Financial System & Its Structure
Financial System
A financial system is an economic arrangement wherein financial institutions facilitate
the transfer of funds and assets between borrowers, lenders, and investors. A financial
system is a network of financial institutions, such as banks, insurance companies,
investment bank and stock exchanges, that permit the exchange of funds. They work
together to exchange and transfer capital from one place to another. Its goal is to
efficiently distribute economic resources to promote economic growth and generate a
return on investment (ROI) for market participants. Furthermore, the financial system
includes sets of laws and policies used by creditors and lenders to determine which
projects are funded, who fund the projects, and scope of financial deal.
The financial system is the main part of running the economy smoothly. Financial
system provides the flow of finance in the economy, which leads to the development of
the country. Financial system shows the strength of the country. Indian Financial System
is a combination of financial institutions, financial markets, financial instruments and
financial services to facilitate the transfer of funds. It is a link between saver and
investor.
Financial System Components
The financial system is composed of many components depending on the level.
From a regional standpoint, the financial system facilitates the exchange of funds
between borrowers and lenders. Players on a national level would include banks and
other financial institutions such as clearinghouses.
On a global scale, the financial system includes the interactions between financial
institutions, investors, central banks, government authorities, the World Bank, and more.
The financial system of the firm is the collection of executed procedures which track the
company's financial activities. Within a company, the financial system covers all facets
of finance, including accounting procedures, revenue and expenditure schedules, salaries,
and verification of balance sheets.
Structure of Financial System in India
The financial system consists of many institutions, instruments and markets. The
following are the four major components that comprise the Indian Financial System:
1. Financial Institutions
2. Financial Markets
3. Financial Instruments/Assets/Securities
4. Financial Services
1. Financial Institutions
Financial institutions are the intermediaries who facilitate the 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.
They provide whole range of services to the entities who want to raise funds from the
markets or elsewhere. The financial Institutions is very important for the functioning of a
financial system.
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
A. 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. The chief regulator of
financial institutions in our country is the Reserve bank of India.
B. Banking Institutions
Indian banking industry is subject to the control of the Central Bank. The RBI as the apex
institution organizes, runs, supervises, regulates and develops the monetary system and
the financial system of the country. These institutions mobilize the savings of people.
They provide a mechanism for the smooth exchange of goods and services. The Indian
banking institutions can be broadly classified into two categories:
1. Organised Sector
2. Unorganised Sector
1. Organised Sector
The organised banking sector consists of:
a. Commercial Banks
b. Cooperative Banks
a. Commercial bank
Commercial bank is an institution that accepts deposit, makes loans and offer related
services. These institutions run to make profit. The main legislation governing
commercial banks in India is the Banking Regulation Act, 1949.
Commercial banks provide administrations services such as making business advances,
offering fundamental investment schemes, encouraging saving deposits, fixed deposits,
issuing bank drafts and bank cheques, giving overdraft facilities, cash management,
mortgage loans, debit cards, credit cards, etc.
Commercial banking can be further divided into four parts as follows:
i. Public Sector banks
ii. Private Sector banks
iii. Foreign Banks
iv. Regional Rural Banks
i. Public Sector Banks
Public Sector Banks (PSBs) are banks where in the majority stake (i.e., more than 50%)
is held by Government of India.
The nationalization of 14 major commercial banks on 19 July 1969 and the
nationalization of 6 more commercial banks on 15 April 1980. 12 banks constitute the
public sector in Indian Commercial Banking. The public sector accounts for 90 percent of
the total banking business in India as most of the depositors believe that their money is
safer in public sector banks because they are owned by the government. The State Bank
of India (SBI) is India's largest public sector bank.
ii. Private Sector Banks
These banks are registered as companies with limited liability. At present, Private Banks
in India include leading banks, namely, ICICI Bank, HDFC Bank, Kotak Mahindra Bank,
etc.
Private banks subject to an essential part of wealth management for high income groups.
They provide services like: assets management, tax advisory, financial brokers, offered
solitary relationship manger. Private sector banks are those whose equity is held by
private shareholders. Private sector bank plays a major role in the development of Indian
banking industry.
iii. Foreign Banks
These banks are registered and have their headquarters in a foreign country but operate
their branches in India. Some of the foreign banks operating in India are Hong Kong and
Shanghai Banking Corporation (HSBC), Citibank, American Express Bank, Standard
Chartered Bank, and Bank of Tokyo Ltd., etc. At present, there are 46 total foreign banks
in India as per the RBI (As on 2020).
iv. Regional Rural Banks
Regional Rural Banks (RRBs) were first established in October 2, 1975 and are playing a
pivotal role in the economic development of rural India. The main objective of RRB is to
develop rural economy. Their borrowers include small and marginal farmers, agricultural
labourers, artisans etc.
There were five commercial banks, viz. Punjab National Bank, State Bank of India,
Syndicate Bank, United Bank of India, and United Commercial Bank, which sponsored
the regional rural banks.
Regional Rural Banks are regulated by National Bank for Agriculture and Rural
Development (NABARD).
b. Cooperative Banks
An important segment of the organized sector of Indian banking is the co-operative
banking. The segment is represented by a group of societies registered under the Acts of
the states relating to cooperative societies. In fact, co-operative societies may be credit
societies or non-credit societies. Different types of co-operative credit societies are
operating in Indian economy. These institutions can be classified into two broad
categories: (a) Rural credit societies which are primarily agriculture, (b) Urban credit
societies which are primarily non-agriculture.
2. Unorganised Sector.
In the unorganised banking sector are the Indigenous Bankers, Money Lenders.
1. Indigenous Bankers
Indigenous Bankers are private firms or individual who operate as banks and as
such both receive deposits and give loans. Like bankers, they are also financial
intermediaries.
2. Money Lenders
Money lenders depend entirely on their own funds. Money Lenders may be rural or
urban, professional or non-professional. They include large number of farmers,
merchants, traders. Their operations are entirely unregulated. They charge very
high rate of interest.
C. Non-banking Institutions
Non-banking financial institutions (NBFIs) also mobilize financial resources directly or
indirectly from people. They lend funds but do not create credit. Companies such as LIC,
UTI, Development Financial Institutions, Organization of Pension and Provident Funds
fall into this category.
Non-banking financial institutions can be categorized as investment companies, housing
companies, leasing companies, specialized financial institutions (EXIM Bank), etc. They
are not subject to certain regulatory prescriptions applicable to banks.
Some of the NBFIs are as below:
1. Tourism Finance Corporation of India Ltd. (TFCI)
2. General Insurance Corporation (GIC)
3. Export-Import Bank of India (EXIM)
4. National Bank for Agriculture and Rural Development (NABARD)
5. National Housing Bank (NHB)
2. Financial Market
It is through financial markets and institutions that the financial system of an economy
works. Financial markets refer to the institutional arrangements for dealing in financial
assets and credit instruments of different types such as currency, cheques, bank deposits,
bills, bonds etc.
These organised markets can be further classified into two they are:
(i) Capital Market
(ii) 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 may be further divided into three namely:
(I) Industrial securities market
(II) Government securities market
(III) Long term loans market
(I) Industrial Securities Market
As the very name implies, it is a market for industrial securities namely:
(i) Equity shares or ordinary shares
(ii) Preference shares
(iii) Debentures or bonds
It is a market where industrial concerns raise their capital or debt by issuing appropriate
instruments. It can be further subdivided into two. They are:
(i) Primary market or New issue market
(ii) Secondary market or Stock exchange
(i) Primary Market
Primary market is a market for new issues or new financial claims. Hence, it is also called
New Issue market. The primary market deals with those securities which are issued to the
public for the first time. Primary market facilitates capital formation. There are three
ways by which a company may raise capital in a primary market. They are:
The most common method of raising capital by new companies is through sale of
securities to the public. It is called public issue. When an existing company wants to raise
additional capital, securities are first offered to the existing shareholders on a pre-emptive
basis. It is called rights issue. Private placement is a way of selling securities privately to
a small group of investors.
(ii) Secondary Market
Secondary market is a market for secondary sale of securities. In other words, securities
which have already passed through the new issue market are traded in this market. This
market consists of all stock exchanges recognised by the Government of India. The stock
exchanges in India are regulated under the Securities Contracts (Regulation) Act 1956.
The Bombay Stock Exchange is the principal stock exchange in India which sets the tone
of the other stock markets.
(II) Government Securities Market
It is otherwise called Gilt - Edged securities market. It is a market where Government
securities are traded. In India there are many kinds of Government Securities - short term
and long term. Long term securities are traded in this market while short term securities
are traded in the money market. Securities issued by the Central Government, State
Governments, Semi Government authorities like City Corporations, Port Trusts etc.
(III) Long Term Loans Market
Development banks and commercial banks play a significant role in this market by
supplying long term loans to corporate customers. Long term loans market may further be
classified into:
(1) Term loans market
(2) Mortgages market
(3) Financial Guarantees market
ii. Money Market
Money market is a market for dealing with financial assets and securities which have
a maturity period of upto one year. It is a market for purely short-term funds. The
money market may be subdivided into four. They are:
(i) Call money market
(ii) Commercial bills market
(iii) Treasury bills market
(iv) Short term loan market
(i) Call Money Market
The call money market is a market for extremely short period loans say one day to
fourteen days. So, it is highly liquid. The loans are repayable on demand at the option
of either the lender or the borrower. In India, call money markets are associated with
the presence of stock exchanges and hence, they are located in major industrial towns
like Bombay, Calcutta, Madras, Delhi, Ahmedabad etc. The special feature of this
market is that the interest rate varies from day to day and even from hour to hour and
Centre to Centre. It is very sensitive to changes in demand and supply of call loans.
(ii) Commercial Bills Market
It is a market for Bills of Exchange arising out of genuine trade transactions. In the case
of credit sale, the seller may draw a bill of exchange on the buyer. The buyer accepts
such a bill promising to pay at a later date specified in the bill. The seller need not wait
until the due date of the bill. Instead, he can get immediate payment by discounting the
bill.
(iii) Treasury Bills Market
It is a market for treasury bills which have 'short-term' maturity. A treasury bill is a
promissory note or a finance bill issued by the Government. It is highly liquid because its
repayment is guaranteed by the Government. It is an important instrument for short-term
borrowing of the Government. There are two types of treasury bills namely
a. Ordinary treasury bills are issued to the public, banks and other financial
institutions with a view to raising resources for the Central Government to meet
its short-term financial needs.
b. Ad hoc treasury bills are issued in favor of the RBI only. They are not sold
through tender or auction. They can be purchased by the RBI only. Ad hocs are
not marketable in India but holders of these bills can sell them back to RBI.
(iv) Short - Term Loan Market
It is a market where short - term loans are given to corporate customers for meeting their
working capital requirements. Commercial banks play a significant role in this market.
Commercial banks provide short term loans in the form of cash credit and overdraft. Over
draft facility is mainly given to business people whereas cash credit is given to
industrialists.
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, Treasury Bill. Financial securities can be classified into:
(i) Primary or direct securities
(ii) Secondary or indirect securities
i. Primary Securities
These are securities directly issued by the ultimate investors to the ultimate savers. E.g.,
shares and debentures issued directly to the public.
ii. Secondary Securities
These are securities issued by some intermediaries called financial intermediaries to the
ultimate savers.
E.g., 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.
Again, these securities may be classified on the basis of duration as follows:
i. Short - term securities are those which mature within a period of one year. E.g.,
Bill of Exchange, Treasury bill, etc.
ii. Medium term securities are those which have a maturity period ranging between
one and five years. E.g., Debentures maturing within a period of 5 years.
iii. Long - term securities are those which have a maturity period of more than five
years. E.g., Government Bonds maturing after 10 years.
4. Financial Services
Efficiency of emerging financial system largely depends upon the quality and variety of
financial services provided by financial intermediaries. The term financial services can be
defined as “activities, benefits, and satisfactions, connected with the sale of money, that
offer to users and customers, financial related value. Within the financial services
industry the main sectors are banks, financial institutions, and non-banking financial
companies.
Kinds of Financial Services
Financial services provided by various financial institutions, commercial banks and
merchant bankers can be broadly classified into two categories.
1. Asset based/fund-based services.
2. Fee based/advisory services.
1. Asset based/fund-based services
The asset/ fund-based services provided by banking and non - banking financial
institutions are:
a. Equipment Leasing/ Lease Financing - Leasing is an arrangement that provides a
firm with the use and control over assets without buying and owning the same. It is
a form of renting assets. However, in making an investment, the firm need not own
the asset. It is basically interested in acquiring the use of the asset. Thus, the firm
may consider leasing of the asset rather than buying it.
b. Hire Purchase and Consumer Credit- Hire purchase means a transaction where
goods are purchased and sold on the terms that (i) payment will be made in
installments, (ii) the possession of the goods is given to the buyer immediately, (iii)
the property ownership) in the goods remains with the vendor till the last
installment is paid,(iv) the seller can repossess the goods in case of default in
payment of any instalment, and (v) each instalment is treated as hire charges till the
last instalment is paid.
Consumer credit includes all asset-based financing plans offered to individuals to
help them acquire durable consumer goods. In a consumer credit transaction, the
individual/ consumer/ buyer pays a part of the cash purchase price at the time of
the delivery of the asset and pays the balance with interest over a specified period
of time.
c. Venture Capital - venture capital financing is one of the most recent entrants in
the Indian capital market. There is a significant scope for venture capital
companies in our country because of increasing emergence of technocrat
entrepreneurs who lack capital to be risked. These venture capital companies
provide the necessary risk capital to the entrepreneurs so as to meet the promoter’s
contribution as required by the financial institutions.
d. Insurance Services -Insurance is a contract where by the insurer e. insurance
company agrees/ undertakes, in consideration of a sum of money (premium) to
make good the loss suffered by the insured (policy holder) against a specified risk
such as fire or compensate the beneficiaries (insured) on the happening of a
specified event such as accident or death. Depending upon the subject matter,
insurance services are divided into (i) life (ii) general.
e. Factoring - It is another method of raising short - term finance through account
receivable credit offered by commercial banks and factors.
A commercial bank may provide finance by discounting the bills or invoices of its
customers. Thus, a firm gets immediate payment for sales made on credit. A factor
is a financial institution which offers services relating to management and
financing of debts arising out of credit sales.
2. Fee Based Advisory Services
(i) Merchant Banking - Fee based advisory services includes all these financial
services rendered by Merchant Bankers. Merchant bankers play an important
role in the financial services Sector. The Industrial Credit and Investment
Corporation of India (ICICI) was the first development finance institution to
initiate such service in 1974. Financial Services provided by these organisations
include loan syndication portfolio management, corporate counselling project
counselling debenture trusteeship, mergers acquisitions.
(ii) Credit Rating - Credit rating is the opinion of the rating agency on the relative
ability and willingness of the issuer of debt instrument to meet the debt service
obligations as and when they arise. For the investors, it is an indicator
expressing the underlying credit quality of a (debt) issue programme. The
investor is fully informed about the company as any effect of changes in
business/ economic conditions on the agency company is evaluated and
published regularly by the rating agency.
(iii) Stock – Broking - Prior to the setting up of SEBI, stock exchanges were being
supervised by the Ministry of Finance under the Securities Contracts Regulation
Act (SCRA) and were operating more or less self-regulatory organisations. The
need to reform stock exchanges was felt, when malpractices crept into Trading
and in order to protect investor's interests, SEBI was set up to ensure that stock
exchange perform their self - regulatory role properly. Since then, stock broking
has emerged as a professional advisory.
Conclusion
Indian Financial System accelerates the rate and volume of savings through the provision
of various financial instruments and efficient mobilization of savings. It aids in increasing
the national output of the country by providing funds to corporate customers to expand
their respective business. It helps economic development and raising the standard of
living of people and promotes the development of the weaker section of the society
through rural development banks and co-operative societies.
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