INDIAN FINANCIAL SYSTEM
UNIT-1
INTRODUCTION TO INDIAN FINANCIAL SYSTEM
SYLLABUS:
Introduction – Meaning of Financial System, Features, Objectives, Components, Structure,
Role of Financial System in Economic Development(Gordon) - SWOT of Indian Financial
System.
Financial Regulators in India- A brief note on RBI, SEBI, IRDAI, and PFRDAI.
----------------------------------------------------------------------------------------------------------------
The word Finance is derived from the latin word ‘finis’ which means money. Finance is an
activity by which savings especially bank deposits or currency notes are pooled and then placed
in the hands of the investors.
Finance also refers to the science that describes the management, creation and study of money,
banking, credit, investments, assets and liabilities. Finance consists of Financial systems, which
include the public, private and government spaces, and the study of finance and financial
instruments, which can relate to countless assets and liabilities.
Definition of Finance:
According to Simon Andrade, “Finance is the area of economic activity in which money is the
basis of various embodiments, whether stock market investments, real estate, industrial,
construction, agricultural development, so on”
Definition of Financial System
In the words of Dr. S. Gurusamy, in his book financial services and systems defined the term
financial system as "a set of complex and closely interconnected financial institutions, markets,
instruments, services, practices and transactions."
Features of Financial System
(i)It is a set of inter related activities or services.
(ii) Services are working together to achieve predetermined goals.
(iii) The system allows transfer of money between savers and borrowers.
(iv) It is applicable at global, regional and firm level.
(v) It includes financial institutions, markets, instruments, services, practices and transactions.
(vi) The main Objective is to formulate capital, investment and profit generation.
Objectives of financial system:
The primary objectives of a financial system are concerned to formulate capital, facilitate
investment and profit generation. These objectives are also the significance or importance of
financial system in an economy.
(1) To mobilize the savings: The financial system begins its operations by the mobilizing
of savings from the small saving community. It collects the fund by offering different
schemes which attract the investors to fund their savings in different institutions,
services, securities etc.
(2) To distribute the savings for the industrial investment: The purpose of mobilizing
the fund from the saving community is to invest them in different Industries. Thereby
it meets the fund requirement of industrial sector. Hence it helps in the growth of
Industrial
(3) To stimulate capital formation: The objective of supporting the industries is not
ended with sanctioning of fund to them. Further, it makes them to formulate the capital
out of their earnings for the further capital requirement and industrial Investment
(4) To accelerate the process of economic growth: The ultimate aim of the financial
Institutions is to support the process of economic growth of a nation. Directing the
saving fund to the industrial capital need, motivating them for the capital formation
support the acceleration of the process of economic growth.
COMPONENTS OF FINANCIAL SYSTEM:
The 4 Major components are
1) Financial institution: The entities that provide financial services, such as banks,
credit unions, insurance companies, investment banks, and pension funds, are called
financial institutions. They act as intermediaries between savers and borrowers,
channeling funds from savers to borrowers.
2) Financial markets: Financial markets are platforms where individuals, businesses,
and governments buy and sell financial assets. Here are the various types of financial
markets:
• Stock markets (for trading shares of companies), bond markets (for trading debt
securities)
• Commodity markets (for trading commodities like gold, oil, etc.)
• Foreign exchange markets (for trading currencies)
3) Financial instruments: Financial instruments are monetary contracts that can be
traded. Financial instruments include stocks, bonds, options, futures contracts,
mortgages, and derivatives. Financial instruments provide a means for investors to
invest their funds and for borrowers to raise capital
4) Financial services: The various services offered by financial institutions, such as
loans, deposits, payment services, investment services, insurance services, financial
advisory services, and risk management services, are termed financial services
STRUCTURE/CLASSIFICATION OF FINANCIAL SYSTEM (INDIAN FINANCIAL
SYSTEM)
The structure or classification of Indian Financial system is vast and includes different financial
institutions, markets, instruments, and services. These are configured and discussed below.
Financial Institutions:
Definition:
Financial institutions are defined as “an establishment that focuses on dealing with financial
transactions, such as investment, loans and deposits”.
Meaning:
Financial institutions are the institutions which offer financial services for its clients or
members. The most probable financial service is financial intermediation. The institutions
include Banks, trust companies, insurance companies and investment dealers .
Features of financial institution:
• It is an institution as well as intermediary.
• It channelizes savings funds into investment funds
• It creates financial aassets such as deposits, loans, securities etc
• It inckudes banking and non banking instiutions
• It includes both organized and unorganized insitutuions
• Established with a clear operationg function
• Regulated by the government and regulating authority
The financial institutions are classified into banking and non banking institutions:
(1) Banking institutions: These are the type of financial institutions which involve in
accepting public deposits and lending the same to the needy customers. These are
fundamentally established to earn profit, secondarily to safe guard the interest of the
members.
a) Commercial Banks: These are also called as Business banks. The following are
the types of commercial banks.
• Public sector
• Private sector
• Regional Rural Banks (RRBs)
• Foreign Banks
b). Cooperative Banks: These are established to safeguard the interest of its members.
These are organized on a cooperative basis, accept deposit and lend money to the
required members.
(2) Non Banking Institutions: These are the financial institutions that provide banking
services without meeting the legal definition of a bank. These are not allowed to accept the
deposits from the public and are not licensed institutions
The following are the examples for non banking institutions:
• Provident and Pension Fund
• Small Saving Organization
• Life Insurance Corporation (LIC)
• General Insurance Corporation (GIC)
• Unit Trust of India (UTI)
FINANCIAL MARKETS
Financial markets are the essential players in the economic development of a nation. They
function as facilitating originations in the savings-investment process and act as n effective part
of a financial system.
Definition:
Financial Market is defined as a market for the exchange of capital and credit, including the
money markets and the capital markets
a) Money market: A market where short term funds are borrowed and lend is called
money market It deats In short term monetary assets with a maturity period of one year
or less. Liquid funds as well as highly liquid securitles are traded in the money market.
Examples of money market are Treasury bill market, call money market, commercial
bill market etc.
• Call money market :The call money market is a segment of the money market where
short-term funds are lent and borrowed. In this market, financial institutions (such as
banks) lend money to one another for very short periods, typically overnight. The loans
are "callable," meaning the lender can demand repayment at any time, usually with
little notice.
• Commercial bill market : The commercial bill market is a financial market where
commercial bills (short-term, negotiable instruments like promissory notes or bills of
exchange) are bought and sold. These bills are typically used by businesses to finance
their short-term needs, such as inventory or accounts receivable.
• Treasury bill market: The Treasury bill market is a segment of the financial market
where Treasury bills (T-bills) are issued and traded. T-bills are short-term debt
instruments issued by the government to raise funds, typically with maturities ranging
from a few days to one year.
b) Capital Market: The capital market is a market for financial assets which have a long
or indefinite maturity. The capital market instruments become mature for the period
above one year. It is also called as long term securities market. It is an institutional
arrangement to borrow and lend money for a longer period of time. It consists of
financial institutions like IDBL, ICICI, UTI, LIC etc.
• Primary Market: It is also called as new issue market. In this market the
securities are purchased directly from the issuer. Primary market differs from
capital market. This market helps in capital formation for different industries.
• Secondary Market: It is a financial market where previously issued financial
instruments such as stock, bonds, options and futures are bought and sold.
• The derivatives market : The derivatives market is the financial
market for derivatives - financial instruments like futures contracts or options -
which are derived from other forms of assets.
FINANCIAL INSTRUMENTS
Financial instruments are also called as financial assets / securities. They are intangible
assets which receives value due to contractual transactions. These are one or other items
used for commercial transactions in capital and money market.
Definition: Financial instruments
Financial instruments are defined as “an assets that derives value because of contractual
claim.
1) Term financial instruments :
These are the tradable financial assets and exchanged on term basis. These are again classified
into short term, medium term and long term securities.
a) Short term securities : This sub – category comprises securities with maturity of one year
or less.
b) Medium term securities :Basis for classifying securities under this sub-category depend
on practices applied in financial markets of the given country. Normally, this sub-category
includes securities with maturity from 1 to 5 years.
c) Long term securities : This sub category comprises securities with maturity longer than
those of short and medium term securities.
2) Type based securities:
Under this classification financial securities are classified into primary, secondary and
innovative instruments.
a) Primary instruments / securities : Primary instruments are defined as “a financial instrument
whose value is not derived from that of another instrument, but instead is determined directly
by the market.” These are issued by non financial institutions. The examples for the primary
instruments are equity shares, preference shares and debentures.
b) Secondary instruments / securities : A primary security is an instrument issued directly by
the financial institutions to an investor. For example, when you are investing in a mutual fund,
you are investing in a secondary security. Some other examples for primary securities are
mutual fund, money market funds, commercial paper, certificate of deposits.
c) Innovative instruments : These are the financial innovative instruments to suit the need of
cooperates and investors group. For example Derivates , securitized assets foreign currency
mortgages and so on.
FINANCIAL SERVICES
Definition
The financial services are defined as "facilities such as saving accounts, checking accounts, confirming,
leasing and money transfer, provided generally by banks, credit unions and finance companies"
Financial Services are also called as financial intermediation. Financial intermediation is a process of
mobilization of surplus of people and allocation of mobilized fund to various needy groups (industries,
companies, business people, individual etc.) for economic development
Classification of Financial Services:
Financial services are classified into Fund based services and Fee Based services.
(1) Fund Based Services: Fund based or asset based financial services are those services which
are rendered for commission basis or for a certain amount of interest.
• Hire purchase: Hire purchase system is a method of selling goods on credit where
purchaser is allowed to purchase goods and allowed him to pay the amount in
installment basis and the title of the goods transferred from seller to buyer at the end
of final instalment
• Leasing: It refers to a written agreement between lessor and lessee where lessor allows
lessee to use his property for specified period of time or rent is called lease.
• Factoring: Factoring is a facility provided by factor (financial institution) to its clients
(company), where as factor purchase debts and receivable accounts of the clients at
discount rates and offers immediate cash. This facility is called as factoring It is also
called as account receivable finance
(2) Fee Based Services: Fees based financial services are those which are paid for a flat fee rather
than commission. Those services are known as fees based services.
• Merchant banking: Merchant banking is a professional service provided by
the merchant banks to their customers considering their financial needs, for
adequate consideration in the form of fee. Merchant banks are banks that
conduct fundraising, financial advising and loan services to large corporations.
• Credit rating: Credit rating is an assessment of the creditworthiness of a
borrower, typically a company or government, based on their ability to repay
debt. These ratings are issued by credit rating agencies and are used by
investors to gauge the risk of lending money or investing in bonds. Higher
credit ratings indicate lower risk, while lower ratings suggest higher risk.
• Mergers refer to the combination of two or more financial institutions, such as banks,
insurance companies, or investment firms, into a single entity. This can be done to
achieve various objectives, including expanding market share, reducing competition,
achieving economies of scale, or diversifying services and products
FINANCIAL SYSTEM AND ECONOMIC DEVELOPMENT
The financial system playa a significant role in the process of economic development of a country. The
financial system comprises of a network of commercial banks. Non-banking companies, development
banks and other financial and investment institutions offer a varieties of financial products and services
to suit to the varied requirements of different categories of people. Since they function in a fairly
developed capital and money markets, they play a crucial role in spurring economic growth
1) Mobilising Savings:The financial system mobilises the savings of the people by offering
appropriate incentives and by deepening and widening the financial structure. In other words,
the financial system creates varieties of forms of savings so that savings can take place
according to the varying asset preferences of different classes of savers.
2) Promoting Investments: For the economic growth of any nation, investment is absolutely
essential. This, investment has to flow from the financial system. In fact, the level of investment
determines the increase in output of goods and services and incomes in the country.
3) Providing a Spectrum of Financial Assets: The financial system provides a spectrum of
financial srets so as to meet the varved requiremenes and preferences of household. Thus, it
enables them to choose their asset portfolios in such a way as to achieve a preferred mix of
return, liquidity and risk. Thus, it contributes to the economic development of a country.
4) Financing Trade, Industry and Agriculture: All the financial institutions operating in a
financial system take all efforts to ensure that no worthwhile project be it in trade or agriculture
or industry-suffers due to lack of funds. Thus, they promote industrial and agricultural
development which have a greater say on the economic developmen of a country
5) Encouraging Entrepreneurial Talents: The financial institutions encourage the managerial
and entrepreneurial talente in the economy try promoting the spirit of enterprise and risk taking
capacity They also furnish the necessary technical consultancy services to the entrepreneurs so
that they may succeed in their innovative ventures.
6) Developing Backward Areas: The integral policy of the national development plans of every
country concentrates on the development of relatively less developed areas called backward
areas. The financial institutions provid a package of services, infrastructure and incentives
conducive to a healthy growth of industries such backward areas
SHORT NOTES
The Reserve Bank of India
The Reserve Bank of India (RBI), established on April 1, 1935, under the Reserve Bank of
India Act, 1934, is the central bank of India and plays a critical role in the Indian financial
system. It was originally set up to respond to economic issues after World War I, and since its
inception, it has become a cornerstone of the Indian economy, tasked with the responsibility of
managing the country’s monetary policy and ensuring financial stability.
Key Functions of the RBI:
1. Monetary Authority: The RBI formulates and implements monetary policy with the
primary objective of maintaining price stability while also considering economic
growth. It manages inflation and controls liquidity in the economy by adjusting interest
rates and the money supply.
2. Regulator of the Financial System: As the regulator of India’s financial system, the
RBI supervises and regulates commercial banks, cooperative banks, non-banking
financial companies (NBFCs), and other financial institutions. It ensures that these
entities operate in a sound and stable manner, safeguarding the interests of depositors
and maintaining public confidence in the financial system.
3. Issuer of Currency: The RBI is the sole authority for issuing and managing currency
in India. It ensures the availability of an adequate supply of clean and secure banknotes
and coins to meet the public demand and also manages the design, production, and
distribution of currency.
4. Manager of Foreign Exchange: The RBI manages India’s foreign exchange reserves
and regulates the foreign exchange market. It oversees foreign exchange transactions,
ensures the stability of the Indian rupee, and facilitates trade and investment flows
between India and the rest of the world.
5. Banker to the Government: The RBI acts as the banker to both the central and state
governments, handling their banking transactions, managing public debt, and providing
financial advice. It also plays a key role in managing government accounts and
disbursements.
6. Developmental Role: The RBI is instrumental in promoting financial inclusion,
expanding banking services to unbanked regions, and supporting rural development and
small enterprises. It also plays a significant role in fostering innovation in the banking
and financial sectors
Securities and Exchange Board of India (SEBI)
The Securities and Exchange Board of India (SEBI) was established in 1988 and given
statutory powers on April 12, 1992, under the SEBI Act, 1992. SEBI serves as the regulatory
authority for the securities market in India, with the primary objective of protecting the interests
of investors and promoting the development of a fair and efficient capital market.
Key Functions of SEBI:
1. Regulation of the Securities Market: SEBI regulates stock exchanges, securities
transactions, and other market intermediaries to ensure transparency, efficiency, and
fairness in the market. It sets rules and guidelines for the functioning of these entities
and oversees compliance with these regulations.
2. Protection of Investors’ Interests: One of SEBI’s primary roles is to protect investors
from fraudulent and unfair practices in the securities market. It ensures that companies
and intermediaries disclose accurate and timely information, helping investors make
informed decisions. SEBI also takes action against market malpractices, such as insider
trading and price manipulation.
3. Development of the Securities Market: SEBI works to promote and develop the
Indian securities market by introducing reforms, modernizing trading systems, and
encouraging innovation. It aims to create a conducive environment for capital formation
and investment by improving market infrastructure and processes.
4. Regulation of Market Intermediaries: SEBI regulates and oversees various market
intermediaries, including brokers, merchant bankers, portfolio managers, and mutual
funds. It ensures that these entities operate with integrity and professionalism, adhering
to the regulatory framework.
5. Enforcement and Supervision: SEBI has the authority to investigate and enforce
actions against any violations of securities laws. It can impose penalties, suspend
trading, and take legal action against offenders to maintain market integrity and investor
confidence.
Importance: SEBI plays a crucial role in ensuring that the Indian securities market functions
smoothly, fairly, and transparently. By protecting investors and regulating market participants,
SEBI fosters trust in the financial markets, which is essential for attracting domestic and foreign
investments. Its efforts contribute significantly to the growth and stability of India's capital
markets, making it a key institution in the country's financial ecosystem
Insurance Regulatory and Development Authority of India (IRDAI)
The Insurance Regulatory and Development Authority of India (IRDAI) is the regulatory body
responsible for overseeing and regulating the insurance industry in India. Established in 1999
under the IRDA Act, 1999, IRDAI’s primary objective is to protect policyholders' interests and
promote the orderly growth of the insurance industry.
Key Functions of IRDAI:
1. Regulation and Supervision of Insurance Companies: IRDAI regulates all insurance
companies in India, including life insurance, general insurance, and health insurance
providers. It ensures that these companies operate in a financially sound manner,
comply with regulations, and maintain solvency to meet policyholders' claims.
2. Protection of Policyholders’ Interests: IRDAI is committed to safeguarding the
interests of policyholders. It ensures that insurance companies provide transparent
information about their products, adhere to fair practices, and promptly address
customer grievances. IRDAI also provides guidelines for claims settlement, ensuring
policyholders receive timely and fair compensation.
3. Promotion of Insurance Industry Development: IRDAI works to promote the growth
and expansion of the insurance sector in India. It encourages competition among
insurance providers, fosters innovation in insurance products, and aims to increase
insurance penetration across the country, particularly in rural and underserved areas.
4. Framing and Enforcing Regulations: IRDAI formulates and enforces regulations that
govern the operations of insurance companies and intermediaries, such as agents and
brokers. These regulations cover various aspects, including product approvals, pricing,
market conduct, and investment guidelines.
5. Licensing and Registration: IRDAI is responsible for issuing licenses to insurance
companies, agents, brokers, and other intermediaries. It ensures that only qualified and
reliable entities are allowed to operate in the insurance market, thereby maintaining the
integrity and credibility of the industry.
6. Consumer Education and Awareness: IRDAI undertakes initiatives to educate
consumers about insurance products, their rights, and the benefits of insurance. It aims
to empower consumers to make informed decisions and increase awareness about the
importance of insurance.
Importance: IRDAI plays a vital role in ensuring the stability, transparency, and
trustworthiness of the insurance sector in India. By regulating the industry, protecting
policyholders, and promoting its growth, IRDAI helps in building a robust insurance market
that contributes to the financial security of individuals and businesses across the country. Its
efforts are crucial in increasing insurance penetration and ensuring that the benefits of
insurance reach all segments of society.
Pension Fund Regulatory and Development Authority of India (PFRDA)
The Pension Fund Regulatory and Development Authority of India (PFRDA) is the regulatory body
responsible for overseeing and promoting the pension sector in India. It was established in 2003 by the
Government of India and given statutory status in 2013 under the PFRDA Act, 2013. PFRDA plays a
crucial role in ensuring that the retirement savings of individuals are managed prudently and securely.
Key Functions of PFRDA:
1) Regulation and Supervision of Pension Schemes: PFRDA regulates and supervises pension
schemes such as the National Pension System (NPS) and the Atal Pension Yojana (APY). It
ensures that these schemes are managed efficiently, transparently, and in the best interests of
subscribers
2) Protection of Subscribers’ Interests: PFRDA is committed to protecting the interests of
pension scheme subscribers. It ensures that pension funds are invested in a manner that balances
growth and security, and it establishes guidelines to ensure transparency and fairness in the
management of pension funds.
3) Development of the Pension Sector: PFRDA promotes the development of the pension sector
by encouraging participation in pension schemes, especially among unorganized workers and
the self-employed. It works to increase awareness about the importance of retirement planning
and pension savings.
4) Licensing and Regulation of Pension Fund Managers: PFRDA licenses and regulates
pension fund managers (PFMs) who are responsible for managing the investment of pension
funds. It sets investment guidelines and monitors the performance of PFMs to ensure that they
act in the best interest of subscribers.
5) Framing and Enforcing Regulations: PFRDA formulates and enforces regulations related to
the operation of pension schemes and the conduct of pension fund managers and intermediaries.
It also issues guidelines for the governance, transparency, and disclosure standards in the
pension sector.
6) Promotion of Retirement Savings: PFRDA actively promotes retirement savings through the
NPS and other pension schemes. It encourages individuals to save for their retirement and aims
to create a robust pension system that can provide financial security to individuals in their old
age.
Importance:
PFRDA plays a critical role in ensuring the sustainability and effectiveness of the pension system in
India. By regulating and developing the pension sector, it helps millions of individuals secure their
financial future post-retirement. PFRDA’s efforts are essential in expanding the coverage of pension
schemes across the country, particularly among the unorganized workforce, thereby contributing to the
overall financial security and stability of the population.