Example: If you invest Rs100,000 for one year at 12%, at the end of year you will get
1,12,000

Effective Interest Rate

Effective rate is the higher rate achieved due to shorter period of compounding rather than
annually. The more frequent the compounding periods, the higher the rate.

Formula to find out effective interest Rate = [ 1+ i/n) n -1

i = rate of interest
n= number of compounding period.
The development of the financial system in India
The development of the financial system in India can be broadly divided into three phases:
1. Pre-Independence Era (Pre-1947):
• During this phase, India had a simple financial system that was largely
controlled by foreign banks and financial institutions.
• The Reserve Bank of India (RBI) was established in 1935, which laid the
foundation for modern banking regulation and monetary policy.
• The financial sector was dominated by foreign banks and a few Indian banks
with limited branch networks.
2. Post-Independence Era (1947-1990s):
• This phase witnessed significant changes and reforms in the Indian financial
system.
• Nationalization of Banks: In 1969 and 1980, major banks were nationalized
to bring banking services to the rural population and promote financial
inclusion.
• Establishment of Development Finance Institutions (DFIs): Institutions like
the Industrial Development Bank of India (IDBI) and National Bank for
Agriculture and Rural Development (NABARD) were set up to provide long-
term financing for industrial and agricultural development.
• Liberalization: In the early 1990s, India embarked on a path of economic
liberalization, deregulation, and globalization. The financial sector was
opened up to private and foreign players.
• Stock Market Development: The stock markets, particularly the Bombay
Stock Exchange (BSE) and the National Stock Exchange (NSE), witnessed
significant growth and modernization.

3. Post-Liberalization Era (1990s-Present):

• Financial Sector Reforms: The post-liberalization era brought about a series
of reforms aimed at modernizing the financial system. These included
reforms in banking, insurance, and capital markets.
• Private Sector Banks: New private sector banks like HDFC Bank, ICICI
Bank, and Axis Bank entered the market, increasing competition and
customer choices.
• Foreign Banks: Foreign banks also expanded their presence in India,
contributing to the diversification and globalization of the financial sector.
• Technology and Digitalization: The adoption of technology, the growth of
online banking, and the rise of fintech companies have revolutionized the way
financial services are delivered.
• Regulatory Changes: The RBI introduced prudential norms and regulatory
measures to strengthen the banking sector's stability and protect the interests
of depositors.
• Financial Inclusion: Efforts have been made to promote financial inclusion
through initiatives like the Jan Dhan Yojana, which aims to provide banking
services to the unbanked and underbanked population.
Financial Sector Reform
1. Banking Sector Reforms:
• Nationalization of Banks (1969 and 1980): One of the earliest and most
significant banking sector reforms was the nationalization of major banks in
1969 and 1980. This was done to promote social welfare, ensure credit flow to
priority sectors, and extend banking services to rural areas.
• Liberalization and Entry of Private Banks: In the 1990s, as part of broader
economic reforms, the government allowed the entry of new private sector
banks like HDFC Bank, ICICI Bank, and Axis Bank. These banks brought
competition and innovation to the sector.
• Narasimham Committee Recommendations: The Narasimham Committee
reports in 1991 and 1998 proposed a series of reforms to strengthen the
banking sector. These included reducing government interference in banking
operations, improving asset quality, and enhancing transparency.
• Basel III Norms: India adopted the Basel III norms to improve the capital
adequacy and risk management practices of banks, making the banking system
more resilient.
• Asset Quality Review (AQR): The RBI initiated the AQR in 2015 to
recognize and address the issue of non-performing assets (NPAs) or bad loans
in the banking system.

2. Debt Market Reforms:

• Development of Government Securities Market: The government securities
market was developed to provide a benchmark for interest rates and facilitate
government borrowing. It has grown substantially, with the introduction of
electronic trading platforms like NDS (Negotiated Dealing System) and NDS-
OM (Order Matching System).
• Corporate Bond Market: Efforts have been made to develop the corporate
bond market, including reducing issuance costs, improving credit ratings, and
introducing a regulatory framework.
• Securitization and Asset Reconstruction Companies (ARCs): The
introduction of securitization and ARCs has helped in resolving bad loans and
improving the liquidity of banks.

3. Foreign Exchange Market Reforms:

• Liberalization of Exchange Control: The Indian government gradually
relaxed exchange controls, leading to the liberalization of the foreign
exchange market. The rupee was made partially convertible on the current
account in 1994 and on the capital account in 2000.
 • Foreign Exchange Management Act (FEMA): FEMA replaced the outdated
Foreign Exchange Regulation Act (FERA) in 1999, streamlining foreign
exchange transactions and liberalizing capital flows.
• Forex Derivatives Market: The development of the foreign exchange
derivatives market has allowed businesses to hedge their currency risk
effectively.
• Reserve Accumulation: India's foreign exchange reserves have grown
significantly, providing stability to the exchange rate and acting as a buffer
against external shocks.
Overall, these financial sector reforms in the banking sector, debt market, and foreign
exchange market have played a crucial role in modernizing and strengthening India's
financial system, promoting economic growth, and attracting foreign investment.

Role of Financial System in Economic Development

1. Capital Formation:
The financial system facilitates the mobilization of savings from households,
businesses, and institutions and channels these funds into productive investments.
This process of capital formation is essential for funding infrastructure projects,
businesses, and technological advancements, all of which contribute to economic
development.
2. Resource Allocation:
A well-functioning financial system efficiently allocates financial resources to the
most productive and promising sectors of the economy. This ensures that capital is
directed toward projects and industries that can generate the highest returns and
contribute to economic growth.
3. Risk Diversification:
Through various financial instruments and products, the financial system allows
individuals and businesses to diversify their risk. This risk-sharing mechanism
encourages investment and entrepreneurship, as it reduces the fear of financial loss
associated with business ventures.
4. Savings and Investment:
The financial system encourages savings by offering interest-bearing deposit accounts
and investment opportunities. These savings are then channeled into productive
investments, fostering economic growth. Investment, in turn, leads to the creation of
jobs and income generation.
5. Payment System:
An efficient payment and settlement system provided by the financial system is
essential for the smooth functioning of an economy. It allows for the easy transfer of
money, facilitates trade, and supports economic transactions.
6. Entrepreneurship and Innovation:
Access to capital through banks, venture capitalists, and other financial
intermediaries enables entrepreneurs to fund new ventures and innovations.
7. Financial Inclusion:
 A well-developed financial system ensures that a larger portion of the population has
access to formal financial services, including banking, insurance, and credit. Financial
inclusion reduces poverty and income inequality and empowers individuals and
businesses to participate in economic activities more effectively.
8. Monetary Policy Transmission:
The financial system serves as a conduit for monetary policy. Central banks use
various tools to influence interest rates and the money supply, which can impact
inflation, investment, and overall economic stability.
9. Infrastructure Development:
The financial system provides long-term funding for infrastructure projects such as
roads, bridges, and utilities. These investments enhance a country's productive
capacity and competitiveness.
10. Foreign Investment:
A stable and well-regulated financial system attracts foreign investment, which can
provide additional resources and expertise to the local economy. This foreign capital
can be instrumental in promoting economic development.
11. Wealth Creation:
The financial system enables individuals and institutions to accumulate wealth over
time. This wealth can be used for investment, retirement planning, and philanthropy,
all of which contribute to economic well-being and development.

Weaknesses of Indian Financial System

1. Non-Performing Assets (NPAs):
The banking sector continues to grapple with high levels of non-performing assets,
especially in public sector banks. This not only affects the health of these banks but
also hampers their ability to lend for productive purposes.
2. Financial Inclusion:
Despite efforts to promote financial inclusion, a significant portion of the population
remains unbanked or underbanked, particularly in rural areas. Access to basic
financial services like banking and insurance is still limited for many Indians.
3. Lack of Depth in Bond Markets:
India's corporate bond market is not as developed as the banking sector, making it
challenging for companies to raise long-term debt capital. This results in a heavy
reliance on bank loans for corporate financing.
4. Informal Economy:
A substantial part of the Indian economy operates in the informal sector, which often
relies on informal credit sources. This lack of formalization hinders the effectiveness
of monetary policy and financial regulation.
5. Regulatory Challenges:
Regulatory bodies such as the Reserve Bank of India (RBI) and Securities and
Exchange Board of India (SEBI) have faced criticism for delays in decision-making
and regulatory gaps. Streamlining and strengthening regulatory frameworks is an
ongoing challenge.
6. Cybersecurity Risks:
 As digital banking and online transactions become more prevalent, the financial sector
faces increased cybersecurity threats. Protecting customer data and ensuring the
security of financial systems is a critical concern.
7. Savings and Investment Gap:
India's savings rate has been declining, and there is a need to encourage household
savings and channel them into productive investments.
8. Slow Adoption of Financial Technology:
While there has been progress in digital payments and fintech, the adoption of
financial technology in India, especially in rural areas, remains slow. This limits the
potential for financial innovation and inclusion.
9. Lack of Long-Term Funding:
There is a scarcity of long-term funding sources for various sectors, including
infrastructure and housing, which require stable and extended financing options.
10. Governance Issues:
Instances of corporate governance failures and financial frauds have raised concerns
about the effectiveness of corporate governance standards and the role of auditors and
regulators.

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