Module 1:
Indian Financial System
Ms. Swati Abhang
Contents
• Characteristics Components and Functions of Financial System
• Financial Instruments: Meaning, Characteristics and Classification of
Basic Financial Instruments Equity Shares, Preference Shares,
• Bonds-Debentures Certificates of Deposit and Treasury Bills,
• Financial Markets: Meaning Characteristics and Classification of
Financial Markets Capital Market Money Market and Foreign
Currency Market
• Financial Institutions: Meaning Characteristics and Classification of
Financial Institutions, Commercial Banks ,
• Investment Merchant Banks and Stock Exchanges
Introduction
• A financial system plays a vital role in the economic growth of a
country.
• It intermediates between the flow of funds belonging to those who
save a part of their income and those who invest in productive assets.
• It mobilizes and usefully allocates scarce resources of a country.
• A financial system is a complex, well-integrated set of sub-systems
of financial institutions, markets, instruments, and services which
facilitates the transfer and allocation of funds, efficiently and
effectively.
Formal and Informal Financial Sectors
• The formal financial sector is characterized by the presence of an
organized, institutional, and regulated system which caters to the
financial needs of the modern spheres of economy;
• The informal financial sector is an unorganized, non-institutional,
and non-regulated system dealing with the traditional and rural
spheres of the economy.
• The informal financial sector has emerged as a result of the intrinsic
dualism of economic and social structures in developing countries,
and financial repression which inhibits the certain deprived sections
of society from accessing funds.
• The informal system is characterized by flexibility of operations and
interface relationships between the creditor and the debtor.
Difference between formal and
informal financial services
Significance of Financial System
• Financial System helps the economy to grow.
• Financial System brings investment.
• Financial System creates a bridge between investors and
companies.
• Financial system helps in fiscal discipline and control of the
economy.
• Financial System brings accountability for investors.
The Indian Financial System
Financial system
• The Financial system is a process of allowing net savers to lend
funds to net spenders.
• A financial system is also a network of financial institutions,
financial markets, financial instruments, and financial services to
facilitate the transfer of funds and make sure the flow of the
investent in the economy.
• According to Dhanilal,
“Financial system is the set of interrelated and
interconnected components consisting financial
institutions, markets and securities.”
Meaning of Indian financial system
• The financial system enables lenders and borrowers to exchange
funds.
• India has a financial system that is controlled by independent
regulators in the sectors of insurance, banking, capital markets and
various services sectors.
• Financial system can be said to play a significant role in the
economic growth of a country by mobilizing the surplus funds and
utilizing them effectively for productive purposes.
Features of the Indian Financial system
• It plays a vital role in the economic development of the country as it
encourages both savings and investment
• It helps in mobilizing and allocating one’s savings
• It facilitates the expansion of financial institutions and markets
• Plays a key role in capital formation
• It helps form a link between the investor and the one saving
• It is also concerned with the Provision of funds
Characteristics of Indian financial
system
• To growth of the economy, Financial system helps to grow the
economy of the country. it improves lifestyle and standard of living
of the host country.
• To brings investment, When the financial institution work properly,
it brings investment to the host country. Because it provides trust to
the investors to invest in the country.
• To encourage savings, When the people started earning, they
started saving and investing.
• To Allocation of Funds, When the saving and investments starts in
the economy. it gives opportunities to banks to allocate the funds
properly.
India’s Financial System
Limitations of Indian Financial System
• Indian Financial system has a monopoly in their industry.
• India Financial system has inactive capital market.
• India Financial system has a lack of coordination with Financial
Institutions.
• India Financial system has Dominance of Development Banks in
Industrial Financing.
• Indian Household is not aware of investment.
Components of Indian Financial System
1. Financial Institutions
• Financial institutions facilitate smooth working of the financial system
by making investors and borrowers meet.
• They mobilize the savings of investors either directly or indirectly via
financial markets, by making use of different financial instruments as well
as in the process using the services of numerous financial services
providers.
• They could be categorized into Regulatory, Intermediaries, Non-
intermediaries and Others.
• They offer services to organizations looking for advises on different
problems including restructuring to diversification strategies.
• They offer complete array of services to the organizations who want to
raise funds from the markets and take care of financial assets for example
deposits, securities, loans, etc.
1. Financial Institutions
• Financial institutions are also termed as financial intermediaries
because they act as middle between savers by accumulating Funds
them and borrowers by lending these fund.
• It is also act as intermediaries because they accept deposits from a set
of customers (savers lend these funds to another set of customers
(borrowers).
• Like - wise investing institutions such ICCIC, mutual funds also
accumulate savings and lend these to borrowers, thus perform the
role of financial intermediaries.
A. BANKING INSTITUTIONS (Reserve
Bank of India)
• 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.
• The main legislation governing commercial banks in India is the
Banking Regulation Act, 1949.
• The Indian banking institutions can be broadly classified into two
categories:
• Organized Sector
• Unorganized Sector.
B. NON – BANKING INSTITUTIONS
• The non – banking institutions may be categorized broadly into two
groups:
(a) Organized Non – Banking Financial Institutions.
(b) Unorganized Non – Banking Financial Institutions.
[Link] Markets
• A financial market is the place where financial assets are created or
transferred.
• It can be broadly categorized into money markets and capital markets.
• Money market handles short-term financial assets (less than a year)
whereas capital markets take care of those financial assets that have
maturity period of more than a year.
• One more classification is possible:
• Primary markets : handles new issue of securities
• Secondary markets. take care of securities that are presently available in the
stock market
Functions of financial markets
• To facilitate creation and allocation of credit and liquidity
• To serve as intermediaries for mobilization of savings.
• To assist the process of balanced economic growth.
• To provide financial convenience.
• To cater to the various credit needs of the business houses.
Classification of financial market
Financial market
a. Capital Market
• These deal with trades and transactions which take place in the
market.
• These take place for a period of 1 year.
• These are of 3 major types:
• Corporate Securities Market
• Government Securities Market
• Long Term Loan Market
b. Money Market
• These are for short-duration investments.
• They are denominated by the government, banks, and other
institutions.
• This market is based on wholesale debt having a low-risk factor with
transparent instruments and formats used.
• It has 2 main types:
• Organized Money Market
• Unorganized Money Market
Comparison between Money Market and
Capital Market
• Involves dealing with long-
term funds.
• Involves dealing with • Associates with assets such
short-term funds. as shares, debentures, bonds
Comparison and government securities.
• Associates with assets like
treasury bills, commercial • Its participants include
paper, bills of exchange, Stockbrokers, underwriters,
certificate of deposits, etc. mutual funds, individual
investors, financial
• Its participants include institutions etc.
commercial banks, NBFS,
chit funds, etc. • The SEBI is responsible for
its working.
• The RBI is responsible for
its working.
c. Foreign Exchange Market
• A highly developed market dealing with several currencies.
• It is responsible for the foreign transfer of funds.
• This takes place on the basis of foreign currency rates.
d. Credit Market
• This involves both short-duration loans and long-duration loans.
• It can be given to both individuals and organizations.
• These are granted by several banks, financial institutions, non –
financial institutions, etc.
3. Financial Instruments
• A financial instrument is defined as a contract between individuals/parties that
holds a monetary value.
• They can either be created, traded, settled, or modified as per the involved
parties' requirement.
• In simple words, any asset which holds capital and can be traded in
the market is referred to as a financial instrument.
• The products which are traded in a financial market are financial assets,
securities or other type of financial instruments.
• There is a wide range of securities in the markets since the needs of investors
and credit seekers are different.
• They indicate a claim on the settlement of principal down the road or payment
of a regular amount by means of interest or dividend.
• Some examples of financial instruments are cheques, shares, stocks, bonds,
futures, options contracts equity shares, debentures, bills,etc
Financial Instrument
Without any Without any
assurance, this is a assurance, this is a
loan lent for just a loan rent for more
day which is repaid than a day but less
the next day. than a duration of
14 days
When the duration With the duration of
of the maturity of a maturity of less than a
particular amount year, these belong to the
deposited is more government in the bond or
than 14 days debt security format. E.g.
government T– Bills
This works on the Used by corporates,
format of electronic it is an instrument
funds that remain that is not secured
deposited in a even though for a
particular bank for a short duration of
fixed period of time. debt
Financial Instrument
Bonds
• Bonds are debt financial instruments that both public and private sector
companies use to raise funds for their operations.
• The government agencies, financial institutions as well as private
enterprises issue these instruments to investors.
• Bonds are secured by their physical assets.
• The holder of these bonds is the lender, while the issuer of these bonds
is the borrower.
• The borrower can issue these bonds to the lender, only by promising to
pay back the loan at a specific maturity date with a fixed interest rate.
• This interest rate is generally lower than debentures because the
physical assets of a company secure bonds whereas the debentures are
unsecured instruments.
Types of bonds
• There are ten main types of bonds issued by government agencies,
financial institutions and corporations which are as follows:
• Fixed-rate bonds
• War bonds
• Perpetual bonds
• Inflation-linked bonds
• Floating rate bonds
• Bearer bonds
• Climate bonds
• Serial bonds
• Subordinated bonds
• Zero-interest rate bonds
Debentures
• Debentures are also debt financial instruments like bonds.
• Organizations use these instruments to get funding for their daily needs.
• They are generally not secured by any physical assets of the issuers,
which makes them riskier than bonds.
• They also carry a fixed or floating interest rate.
• The debenture holders get first preference over shareholders of a
company when it comes to the payment of interests/dividends.
• The interest rate on debentures is generally higher than bonds because
they are not secured by the physical assets of a company.
The different types of debentures
• There are eight main types of debentures issued by a company, which
are as follows:
• Secured debentures
• Convertible debentures
• Registered debentures
• Redeemable debentures
• Unsecured debentures
• Non-redeemable debentures
• Non-convertible debentures
• Bearer debentures
Difference between Bonds and debentures
BONDS DEBENTURES
Bonds are secure in nature. Debentures can be secure as well as
unsecured.
One can have bonds of a corporation, On the other hand debentures are issued by
government agencies or it can be of any private companies.
financial institution.
Bonds are less risky comparatively. Whereas debentures are at high risk.
Talking about liquidity bonds are at the Whereas in the case of debentures liquidity
first priority. can only be done after the bondholders are
paid.
Bonds give you low interest, but it depends Whereas debentures give you high interest.
on the issuing body totally.
Receivable
• Receivables, also referred to as accounts receivable, are debts owed to a
company by its customers for goods or services that have been delivered
or used but not yet paid for.
• Receivables are created by extending a line of credit to customers and
are reported as current assets on a company's balance sheet.
• They are considered a liquid asset, because they can be used as collateral
to secure a loan to help meet short-term obligations.
• Receivables are part of a company’s working capital.
• Effectively managing receivables involves immediately following up with
any customers who have not paid and potentially discussing a payment
plan arrangement, if needed.
• This is important because it provides extra capital to support operations
and lowers the company’s net debt.
KEY TAKEAWAYS
• Companies that allow customers to purchase goods or services on credit will
have receivables on their balance sheet.
• Receivables are recorded at the time of a sale when a good or service has
been delivered but not yet been paid for.
• Receivables will decrease when payment from customers is received.
• The amount of receivables estimated to be uncollectible is recorded in an
allowance for doubtful accounts.
• A receivable account indicates money that a corporation expects to collect
later.
• It helps businesses recognize the revenue period for which they anticipate
getting paid.
• Receivables are created when you sell a good or a service, and the new party
pays you after the sale transaction is completed.
• The receivables are shown as assets on the balance sheet, and the general
ledger shows a debit balance.
Shares
• Shares are units of equity ownership in a corporation.
• For some companies, shares exist as a financial asset providing for an
equal distribution of any residual profits, if any are declared, in the
form of dividends.
• Shareholders of a stock that pays no dividends do not participate in a
distribution of profits.
• Instead, they anticipate participating in the growth of the stock price
as company profits increase.
• Shares represent equity stock in a firm, with the two main types of
shares being common shares and preferred shares. As a result,
"shares" and "stock" are commonly used interchangeably.
KEY TAKEAWAYS
• Shares represent equity ownership in a corporation or financial asset,
owned by investors who exchange capital in return for these units.
• Common shares enable voting rights and possible returns through price
appreciation and dividends.
• Preferred shares do not offer price appreciation but can be redeemed at an
attractive price and offer regular dividends.
• Most companies have shares, but only the shares of publicly traded
companies are found on stock exchanges.
• Shares can be further categorized into two types. These are:
• Equity shares
• Preference shares
Equity Shares
• These are also known as ordinary shares and comprise the bulk of the shares
being issued by a particular company.
• Equity shares are transferable and are traded actively by investors in stock
markets.
• As an equity shareholder, you are not only entitled to voting rights on company
issues but also have the right to receive dividends.
• These dividends, however, are not fixed.
• Equity shareholders also partake in any losses faced by the company, limited to
the amount they had invested.
• Equity shares can be further divided based on:
• Share capital
• Definition
• Returns
Preference Shares
• Preferential shareholders receive preference in receiving profits of a
company as compared to ordinary shareholders.
• Also, in the event of liquidation of a particular company, the
preferential shareholders are paid off before ordinary shareholders.
• Here are the different types of shares in this category:
• Cumulative And Non-Cumulative Preference Shares
• Participating/Non-Participating Preference Share
• Convertible/Non-Convertible Preference Shares
• Redeemable/Irredeemable Preference Share
A Treasury Bills
• A Treasury Bill (T-Bill) is a short-term U.S. government debt obligation
backed by the Treasury Department with a maturity of one year or less.
• Treasury bills are usually sold in denominations of $1,000.
• However, some can reach a maximum denomination of $5 million in non-
competitive bids.
• These securities are widely regarded as low-risk and secure investments.
• The Treasury Department sells T-Bills during auctions using a
competitive and non-competitive bidding process.
• Noncompetitive bids—also known as non-competitive tenders—have a
price based on the average of all the competitive bids received.
• T-Bills tend to have a high tangible net worth.
Types of Treasury Bills
• 14-day Treasury bill:
• Maturity on 14 days from the date of issue.
• Auctioned on Wednesday, and the payment is made on the following Friday.
• Auction occurs every week.
• Sold in the multiples of Rs.1lakh and the minimum amount to invest is also Rs.1
lakh.
• 91-day Treasury bill:
• Maturity on 91 days from the date of issue.
• Auctioned on Wednesday, and the payment is made on the following Friday.
• Auctioned every week.
• Bills are sold in the multiples of Rs.25000 and the minimum amount to invest is
also Rs.25000.
Types of Treasury Bills
• 182-day Treasury bill:
• Maturity on 182 days from the date of issue.
• Auctioned on Wednesday, and the payment is made on the following Friday when
the term expires.
• Auctioned every alternate week.
• These bills are sold in the multiples of Rs.25000 and the minimum amount
to invest is also Rs.25000.
• 364-day Treasury bill:
• Maturity 364 days from the date of issue.
• Auctioned on Wednesday, and the payment is made on the following Friday when
the term expires.
• Auctioned every alternate week.
• These bills are sold in the multiples of Rs.25000 and the minimum amount
to invest is also Rs.25000.
KEY TAKEAWAYS
• A Treasury Bill (T-Bill) is a short-term debt obligation backed by the
U.S. Treasury Department with a maturity of one year or less.
• Treasury bills are usually sold in denominations of $1,000 while
some can reach a maximum denomination of $5 million.
• The longer the maturity date, the higher the interest rate that the T-
Bill will pay to the investor.
4. Financial Services
• The major objective of these is to provide counseling to their
visitors regarding the purchase or selling of a property, permitting
transactions, deals, lending, and investments.
• These make sure the effectiveness of the investment and
arrangement of the fund source too.
• These are usually taken up by asset and liability management
companies.
4. Financial Services
• Banking Services: Functions performed by a bank such as the
provision of loans, accepting debits, giving out credit or debit cards,
account opening, granting checkbooks, etc are a part of these services.
• Insurance Services: These include services of offering insurance,
selling policies, brokerage deals, etc.
• Investment Services: These services include overlooking and
management of investment, assets, and deposits.
• Foreign Exchange Services: These include currency exchanges,
foreign exchanges, and foreign fund transfers.
5. Money
• It is an important medium of exchange that can be used to purchase
goods and services.
• It can also act as a store of value.
• It is uniformly accepted everywhere.
• It eases transactions especially impromptu daily purchases.
• It makes the goods and services easily exchangeable.
• It acts as a verifiable record in the socio-economic context.
Money Market
• Money markets are unorganized markets where banks, financial
institutions , money dealers, and brokers trade in financial instruments
quickly.
• For example, they trade in short-term debt instruments like trade
credit, commercial paper, certificate of deposit , T bills, etc. They are
highly liquid and can be redeemed in less than 1.
• Trading in the money market is done mostly through over-the-counter
(OTC), i.e., no or little use of exchanges.
• However, they provide businesses with short-term credit and play a
major role in providing liquidity in the economy over the short term.
• In addition, it helps the business and industries with working capital
requirements.
In short
• The money market is a short-term lending system.
• Borrowers tap it for the cash they need to operate from day to day.
• Lenders use it to put spare cash to work.
• The capital market is geared toward long-term investing.
• Companies issue stocks and bonds to raise money to grow their
businesses.
• Investors buy them to share in that growth.
• The money market is less risky than the capital market while the
capital market is potentially more rewarding.
Capital Market
• The capital market is a type of financial market where financial
products like stocks, bonds, debentures are traded for a long time.
• They serve the purpose of long-term financing and long-term
capital requirement.
• The capital market is a dealer and an auction market and consists of
two categories:
• Primary market: A primary market where the fresh issue of securities is
offered to the public.
• Secondary market: A secondary market where securities are traded between
the investors.
Types of Capital Market
• The capital market is roughly divided into a primary market and a
secondary market.
• A company that issues a round of stock or a new bond places it in the
primary market for sale directly to investors or institutions.
• If and when those buyers decide to sell their shares or bonds, they do
so on the secondary market.
• The original issuer of those stocks or bonds does not immediately
benefit from their resale, although companies certainly have an
interest in the price of their stock shares rising over time.
Comparative Table
Basis for Comparison Money Market Capital Market
Capital market is part of the financial market where
It is the part of financial market where lending and
Definition lending and borrowing takes place for the medium-
borrowing takes place for short-term up to one year
term and long-term
Money markets generally deal in promissory
Types of instruments Capital market deals in equity shares, debentures,
notes, bills of exchange, commercial paper, T bills,
involved bonds, preference shares, etc.
call money, etc.
Institutions The money market contains financial banks, the It involves stockbrokers, mutual funds, underwriters,
involved/types of central bank, commercial banks, financial companies, individual investors, commercial banks, stock
investors chit funds, etc. exchanges, Insurance Companies
Nature of Market Money markets are informal Capital markets are more formal
Liquidity of the market Money markets are liquid Capital Markets are comparatively less liquid
The maturity of financial instruments is generally The maturity of capital markets instruments is longer
Maturity period
up to 1 year and they do not have stipulated time frame
Since the market is liquid and the maturity is less Due to less liquid nature and long maturity, the risk is
Risk factor
than one year, Risk involved is low comparatively high
The market fulfills the short-term credit needs of The capital market fulfills the long-term credit needs
Purpose
the business of the business
The money markets increase the liquidity of funds in The capital market stabilizes the economy due to long-
Functional merit
the economy term savings
The returns in capital markets are high because of
Return on investment The return in money markets are usually low
higher duration
Key Differences
• Short-term securities are traded in money markets, whereas long-term securities are
traded in capital markets.
• Capital markets are well organized, whereas money markets are not that organized.
• Liquidity is high in the money market, whereas liquidity is comparatively low in
capital markets.
• Due to high liquidity and low maturity duration in money markets, instruments in
money markets are a low risk, whereas capital markets are comparatively high risk.
• A central bank, commercial banks and non-financial institutions majorly work in
money markets, whereas stock exchanges, commercial banks, and non-banking
institutions work in capital markets.
• Money markets are required to fulfill the capital needs in the short term, especially the
working capital requirements. Capital markets are required to provide long-term
financing and a fixed capital for purchasing land, property, machinery, building, etc.
• Money markets provide liquidity in the economy where capital markets stabilize the
economy due to long-term financing and savings mobilization.
• Capital markets generally give higher returns, whereas money markets give a low
return on investments
Merchant bank
• A merchant bank is a firm or financial institution that invests equity capital
directly in businesses and often provides those businesses with advisory
services.
• A merchant bank offers the same services as an investment bank; however,
it typically services smaller clients and makes direct equity investments in
them.
• Merchant banks mainly work with small-scale enterprises that are unable to
raise funds through an initial public offering (IPO) by providing mezzanine
financing, bridge financing, equity financing, and corporate credit products.
• They also issue and sell securities on behalf of corporations
through private placements to refined investors who require less regulatory
disclosure.
Functions of Merchant Banks
• Equity Underwriting:
• The process through which investment banks raise capital from investors on
behalf of firms and governments issuing these securities.
• Credit Syndication :
• Refers to the process of involving a group of lenders that fund various portions
of a credit for a single borrower.
• Portfolio Management:
• The selection, prioritization and control of an organization's programmes and
projects, in line with its strategic objectives and capacity to deliver.
Investment Bank
• An investment bank is a financial services company that acts as an
intermediary in large and complex financial transactions.
• An investment bank is usually involved when a startup company prepares
for its launch of an initial public offering (IPO) and when a corporation
merges with a competitor.
• It also has a role as a broker or financial adviser for large institutional
clients such as pension funds.
• Global investment banks include JPMorgan Chase, Goldman Sachs,
Morgan Stanley, Citigroup, Bank of America, Credit Suisse, and Deutsche
Bank.
• Many of these names also offer storefront community banking and have
divisions that cater to the investment needs of high-net-worth individuals.
Merchants banking vs. Investment banking
Stock exchanges
• A stock exchange does not own shares.
• It acts as a market where stock buyers connect with stock sellers.
• A stock exchange is a centralized location that brings corporations and
governments so that investors can buy and sell equities.
• The stock market allows buyers and sellers of securities to meet, interact,
and transact.
• The markets allow for price discovery for shares of corporations and serve
as a barometer for the overall economy.
• Buyers and sellers are assured of a fair price, high degree of liquidity, and
transparency as market participants compete in the open market.
Stock exchanges
• Auction-based exchanges such as the New York Stock Exchange allow
traders and brokers to physically and verbally communicate buy and
sell orders.
• Electronic exchanges take place on electronic platforms, so they don't
require a centralized physical location for trades.
• Electronic communication networks connect buyers and sellers
directly by bypassing market makers.
• The OTCBB( Over-the-Counter Bulletin Board : an electronic
community of market makers) has been closed by FINRA (Financial
Industry Regulatory Authority: an independent, nongovernmental
organization that writes and enforces the rules governing registered
brokers and broker-dealer firms in the United States.).
Important questions
1. Define Financial Management.
2. State the primary objective of Financial management.
3. List and explain component of financial system.
4. Explain organized and non organized financial institutions.
5. How bonds differ from debentures?
6. Differentiate between bond and debentures.
7. Explain financial instruments.
8. What are different types of T- bills? List and explain.
9. Which are financial services provided by any financial system?
Important questions
10. Explain capital market and money market.
11. Differentiate between capital and money market.
12. Differentiate between formal and informal financial services.
13. State Significance of Financial System.
14. List features of the Indian Financial system.
15. List characteristics of the Indian Financial system.
16. Explain types of financial markets.