INDIAN FINANCIAL SYSTEM

1. AN OVERVIEW :
The financial system of a country is like the circulatory system of a human
body, controls the health of the economy and growth of business and
society, through the circulation of money. A healthy economy needs an
efficient financial system. The financial system consists of many
institutions, instruments, and markets. Financial institutions range from
pawnshops and moneylenders to banks, pension funds, insurance
companies, brokerage houses, investment trusts and stock exchanges.
Financial instruments range from the common — coins, currency notes
and cheques; mortgages, corporate bills, bonds and stocks — to the more
exotic — futures and swaps of high finance. Markets for these instruments
may be organized formally (as in stock or bond exchanges with centralized
trading floors) or informally (as in over-the-counter or curb markets). The
financial system provides services that are essential in a modern economy.
It is a core factor of development and growth. The primary role of any
financial system is to act as a conduit for the transfer of financial resources
from net savers to borrowers, i.e., from those who spend less than they
earn to those who earn less than what they spend. The economic
development of a country depends, inter alia, on its financial structure. In
the long run, the larger the proportion of financial assets to real assets, the
greater the scope for economic growth. Investment is a pre-condition of
economic growth. This apart, to sustain growth, continued investment in
the growth process is essential. Since finance is an important input in the
growth process, it has a crucial role to play in the economy. The more
efficient composition of real wealth is obtained by the promotion of
financial assets which provide incentives to savers to hold a large part of
their wealth in financial form. The increasing rate of saving is correlated
with the increase in the proportion of savings held in the form of financial
assets relative to tangible assets. The major function of financial
institutions, whether short-term or long-term, is to provide the maximum
financial convenience to the public. This may be done in three ways: (i)
Promoting the overall savings of the economy by deepening and widening
the financial structure; (ii) Distributing the existing savings in a more
efficient manner so that those in greater need, from the social and
economic point of view, get priority in allotment; (iii) Creating credit and
deposit money and facilitating the transactions of trade, production and
distribution in furtherance of the economy. For years, the Indian financial
system was caught in the narrow, inflexible regulations that made it tough
to manoeuvre. In a market where everyone was equally handicapped,
individual institutions had little chance or reason to excel. Interest rates
were regulated for both deposits and lending. Real change started when
RBI governor R.N. Malhotra kicked off a gradual deregulation in 1988.
Suddenly, things have changed. In a rare burst of innovation the RBI has
taken some major policy initiatives to liberalise the over-regulated
financial markets. Short-term interest rates on call money, bill
rediscounting, and even cash credit have been freed. New instruments for
short-term trading like commercial paper and certificates of deposit have
been introduced without any restrictions on the interest rates or the number
of participants. The economic scene in the post independence period has
seen a sea change; the end result being that the economy has made
enormous progress in diverse fields. There has been a quantitative
expansion as well as diversification of economic activities. The experience
of the 1980s has led to the conclusion that to obtain all the benefits of
greater reliance on voluntary, market-based decision-making, India needs
efficient financial systems. The financial system is possibly the most
important institutional and functional vehicle for economic transformation.
Finance is a bridge between the present and the future and whether it be
the mobilisation of savings or their efficient, effective and equitable
allocation for investment, it is the success with which the financial system
performs its functions that sets the pace for the achievement of broader
national objectives.
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.

2. STRUCTURE OF INDIAN FINANCIAL SYSTEM:

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.
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.
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.
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.
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 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.
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.

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
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.