Finance involves the inflow and outflow of funds from the individual/institute who has

in excess to the individual/institute who is the need of the same. The financial system
refers to the various institute in the form of banks, insurance companies, and stock
exchanges, which permits the exchange of funds. Financial systems generally exist
on firm, regional, and global levels.
It plays a significant role in the economic growth of a country by mobilizing surplus
funds and utilizing them effectively for productive purposes.
It encourages both savings and investment, helps in capital formation, and allocation
of risk, and facilitates the expansion of financial markets.
Role of Indian Financial System
The Indian financial system plays a crucial role in the country's economic
development and stability. Here are some key roles it performs:
1. Mobilization of Savings
The financial system helps to collect savings from individuals, households, and
businesses and utilise them into productive investments. There are variety of
financial products like savings accounts, fixed deposits, mutual funds, and insurance
policies to encourage savings.
2. Provision of Credit
The financial system helps in the allocation of credit facilities in form of different
types of loans, including personal loans, business loans, mortgages, and educational
loans to the various sectors of the economy, including agriculture, industry, and
services, facilitating growth and development.

3. Facilitation of Investments
The financial system involves platforms such as stock exchanges (BSE, NSE) for
businesses to raise capital by issuing shares and bonds. Also, services are offered
to guide investors in making informed decisions through financial advisors, brokers,
and investment banks.
4. Risk Management
The financial system offers various insurance products to protect individuals and
businesses against health issues, accidents, property damage, and interruptions.
This is done by providing financial instruments like futures, options, and derivatives
to hedge against financial risks.
5. Payment and Settlement System
The financial system facilitates smooth and efficient payment and settlement of
transactions through various payment systems like UPI, NEFT, RTGS, and mobile
banking and also helps to manage the distribution and circulation of currency
through banks and ATMs.
6. Economic Stability
A financial institution such as The Reserve Bank of India (RBI) implements monetary
policy to control inflation, regulate the money supply, and maintain economic
stability. It also regulates and supervises financial institutions to ensure their stability,
solvency, and adherence to laws and regulations.
7. Financial Inclusion
There are different inclusive growth programs such as bringing the unbanked
population into the formal financial system through initiatives like Jan Dhan Yojana,
promoting financial literacy, and expanding banking services to rural areas. Similarly,
there is also a provision of financial services to low-income individuals or groups who
lack access to traditional banking services.
8. Development of Financial Markets
Capital Market Development helps to enhance the efficiency and depth of capital
markets, facilitating better price discovery, liquidity, and investment opportunities.
Few of the opportunities such as developing a robust money market have helped in
short-term borrowing and lending, providing liquidity to financial institutions.
9. Support for Government Policies
The financial system helps in raising funds for government expenditure through the
issuance of government bonds and securities. It also supports government economic
reforms by aligning financial policies and regulations with national economic goals.

10. Innovation and Technological Advancement

The financial system promotes digital banking, fintech innovations, and the use of
technology in financial services to enhance accessibility, efficiency, and
convenience. There is continuous innovation new financial products and services to
meet the evolving needs of consumers and businesses.
Overall, the Indian financial system is pivotal in fostering economic growth, ensuring
financial stability, promoting financial inclusion, and supporting the overall
development of the nation.

Components of Financial System

The financial system consists of components such as financial institutions, financial
markets, financial services, financial instruments and financial regulators.
Financial Institutions
The Financial Institutions act as a bridge between the investor and the borrower. It
acts as an intermediary between savers and borrowers mobilizes savings, and
channels them into productive investments, fostering economic growth and financial
stability. Financial institutions perform a few roles: banking services, insurance
services, capital formation, investment advice, and brokerage services.
It is the primary force that keeps the finance industry dynamic. The financial
institutions are the ones that facilitate in conducting transactions related to loans,
deposits, investment opportunity, buying and selling or making and receiving
payments related to any kind of business.

Financial Markets
Financial Market refers to the place where securities trading takes place in the form
for different securities such as stock (shares), bond (debentures), foreign exchange,
money market (short term securities) and derivatives.
This is place which provides finance for companies to help them in investing and
grow. It assists in deciding the securities price by interaction with the investors and
depending on the demand and supply in the market.
It also gives liquidity to the assets. It plays a critical role in the modern economy by
facilitating the flow of funds and financial instruments globally, helping to fuel
economic growth and development.
The participants in financial markets include individual investors, institutional
investors like banks, mutual funds, pension funds, hedge funds, and corporations.
The Financial Market is classified into two categories.

Money Market
 Money Market involves securities which are highly liquid and short-term financial
assets with a maturity of up to 1 year are traded. Thus, the money market caters
to the short-term borrowing needs of working capital.
 Major institutions of the Money Market are – Commercial Banks, RRBs, Markets,
etc.
 Major instruments of the Money Market are – Call Money, Treasury Bills,
Commercial Paper, Certificates of Deposit (CD), etc.
Capital Market
 Capital Market refers to that part of the Financial Market which provides a market
for borrowing and lending of medium and long-term funds, above 1 year. The
capital market is concerned with long-term funding and investment. This involves
the equity market and the debt market.
Primary Market:

This is also known as the new issue market, is where securities are created and sold
for the first time. It is the market for new long-term capital. Companies raise capital
by issuing shares and bonds through initial public offerings (IPOs), follow-on public
offerings (FPOs), private placements and right issues

The participants are

 Issuing Companies: Corporations, government entities, and other organizations

that need to raise capital.

 Underwriters: Investment banks and financial institutions that help in pricing,

marketing, and selling securities.

 Investors: Institutional investors, retail investors, high-net-worth individuals, and

venture capitalists.

Secondary Market:

Where existing securities are traded. It provides liquidity to the financial instruments
issued in the primary market. The major stock exchanges in India are the Bombay
Stock Exchange (BSE) and the National Stock Exchange (NSE).

The participants are

 Retail Investors: Individual investors buying and selling securities for personal
investment.
 Institutional Investors: Mutual funds, pension funds, insurance companies, and
hedge funds engaging in large-scale trading.
 Brokers and Dealers: Intermediaries who facilitate trading between buyers and
sellers.
 Market Makers: Firms or individuals that provide liquidity by being willing to buy
and sell securities at quoted prices.

Both the primary and secondary markets are integral to the overall functioning of the
financial system, each serving complementary roles in supporting economic activity
and investment.

Financial Instruments
Financial Instrument refers to any asset which holds capital i.e. money invested
and which can be liquated (sold) due to increase in its value or even during the need
of funds. These are traded and used to raise capital in financial markets. Some of
the financial instruments involves less risk and are secured in nature but have low
rate of returns such as bank deposits whereas some involve high risk and high
rate of returns.
The different types of financial instruments in the form of traditional one such as
bank deposit, shares, bonds, mutual funds, derivatives – futures and options,
exchange traded funds (ETF) and money market instruments such as treasury bills,
certificate of deposit and commercial paper.
There have been modern instruments in the form of crypto currencies and Real
Estate Investment Trusts (REITs).

Financial instruments are vital components of the financial system, offering diverse
options for investment, risk management, capital raising, and liquidity provision. They
are used for investment, trading, hedging, and raising capital. It is a contract that
gives rise to a financial asset of one entity and a financial liability or equity instrument
of another entity.
The various financial instruments are

Equity instrument – shares (equity and preference)

Investing in stocks:

Investing in the stock market or equities can be a great way to grow wealth over
time. It takes careful analysis to be able to determine the best stocks to invest in, as
well as when to enter and exit the market.
Market volatility can have an effect on the capital growth of investments, and the
returns on these investments depend on the types of investors in India and their risk
tolerance. Fortunately, many stocks have been shown to deliver returns that
outperform inflation over the long run.

Debt instruments – loans, credits, debenture, bonds.

They are a form of debt investment that has become popular in India. Bond investors
provide money to the issuer of the instrument, and in exchange, the bond issuer
pays interest to the investor at a pre-defined coupon rate until the bond matures.
Upon maturity, the investor gets their original investment back. Although most bonds
in India come with a fixed coupon rate, other types of bonds such as floating rate
bonds and zero-coupon bonds are increasingly gaining favour.

To invest in bonds in India, one can either do so directly or through Debt Mutual
Funds. Investors should be aware that the bond issuer is obligated to return the
principal amount to them at the time of maturity.
Money Market Instrument – Treasury Bills, Commercial paper, Certificate of
Deposit

Certificate of Deposit:

Investing in a Certificate of Deposit (CD) is a money market instrument regulated by

the Reserve Bank of India (RBI) and issued by the Federal Deposit Insurance
Corporation (FDIC).
The minimum amount that can be invested in a CD is Rs.1 lakh and its multiples.
Commercial banks typically issue CDs with a maturity period ranging from 7 days to
1 year, while financial institutions offer CDs with a maturity period from 1 year to 3
years.

Hybrid Instrument – Mutual Funds

Mutual Funds (MFs):

Investing in Mutual Fund (MF) can involve stocks, bonds, or a combination of the
two. Depending on your financial goals and risk appetite, different types of investors
in India can choose between equity funds, debt funds, and balanced funds.
Additionally, you can also use Systematic Investment Plan (SIP) to invest smaller
amounts periodically. Before investing, review your risk preferences and be aware of
the taxation system. Moreover, you may opt for tax-saving mutual funds such as the
ELSS (Equity Linked Savings Scheme) to help maximise your returns.

Mutual Funds in India are top-rated because the initial investment amount is very
less and the risk is diversified. While most mutual funds demand a minimum lump
sum investment of Rs. 1000 to Rs. 10,000, investors can invest as low as Rs. 100 by
starting a systematic investment plan (SIP) in these funds. The frequency of
investment is usually monthly or quarterly. Mutual funds offer different schemes to
cater to the needs of the investors are regulated by SEBI. All SEBI-registered mutual
funds are listed and tradable on the stock exchange.
Classification of mutual funds
i) By structure
a) Open-ended Funds: An open-ended fund does not have a maturity date.
b) Closed-end Funds: Closed-end funds run for a specific period.
ii) By investment objective
a) Growth Funds: A mutual fund scheme investing inequity.
b) Bond / Income Funds: A mutual fund scheme investing primarily in government
and corporate debt to provide income on a steady basis.
c) Balanced Funds: A mutual fund scheme investing in a mix of equity and debt.
d) Money Market Funds: A mutual fund scheme investing in money market
instruments.
e) Others: Tax savings schemes (Equity Linked Saving Scheme- ELSS): Equity
funds along with tax benefits to the investors and has a lock in period of three years.
f) Sector funds: They target at the specific sectors of the economy such as financial,
technology, health, etc.
g) Index Funds: This type of mutual fund replicates the performance of a broad
market index such as the SENSEX or NIFTY.

Derivative instruments – Forward, Futures, Options, Swaps

Derivative instruments derive their value from the underlying asset such as
resources, currency, bonds, stocks, indices, etc. The performance of derivatives
instruments is dependent on the performance of the underlying assets. The following
are the most common types of derivative instruments –
Forward: A forward contract is a customized agreement. It is between two parties
that involve the exchange of an underlying asset at a specific exchange during a
specific time period.
Future: This is a derivative contract that involves the exchange of derivatives on a
future date at a predetermined exchange rate.
Options: An option is a derivative contract between two parties. Here, the buyer gets
the right to purchase or sell the underlying asset at a predetermined price for a
specific time period. However, there is no obligation to exercise the right.
Interest Rate Swap: This is a derivative contract between two parties. It involves the
exchange of interest rates where one party agrees to pay the other party’s interest
rate on their loans in different currencies.

Saving Schemes – Saving Bank Account, Fixed Deposit, Recurring Deposit.

Saving Account

A savings deposit is a bank account that an individual can start to save money and
earn interest for future use. Savings Account interest rates, usually between 3% to
6% per annum.

Fixed Deposits (FD):

When you choose to invest in a Fixed Deposit offered by banks or non-banking

financial organisations (NBFCs), you can put aside a lump sum of cash for a pre-
determined period of time and gain interest at the agreed rate. This type of
investment is quite popular in India as it offers a secure way to grow your funds.
Upon completion of the tenure, your deposit gets you interest at the rate that was
set.

REIT’s

REITs are investment vehicles that allow individuals to invest in income-generating

real estate assets, such as commercial buildings, office spaces, malls, and hotels,
without directly owning the property. REITs own, operate and manage a portfolio of
income generating real estate assets.

Key Features:

 Invest in rent-yielding real estate properties.

 Generate revenue through rental income and capital appreciation.

 Mandated to distribute at least 90% of their income as dividends.

 Regulated by SEBI in India.

 Listed on stock exchanges for trading like equities.

Any investor (domestic / foreign / retail / institutional) can buy REIT units in India.
Minimum lot size of 200 units (and multiples thereof). Unit-holders can purchase
REIT units through a Demat account, similar to how they would purchase equity
shares. REIT units can be bought / sold freely on Stock Exchange platform
.Investors can also buy REIT units through participation in REIT IPO whenever a
REIT gets listed
InVITs

InvITs are similar to REITs but focus on infrastructure assets such as roads,
highways, power transmission, pipelines, and renewable energy projects. They help
infrastructure developers monetize their operational assets while providing investors
with stable, long-term returns. InvITs are ideal for long-term investors seeking steady
income from infrastructure assets while participating in India's growth story

Key Features:

 Invest in revenue-generating infrastructure projects.

 Provide returns through user charges, tolls, or government contracts.

 Mandated to distribute at least 90% of their income as dividends.

 Help developers monetize operational infrastructure assets.

Investors in InvITs can earn returns in two ways: through regular distributions and
potential capital appreciation.

InvITs typically distribute most of their earnings to investors in the form of dividends,
which can provide a regular income stream. In addition, if the underlying assets
appreciate in value over time, investors can potentially sell their units for a profit.

Challenges of Indian Financial System

The Indian Financial System has seen a phenomenal rise due to the implementation
of technology into financial processes, regulations, and reforms. However, there are
several challenges that it encounters that can affect sustainable economic growth
and financial stability. A few of the challenges of the Indian Financial System are as
follows

1. Regulatory and Compliance Challenges

There are complex regulatory frameworks involving multiple regulators such as the
Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI),
and the Insurance Regulatory and Development Authority of India (IRDAI). This
creates a lot of doubts and concerns in the minds of the investors because of the
various regulation issues. Many times there are frequent changes in regulations and
compliance requirements can be burdensome for financial institutions. At the same
time, ensuring uniform regulations across various financial segments to prevent
regulatory arbitrage.
2. Technological Challenges

One of the major issues of the rise of technology is the concern of

cybersecurity such as protecting against the increasing threat of cyber-attacks and
ensuring different cybersecurity measures. There is also a need to make
continuous investments in upgrading technology and integrating new digital solutions
with legacy systems.

3. Market Volatility and Economic Fluctuations

There are different risks associated with global economic conditions, including trade
wars, geopolitical tensions, and economic slowdowns at the same time domestic
economic fluctuations due to domestic economic challenges such as inflation, fiscal
deficits, and economic slowdown.

4. Structural Issues

There are various structural issues in public sector banks, including governance
reforms, operational efficiency, and reducing government interference. There is also
a need to balance for consolidation in the banking sector to create stronger entities
with the need to maintain competition and diversity.

5. Corporate Governance

There is a need to improve corporate governance standards across financial

institutions to ensure transparency, accountability, and ethical practices. There is
also a need to strengthen the effectiveness of boards of directors in overseeing
management and strategic decision-making.

6. Innovation and Competition

Encouraging innovation while balancing the need for regulation to prevent systemic
risks and maintaining healthy competition in the financial sector to avoid monopolistic
practices and ensure better services for consumers.

Regulators in Financial System

RBI

The Reserve Bank of India (RBI) is India’s central bank. It manages credit supply,
regulates bank operations, and helps maintain a healthy financial system. RBI is an
autonomous governing body that ensures price stability in the country. In addition,
it stabilizes the value of the Indian currency and ensures that the Indian financial
market is stable and robust.

Apart from monetary policy, the RBI performs various other crucial functions. It
regulates and supervises banks, non-banking financial institutions, and other
financial intermediaries to maintain the stability and integrity of the financial system.
It also acts as the banker to the government, managing the government’s banking
transactions, issuing government securities, and maintaining the government’s
accounts.

SEBI

The Securities and Exchange Board of India (SEBI) is the regulatory authority
responsible for overseeing the securities market in India. Established in 1988, SEBI
plays a crucial role in maintaining fair practices, ensuring investor protection, and
promoting the development of a robust and transparent financial ecosystem in the
country. With its regulatory powers and proactive approach, SEBI has become vital
in India’s economic landscape.

SEBI operates under the Securities and Exchange Board of India Act, 1992, and
has been given extensive powers to regulate various market participants, including
issuers, intermediaries, and investors.

IRDAI

The Insurance Regulatory and Development Authority of India is another financial

regulator of the money market in India. It mainly secures the insurance sector in
India. Insurance policies help people to protect their health, assets, and loved
ones. If different insurance companies set different policy rules and rates, it would
put the credibility of general as well as Life Insurance Plans at stake. This is where
IRDAI comes into play. IRDAI is a statutory body that promotes the orderly growth
and proper functioning of the insurance industry in India. It helps protect the
policyholder’s interest and ensures fairness in the insurance sector.

The primary objective of the IRDAI is to regulate, promote, and develop the
insurance industry in India. It operates under the purview of the Insurance
Regulatory and Development Authority Act 1999 and has the authority to issue
guidelines, regulations, and directives to insurance companies, intermediaries, and
other stakeholders.
The key function of the IRDAI is to grant licenses to insurance companies, both life
and non-life, enabling them to operate in the Indian market. These licenses are
issued based on stringent criteria and ensure that only financially sound and ethical
entities enter the insurance sector. The IRDAI also regulates the entry of foreign
direct investment (FDI) into the insurance industry, safeguarding the interests of
domestic players while encouraging healthy competition.

National Housing Bank (NHB)

NHB is the apex regulatory body for the housing finance sector in India. It was
established in 1988 and operates as a subsidiary of the Reserve Bank of India.
NHB regulates and supervises housing finance companies, provides financial
assistance to institutions engaged in housing finance, and promotes the
development of the housing finance market.

The primary mandate of the National Housing Bank is to promote and facilitate the
growth of housing finance institutions (HFIs) and ensure their stability. It plays a
pivotal role in shaping policies, regulations, and strategies to strengthen the
housing finance sector and promote the availability of affordable housing options
across India.

Forward Markets Commission (FMC)

FMC was the regulatory authority for the commodity futures market in India.
However, in 2015, FMC merged with SEBI to consolidate the regulation of
securities and commodity derivatives markets under one authority. Since then,
SEBI has been responsible for regulating both the securities and commodity
derivatives markets.

The Forward Markets Commission (FMC) served as a vital regulatory body in

India’s commodity futures markets. Its functions encompassed overseeing
exchanges, promoting investor protection, managing risks, and fostering market
development. The FMC’s regulatory framework ensured fair trade practices,
transparency, and market integrity. However, it is important to note that as of the
knowledge cutoff date of this article in September 2021, there have been
discussions about merging the FMC with the Securities and Exchange Board of
India (SEBI), which is responsible for regulating securities markets. It is advised to
consult up-to-date sources for the latest information on the regulatory landscape
governing commodity futures trading in India.

Association of Mutual Funds in India (AMFI)

AMFI is an industry association of mutual funds in India. It represents the interests

of asset management companies (AMCs) and promotes the development of the
mutual fund industry. AMFI plays a crucial role in educating investors,
standardizing practices, and maintaining high ethical and professional standards
among AMCs. It works closely with SEBI to ensure compliance with regulatory
requirements.

AMFI’s primary objective is to create an environment that is conducive to the

growth of the mutual fund industry in India. It engages in various activities such as
investor education, industry research, and advocacy with regulatory authorities to
achieve this goal. AMFI also acts as a forum for its members to discuss and
resolve industry issues.