INDIAN FINANCIAL SYSTEM The economic development of a nation is reflected by the progress of the various economic units, broadly classified into corporate sector, government and household sector. There are areas or people with surplus funds and there are those with a deficit. A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. A Financial System is a composition of various institutions, markets, regulations and laws, practices, money manager, analysts, transactions and claims and liabilities. Financial system comprises of set of subsystems of financial institutions, financial markets, financial instruments and services which helps in the formation of capital. It provides a mechanism by which savings are transformed to investment. 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. It consists of - e Individuals (savers), e Intermediaries e Users of savings (investors). 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 mobilize 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 systemis a mechanism by which savings are transformed into investments. Functions of Financial System The financial system of a country performs certain valuable functions for the economic growth of that country. The main functions of a financial system may be briefly discussed as below: 1. Saving function: An important function of a financial system is to mobilize savings and channelize them into productive activities. It is through financial system the savings are transformed into investments. Liquidity function: The most important function of a financial system is toprovide 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. 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. 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. 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. 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. 8 Other functions: It assists in the selecti on 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. Itlinks 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. Ithelps 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. 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 1. Formal (organized) financial system- The formal financial system comprises of Ministry of Finance, RBI, SEBI and other regulatory bodies. 2. The informal (unorganized) financial system - 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: L 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. On the basis of the nature of activities, financial institutions may be classified as: (a) Regulatory and promotional institutions (b) Banking institutions(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, IRDAI, 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). 2. Banking Institutions: Banking institutions mobilize the savings of the people. They provide a mechanism forthe 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, Organization of Pension and Provident Funds etc. fall in this category. Il. 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. 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 mobilization 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 organizations. 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. Capital market Capital market is the market for long term funds. 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. Secondary market. Secondary markets are those markets which deal in existing securities. 4. Classification on the basis of structure or arrangements: On this basis, financial markets can be classified into organized markets and unorganized markets.Organized markets These are financial markets in which financial transactions take place within the well established exchanges or in the systematic and orderly structure. Unorganized 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: 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: A common place where such transactions take place is called the derivative market. It is a market in which derivatives are traded. Ill. 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. 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 tisks 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 anew 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, installment payment systems, merchant banking, factoring, forfeiting etc. Growth and Development of Indian Financial System At the time of independence in 1947, there was no strong financial institutional mechanism in the country. The industrial sector had no access tothe savings of the community. The capital market was primitive and shy. The private and unorganized sector played an important role in the provision of liquidity. On the whole, there were chaos and confusions in the financial system After independence, the government adopted mixed economic system. A scheme of planned economic development was evolved in 1951 with a view to achieve the broad economic and social objective. The government started creating new financial institutions to supply finance both for agricultural and industrial development. It also progressively started nationalizing some important financial institutions so that the flow of finance might be in the right direction. The following developments took place in the Indian financial system: 1, Nationalization of financial institutions: RBI, the leader of the financial system, was established as a private institution in 1935. It was nationalized in 1949. This was followed by the nationalization of the Imperial bank of India. Imperial bank of India was converted in SBI through SBI Regulation Act 1955. It was constituted in 1" July 1955. One of the important mile stone in the economic growth of India was the nationalization of 245 life insurance Corporation in 1956. As a result, Life Insurance Corporation of India came into existence on Ist September, 1956 Another important development was the nationalization of 14 major commercial banks in 1969. In 1980, 6 more banks were nationalized.Another landmark was the nationalization of general insurance business and setting up of General Insurance Corporation in 1972. 2. Establishment of Development Banks: Another landmark in the history of development of Indian financial system is the establishment of new financial institutions to supply institutional credit to industries. In 1949, RBI undertook a detailed study to find out the need for specialized institutions. 1948 - Industrial Finance Corporation of India (IFCI). 1951- Parliament passed State Financial Corporation Act. Under this Act, State Governments could establish financial corporation's for their respective regions. 1955 - The Industrial Credit and Investment Corporation of India (ICICI). 1964- UTI. 1964 - The Industrial Development Bank of India (IDBI). 1971-IDBI and LIC jointly set up the Industrial Reconstruction Corporation of India with the main objective of reconstruction and rehabilitation of sick industrial undertakings. Now its new name is Industrial Investment Bank of India (IIBI). 1982 - Export-Import Bank of India (EXIM Bank) was set up to provide financial assistance to exporters and importers. 1990 - Small Industries Development Bank of India (SIDBI) was set up as a wholly owned subsidiary of IDBI 3. Establishment of Institution for Agricultural Development: In 1963, the RBI set up the Agricultural Refinance and Development Corporation (ARDC) to provide refinance support to banks to finance major development projects, minor irrigation, farm mechanization, land development etc. In orderto meet credit needs of agriculture and rural sector, National Bank for Agriculture and Rural Development (NABARD) was set up in 1982. The main objective of the establishment of NABARD is to extend short term, medium term and long term finance to agriculture and allied activities. 4. Establishment of institution for housing finance: The National Housing Bank (NHB) has been set up in July 1988 as an apex institution to mobilize resources for the housing sector and to promote housing finance institutions.5. Establishment of Stock Holding Corporation of India (SHCIL): In 1987, another institution, namely, Stock Holding Corporation of India Ltd. was set up to strengthen the stock and capital markets in India. Its main objective is to provide quick share transfer facilities, clearing services, support services etc. toinvestors. 6. Establishment of venture capital institutions: The IDB! venture capital fund was set up in 1986. The ICICI and the UTI have jointly set up the Technology Development and Information Company of India Ltd. in 1988 to provide venture capital 7. New Economic Policy of 1991: Indian financial system has undergone massive changes since the announcement of new economic policy in 1991 Liberalization, Privatization and Globalization has transformed Indian economy from closed to open economy. The corporate industrial sector also has undergone changes due to delicensing of industries, financial sector reforms, capital markets reforms, disinvestment in public sector undertakings etc. Since 1990s, Government control over financial institutions has diluted ina phased manner. Public or development financial institutions have been converted into companies, allowing them to issue equity/bonds to the public. Government has allowed private sector to enter into banking and insurance sector. Foreign companies were also allowed to enter into insurance sector in India. Major Issues of Indian Financial System. Even though Indian financial system is more developed today, it suffers from certain weaknesses. These may be briefly stated below: 1. Lack of co-ordination among financial institutions: There are a large number of financial intermediaries. Most of the financial institutions are owned by the government. At the same time, the government is also the controlling authority of these institutions. As there is multiplicity of institutions in the Indian financial system, there is lack of co-ordination in the working of these institutions. 2. Dominance of development banks in industrial finance: The industrial financing in India today is largely through the financial institutions set up by the government. They get most of their funds from their sponsors. They act as. distributive agencies only. Hence, they fail tomobilize the savings of the public. This stands in the way of growth of an efficient financial system in the country.3. Inactive and erratic capital market: In India, the corporate customers are able to raise finance through development banks. So, they need not goto capital market. Moreover, they do not resort to capital market because it is erratic and inactive. Investors too prefer investments in physical assets to investments in financial assets. 4. Unhealthy financial practices: The dominance of development banks has developed unhealthy financial practices among corporate customers. The development banks provide most of the funds in the form of term loans. So there is a predominance of debt in the financial structure of corporate enterprises. This predominance of debt capital has made the capital structure of the borrowing enterprises uneven and lopsided. When these enterprises face financial crisis, the financial institutions permit a greater use of debt than is warranted. This will make matters worse. 5. Monopolistic market structures In India some financial institutions are so large that they have created a monopolistic market structures in the financial system. For instance, the entire life insurance business is in the hands of LIC. The weakness of this large structure is that it could lead to inefficiency in their working or mismanagement. Ultimately, it would retard the development of the financial system of the country itself. 6. Other factors: Apart from the above, there are some other factors which put obstacles to the growth of Indian financial system. Examples are: a. Banks and Financial Institutions have high level of NPA. b. Government burdened with high level of domestic debt. c. Cooperative banks are labeled with scams. d. Investors confidence reduced in the public sector undertaking etc., e. Financial illiteracy.