UM23BC143A

INDIAN FINANCIAL SYSTEM

Unit I - Introduction to Financial System
Introduction:

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.
Thus, a 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.
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. It is a composition of various institutions, markets,
regulations and laws, practices, money manager, analysts, transactions and claims and liabilities.

Seekers of funds Flow of Funds (Savings) Suppliers of funds

(mainly business (mainly
firms and households)

Incomes and Financial

Claims

The word “system”, in the term “financial system”, implies a set of complex and closelyconnected
or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the
economy. The financial system is concerned about money, credit and finance – the three terms are
intimately related, yet are somewhat different from each other. Indian financial system consists of
financial market, financial instruments and financial intermediation.

Meaning and Definition of Financial System

The financial system is possibly the most important institutional and functional vehicle for economic
transformation. Finance is a bridge between the present and the future and whether it be the
mobilization of savings or their efficient, effective and equitable allocation for investment, it is the
success with which the financial system performs its functions that sets the pace for the achievement
of broader national objectives.

According to Christy, the objective of the financial system is to “supply funds to various sectors
and activities of the economy in ways that promote the fullest possible utilization of resources
without the destabilizing consequence of price level changes or unnecessary interference with
individual desires”.

According to Robinson, the primary function of the system is “to provide a link between savings and
investment for the creation of new wealth and to permit portfolio adjustment in the composition of the existing
wealth”.

FEATURES OF INDIAN FINANCIAL SYSTEM:

• It plays a vital role in economic development of a country.
• It encourages both savings and investment.
• It links savers and investors.
• It helps in capital formation.
• It helps in allocation of risk.
• It facilitates expansion of financial markets.
• It is a set of interrelated activities or services. 2.
• Services are working together to achieve some predetermined goal or purpose.
 • The system allows transfer of money between savers and investors.
• Financial system is applicable to firm, regional and global levels.
• The financial system can be understood with reference to its institutions, instruments, services
and markets.
• The major objective of the financial system is to formulate capital, investment and profit
generation.

Functions of Financial System

A good financial system serves in the following ways:

1) Link between Savers and Investors: One of the important functions of a financial system
isto link the savers and investors and thereby help in mobilizing and allocating the
savings efficiently and effectively. By acting as an efficient medium for allocation of resources, it
permits continuous up gradation of technologies for promoting growth on a sustained basis.
2) Helps in Projects Selection: A financial system not only helps in selecting projects to be
funded but also inspires the operators to monitor the performance of the investment. It
provides a payment mechanism for the exchange of goods and services, and transfers
economic resources through time and across geographic regions and industries.
3) Allocation of Risk: One of the most important functions of a financial system is to achieve
optimum allocation of risk bearing. It limits, pools, and trades the risks involved in
mobilizing savings and allocating credit. An efficient financial system aims at containing
riskwithin acceptable limits and reducing the cost of gathering and analyzing information
to assist operators in taking decisions carefully.
4) Information Available: It makes available price-related information which is a valuable
assistance to those who need to take economic and financial decisions.
5) Minimizes Situations of Asymmetric Information: A financial system minimizes
situations where the information is asymmetric and likely to affect motivations among
operators or when one party has the information and the other party does not. It provides
financial services such as insurance and pension and offers portfolio adjustment facilities.
6) Reduce Cost of Transaction and Borrowing: A financial system helps in the creation of
a financial structure that lowers the cost of transactions. This has a beneficial influence on
the rate of return to savers. It also reduces the cost of borrowing. Thus, the system
generates an impulse among the people to save more.
7) Promotion of Liquidity: The major function of the financial system is the provision of
money and monetary assets for the production of goods and services. There should not
beany shortage of money for productive ventures. In financial language, the money and
monetary assets are referred to as liquidity. In other words, the liquidity refers to cash or
money and other assets which can be converted into cash readily without loss. Hence, all
activities in a financial system are related to liquidity – either provision of liquidity or
tradingin liquidity.
8) Financial Deepening and Broadening: A well-functioning financial system helps in
promoting the process of financial deepening and broadening. Financial deepening
refers to an increase of financial assets as a percentage of the Gross Domestic Product
(GDP). Financial broadening refers to building an increasing number and a variety of
participants and instruments.
COMPONENTS/ CONSTITUENTS OF INDIAN FINANCIAL SYSTEM

The financial system consists of four segments or components. These are: financial institutions,
financial markets, financial instruments, and financial services.
1) Financial Institutions: Financial institutions are intermediaries that mobilize savings
and facilitate the allocution of funds in an efficient manner.
Financial institutions can be classified as banking and non-banking financial institutions.
Banking institutions are creators of credit while non-banking financial institutions are purveyors
of credit. While the liabilities of banks are part of the money supply, this may not be true of
non-banking financial institutions. In India, non-banking financial institutions, namely, the
Developmental Financial Institutions (DFIs) and Non-Banking Financial Companies (NBFCs)
as well as housing finance companies (HFCs) are the major institutionalpurveyors of credit.
Financial institutions can also be classified as term-finance institutions such as the Industrial
Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India
(ICICI), Industrial Financial Corporation of India (IFCI), Small Industries DevelopmentBank
of India (SIDBI) and Industrial Investment Bank of India (IIBI).
2) Financial Markets: Financial markets are a mechanism enabling participants to deal in
financial claims. The markets also provide a facility in which their demands and
requirements interact to set a price for such claims.
The main organized financial markets in India are the money market and capital market. The
first is a market for short-term securities while the second is a market for long term securities,
that is, securities having a maturity period of one year or more.
3) Financial Instruments: A financial instrument is a claim against a person or an institution
for the payment at a future date a sum of money and/or a periodic payment in the form of
interest or dividend. The term „and/or‟ implies that either of the payments will be
sufficient but both of them may be promised.
Financial securities may be primary or secondary securities:
i) Primary Securities: Primary securities are also termed as direct securities as they are
directly issued by the ultimate borrowers of funds to the ultimate savers. For
example, primary or direct securities include equity shares and debentures.
ii) Secondary Securities: Secondary securities are also referred to as indirect securities,
as they are issued by the financial intermediaries to the ultimate savers. Mutual fund
units, insurance policies and bank deposits are secondary securities.

Financial instruments differ in terms of marketability, liquidity, reversibility, type of options,

return, risk and transaction costs. Financial instruments help the financial markets and the
financial intermediaries to perform the important role of channelizing funds from lenders to
borrowers.

4) Financial Services: Financial intermediaries provide key financial services such as

merchant banking, leasing, hire purchase, credit-rating, and so on. Financial services
rendered by the financial intermediaries’ bridge the gap between lack of knowledge on the
part of investors andincreasing sophistication of financial instruments and markets. These
financial services are vitalfor creation of firms, industrial expansion, and economic growth.
Before investors lend money, they need to be reassured that it is safe to exchange securities for
funds. This reassurance is provided by the financial regulator who regulates the conductof the
market, and intermediaries to protect the investors‟ interests. The Reserve Bank of India regulates
the money market and Securities and Exchange Board of India (SEBI)regulates capital market.
Financial System and Economic Development
Financial institutions and markets are together called the financial system. This financial system is the
backbone of the national economy. This is because the efficiency with which the financial system works plays
a very important role in the economic development of a nation. The role of the financial system may not be
apparent since we assume its existence to be a given. However, when we do start paying attention to the
financial system, it is easy to see why it plays a foundational role in the economic development of a country.
The following points explain how financial systems play an important role in the economic development of a
nation.
Interest Rates Stabilization: The financial system ensures that all the organizations and institutions which it
is composed of, behave as one unified system. Generally, healthy competition is promoted between the
members of the system. This means that members have to compete with each other by lowering their costs.
As a result, the benefits of lower interest rates are passed on to the consumers. It is the existence of the financial
system, which ensures that interest rates remain stable across the country. The banking system led by a central
bank makes this possible. In the absence of a financial system, each region would have its own interest rate
based on the availability of capital.
Aids Trade and Commerce: Credit risk has always been the main factor that inhibits trade and commerce.
If a seller is not sure about whether they will get paid for the goods which they sold, then they will not sell
more goods till the earlier payment has been received. This reduces inventory turnaround and leads to a decline
in trade and commerce. Financial systems ensure quick and timely payment. With the advent of advanced
technology, it is now possible to remit money to any part of the world within a few seconds. Hence, financial
markets and institutions aid in trade and commerce and even improve the gross domestic product of a country.
Aids International Trade: The risks inherent in trade and commerce get multiplied several times when it
comes to international trade. This is because firstly, the seller and buyer, are in different legal jurisdictions.
Hence, the enforceability of contracts is reduced. Secondly, the quantity of goods involved in import and
export transactions is extremely large. Hence, the outstanding amounts also become large, and this ends up
increasing the overall risk in the transaction.
Aids in Attracting Capital: Stable financial markets raise investor confidence. As a result, investors from
domestic as well as international markets start investing in the capital markets. As a result, more capital
becomes available to domestic companies. They can then use this capital to increase economies of scale,
which makes them more competitive in the international market. If these financial institutions and markets
were not present, foreign investors would find it very difficult to locate investment opportunities and follow
through with them.
Aids Infrastructure Development: Financial markets play a vital role in infrastructure development, as well.
This is because the private sector may face great difficulties in raising large amounts of funds for projects
with a high gestation period. It is the financial markets that provide the liquidity required by investors.
Investors can sell their securities and cash out whenever they want. It is not important for the same investor
to hold on to the security for the entire tenure of the loan. Key sectors like power generation, oil, and gas,
transport, telecommunication, and railways receive a lot of funding at concessional rates thanks to the
financial markets. Financial markets also allow governments to raise large sums of money. This enables them
to continue deficit spending.
Help in Employment Creation: The financial system provides capital to entrepreneurs who want to start a
business. When these businesses come into existence, they, directly and indirectly, require the services of a
wide variety of personnel. As a result, a lot of employment is generated in the economy. The financial services
sector provides a lot of employment. Many of these jobs are high paying white-collar positions that are capable
of bringing the employed person into the middle class.

ROLE OF FINANCIAL SYSTEM IN THE ECONOMIC DEVELOPMENT OF THE COUNTRY

An effective financial system in the country offers a variety of financial products and services to suit the
different requirements of the investing public and corporate. The financial system plays the following role in
the economic development of the country & provides the following benefits:
1. Help to form huge financial resources through mobilization of savings of the public and corporate
2. Promote investment in agriculture, manufacturing and service industries by providing the necessary finance
for the cultivation of land, production of goods and provision of services
3. Transfer surplus funds from one part of the economy to another keeping in mind the national priorities
4. Encourage people to divert their physical assets into financial assets and make it available for balanced
growth of trade, commerce, agriculture, manufacturing and service industries
5. Provide mechanism to control the risk and uncertainties
6. Multiply the monetary resources by the process of credit creation
7. Provide a variety of financial assets to suit the different needs of investing public and corporate
8. Encourage entrepreneurial skills among the public 9. Increase the growth rate of the economy

An overview on Indian financial system

The history of the Indian financial system dates back to ancient times, with the evolution of various
financial practices and institutions. Here is a brief overview of the key milestones in the history
of the Indian financial system:

Ancient and Medieval Period:

During ancient and medieval times, India had a well-developed financial system. Merchants and
moneylenders played a significant role in providing credit and financial services. Indigenous
banking systems like hundis (bill of exchange) and sarrafs (moneychangers) facilitated trade and
commerce. Temples and guilds also acted as financial intermediaries, collecting deposits and
extending loans.

Colonial Era (17th to 19th Century):

During the colonial period, the East India Company established its presence in India, leading to
the introduction of Western banking practices. The establishment of the Bank of Hindostan in
1770 and the Bank of Calcutta (later renamed the Bank of Bengal) in 1806 marked the beginning
of formal banking in India. These banks primarily catered to European businesses and served as a
source of capital for British interests.

Pre-Independence era, especially the period of 1857 to 1947, was a mixed bag for the re-birth of
the modern “Indian Financial System”. In this era, the financial system was highly informal with
elementary financial market structures. Financial intermediaries were taking some shape and
capital flow for long-term financing was non-existent.

Post-Independence (1947 onwards):

After India gained independence in 1947, the country embarked on a path of economic
development. The government took several measures to establish a robust financial system:

a. Nationalization of Banks:
In 1969, the government nationalized 14 major commercial banks, followed by another six in
1980. This move aimed to promote financial inclusion, increase access to credit, and direct credit
towards priority sectors, such as agriculture and small-scale industries.

b. Establishment of Development Financial Institutions (DFIs):

The government established DFIs to provide long-term financing for industrial and infrastructure
development. Institutions like the Industrial Development Bank of India (IDBI), the Industrial
Finance Corporation of India (IFCI), and the National Housing Bank (NHB) played crucial roles
in funding industrial and housing projects.

c. Introduction of Capital Market Reforms:

The establishment of the Securities and Exchange Board of India (SEBI) in 1988 marked a
significant milestone in regulating and developing the capital markets. SEBI introduced reforms
to promote transparency, investor protection, and market integrity. The National Stock Exchange
(NSE) and the Bombay Stock Exchange (BSE) emerged as prominent stock exchanges.

d. Liberalization and Financial Sector Reforms:

In the 1990s, India initiated economic liberalization and financial sector reforms. This included
 relaxation of regulations, encouraging foreign direct investment (FDI), and promoting private
sector participation in banking, insurance, and mutual funds. The Reserve Bank of India (RBI)
implemented various measures to strengthen the banking system and improve prudential norms.

e. Technological Advancements and Digitalization:

With the advancement of technology, the Indian financial system witnessed a significant shift
towards digitalization. The introduction of electronic fund transfers, online banking, and mobile
payment systems revolutionized the way financial transactions were conducted.

Today, the Indian financial system is a dynamic and rapidly evolving landscape. It encompasses a
diverse range of banks, non-banking financial institutions, insurance companies, capital markets, and
regulatory bodies. Efforts continue to deepen financial inclusion, promote innovation, strengthen risk
management frameworks, and adapt to changing market dynamics.

Financial Intermediary
A financial intermediary refers to a third-party, forming environment for conducting financial transactions
between different parties. A financial intermediary is an entity that acts as the middleman between two parties
in a financial transaction, such as a commercial bank, investment bank, mutual fund, or pension fund. Financial
intermediaries offer a number of benefits to the average consumer, including safety, liquidity, and economies of
scale involved in banking and asset management. Although in certain areas, such as investing, advances in
technology threaten to eliminate the financial intermediary, disintermediation is much less of a threat in other
areas of finance, including banking and insurance.
For example, the banks accepting deposits from customers and lending them to the customers who need money
exemplifies the basic financial intermediation process.

Role of Financial Intermediary

1. Link households to the financial market

2. They safeguard customers’ hard-earned money

3. Financial advisory services, provide financial information, and engage in credit rating

4. Reducing the cost of business by offering economies of scale to business owners

5. It helps corporations optimize the capital structure

6. by obtaining an appropriate mix of equity and debt

7. Stimulate economic development

Types of Financial Intermediary

Various types of entities provide financial intermediary services ranging from banking institutions accepting
deposits like Federal Reserve Banks, commercial banks, savings banks, and other depository organizations like
credit unions to entities that do not take deposits such as NBFCs.

Other types from the insurance sector include property insurance companies, private life insurance
organizations, and government insurances. Furthermore, stock exchanges, investment banks, brokers, dealers,
and clearinghouses are some examples signifying the heterogeneity in types.

It can also be segregated based on the source of their funds as primary and secondary financial intermediaries.
The primary intermediary entities collect their funds from households, business enterprises, or governments and
provide loan services to the same groups. In contrast, secondary intermediaries deal with the primary
intermediary entities. An example of secondary intermediaries is factoring companies.

Financial intermediaries: Examples

There are numerous companies or institutions that act as financial intermediaries. These include, for example:

Banks: lending and borrowing money is simplified

Stock exchanges: Trading in shares and other stock exchange products will be centralised and thus more easily
accessible for buyers and sellers
Pension funds: Future pensioners pay the pensions of current pensioners
Factoring provider: Factoring clients receive money from the factoring provider for their outstanding receivables
and thus liquidity
Insurance: For money, insurance companies protect their customers against certain risks

Advantages of financial intermediaries

The biggest advantage of financial intermediaries is that they create a central market where financial transactions
can be conducted. By scaling financial intermediaries appropriately, bureaucracy is kept to a minimum and
experts take care of advising clients and processing transactions. This in turn is cost-efficient for the clients.

Another advantage is that large financial intermediaries can spread their risks very widely by investing the
money or premiums paid in by their clients in a variety of financial products. This also reduces the risk for the
clients.

In addition, it is easier for clients to make use of special financial services, because with the financial
intermediary they have a contact person who can point out solutions.

Disadvantages of financial intermediaries

The biggest disadvantage of financial intermediaries is that they pursue their own interests. This means that they
mainly recommend products that they either offer themselves or receive a commission from other providers.
Clients therefore avoid a bad investment by comparing similar offers from different financial intermediaries.

Another disadvantage is that fees are charged for the services of the financial intermediary, since the latter
ultimately has to cover its own costs and wants to make a profit. For this reason, some financial transactions in
which buyers and sellers come into direct contact with each other are more cost-effective, e.g. direct trading on
the stock exchange.

Major Reforms after 1991 in Financial System

The reforms have had a broad sweep encompassing operational matters, banking, primary and secondary stock
markets, government securities market, external sector policies, and the system as a whole. These have been
classified into three areas: issues relating to creating a flexible banking system; development of institutions such
as private sector banks and mutual funds; and monetary policy instruments such as interest rates, reserve ratios,
and refinancing facilities. In other words, reforms relate to the issues of ownership and control, competition, and
policy and regulation stance.
Systemic and Policy Reforms

1. Most of the interest rates in the economy deregulated; a beginning made to move towards market
rates on government securities: the system of administered interest rates largely dismantled; and
the structure of interest rates greatly simplified.

2. The preemption of banks‟ resources through SLR in favor of the government was brought down
and the rate of return on SLR securities is maintained by and large at market rates. The SLR on
incremental net domestic and time liabilities (NDTL) of banks reduced from 38.5 percent in 1991-
92 to 24 percent now.

3. Capital adequacy norms for banks, financial institutions, and virtually all market intermediaries
introduced. The Basel Committee framework for capital adequacy adopted.

4. A Board of Financial Supervision (BFS) with an advisory council and an independent department
of supervision established in RBI.

5. Recovery of Debts Due to Banks and Financial Institutions Act, 1993 passed to set up Special
Recovery Tribunals to facilitate quicker recovery of loan arrears.

6. In order to moderate or minimize the automatic monetization of the budget deficit, the agreement
to impose a ceiling on the issue of ad hoc Treasury Bills (TBs) and to phase them out in due course
signed by the Government of India (GOI) and RBI in September 1994. Subsequently, the system of
ad hoc treasury bills abolished and replaced by the system of Ways and Means Advances effective
April 1, 1997.
7. The private sector was allowed to set up banks, mutual funds, money market mutual funds,
insurance companies, etc. Public sector banks permitted diversified ownership by law subject to
51 percent holding of government/RBI. SBI, IFCI and IRBI converted into public limited
companies.

8. Capital Issues (Control) Act, 1947 repealed and the office of Controller of Capital Issues abolished.

9. Securities and Exchange Board of India (SEBI) made a statutory body in February 1992 and armed
with necessary authority and powers for regulation and reform of the capital market.

10. Convertibility clause is no longer obligatory in the case of assistance sanctioned by term lending
institutions.

11. Floating interest rate on financial assistance (linked to interest rate on 364 – day TBs) introduced
by all-India development banks.

12. The Reserve Bank of India (Amendment) Act 1997 passed requiring all non-bank financial
companies (NBFCs) with net-owned funds of Rs.25 lacs and more to register with the RBI.

13. Over the Counter Exchange of India (OTCEI) and the National Stock Exchange (NSE) with nation-
wide stock trading and electronic display, clearing and settlement facilities established and made
operational.

Banking Reforms

1. Interest rates on deposits and advances of all co-operative banks including urban cooperative
banks deregulated. Similarly interest rates on commercial bank loans above Rs.2 lacs, and on
domestic term deposits above two years, and Non-Resident (External) Rupee Accounts [NRNR]
deposits decontrolled.

2. The State Bank of India and other nationalized banks enabled to access the capital market for debt
and equity.

3. Prudential norms for income recognition, classification of assets and provisioning for bad debts
for commercial banks, including regional rural banks and financial institutions introduced. They
are required to adopt uniform and sound accounting practices in respect of these matters, and the
valuation of investments. Banks are required to mark to market the securities held by them.

4. The Performance Obligations and Commitments (PO & C) obtained by RBI from each bank; they
provide for essential quantifiable performance parameters which lay emphasis on increased but
low-cost deposits, quality lending, generation of more income and profits, compliance with
priority sectors and export lending requirements, improvement in the quality of investments,
reduction in expenditure, and stepping up of staff productivity.

5. Banks required making their balance sheets fully transparent and making full disclosures in
keeping with International Accounts Standards Committee.

6. Banks given greater freedom to open, shift, and swap branches as also to open extension counters.

7. The perceived constraints on banks such as prior credit authorization, inventory and receivables
norms, obligatory consortium lending and curbs in respect of project finance relaxed.

8. The budgetary support extended for recapitalization of weak public sector banks.

9. Banking Ombudsman Scheme 1995 introduced to appoint 15 ombudsmen (by RBI) to look into
and resolve customers‟ grievances in a quick and inexpensive manner. Most of the
recommendations of Goiporia Committee in connection with improving customer service by
banks implemented.

10. Banks set free to fix their own foreign exchange open position limit subject to RBI approval.

11. Loan system introduced for delivery of bank credit. Banks were required bifurcate the maximum
permissible bank finance into loan component (short-term working capital loan) and cash credit
 component, and the policy of progressively increasing the share of the former introduced.

Primary and Secondary Stock Market Reforms

1. Primary issues to be made compulsory through the Depository Mode after a specified date.

2. 100 per cent Book Building in respect of issues of Rs. 25 crore and above.

3. Reduction in the number of mandatory collection centres in respect of issues above Rs. 10 crore
to four metropolitan cities

4. A norm of five shareholders for every Rs.1 lac of fresh issues of capital and 10 shareholders for
every Rs.1 lac of offer for sale prescribed as an initial and continuing listing requirement.

5. The payment of any direct or indirect discounts or commissions to persons receiving firm
allotment prohibited.

6. Debt issues not accompanied by an equity component permitted to be sold entirely by the
bookbuilding process.

7. Housing finance companies considered to be registered for issue purposes, provided they are
eligible for refinance from the National Housing Bank.

8. Issuers were allowed to list debt securities on stock exchanges without their equity being listed.
Mutual funds permitted to underwrite public issues.

9. The stock exchanges required to disclose, carry forward position scrip-wise and broker-wise at
the beginning of carry forward session.

10. A ceiling of Rs.10 crore imposed on stock market members doing business of financing carry
forward transactions.

11. Depositories Act, 1996 passed to provide a legal framework for the establishment of depositories
to record ownership details in book entry form, and to facilitate dematerialization of securities.

12. Stock lending scheme without attracting capital gains introduced. Under this scheme, short sellers
can borrow securities through an intermediary before making such sales.

13. Stock exchanges asked to modify listing agreements in order to provide for the payment of
interest by companies to investors from the 30th day of the closure of public issue.

14. All stock exchanges required to institute the buy-in or auction process.

15. Stock exchanges was asked to collect 100 percent daily margins on the notional loss of a broker
for every scrip, to restrict gross traded value to 33.33 times the broker‟s base minimum capital,
and to impose quarterly margins on the basis of concentration ratios.

16. The stock exchanges are being modernized; many of them have introduced electronic trading
system; the Bombay Stock Exchange has started its on-line trading system, BOLT.

17. The Bombay Stock Exchange and other exchanges with screen-based trading system were allowed
to expand their trading terminals to locations where no stock exchange exists and to others
subject to an understanding with the local stock exchange.

18. Both short and long sales are required to be disclosed to the exchange at the end of each day, and
they are to be regulated through the imposition of margins.

19. There are many other stock market reforms which have been introduced during the past five to
six years.

Government Securities Market Reforms

1. A 364-day treasury bill (TB) replaced the 182-day TB in 1992-93, and it is being sold by fortnightly
 auction since April 1992.

2. Auction of 91-day TB commenced from January 1993.

3. Maturity period for new issues of Central government securities shortened from 20 to 10 years
and that for state government securities from 15 to 10 years.

4. Funding of Auction TBs into fixed coupon dated securities at the option of holders introduced
since April 19, 1993.

5. Six new instruments were introduced:

i) zero coupon bonds on 18.1.94,

ii) tap stock on 29.7.94,

iii) partly-paid government stock on 15.11.94,

iv) an instrument combining the features of tap and partly-paid stocks on 11-9-95,

v) Floating rate bonds on 29.9.95,

vi) Capital indexed bonds in 1997.

6. State governments and provident funds allowed participating in 91-day TB auctions on a non-
competitive basis from August 1994.

7. A scheme for auction of government securities from RBI‟s own portfolio as a part of its open
market operations announced in March 1995.

8. The institution of primary dealers in government securities market established and guidelines for
them issued in March 1995.

9. A system of Delivery vs. Payment (DVP) in Subsidiary General Ledger (SGL) transactions
introduced in Bombay in July 1995.

10. Reverse repo facility with RBI in government dated securities extended to Discount and Finance
House of India (DFHI) and Securities Trading Corporation of India (STCI).

External Financial Market Reforms

1. Flexible exchange rate system introduced and exchange controls largely dismantled.

2. Foreign Institutional Investors (FIIs) allowed access to Indian capital market on registration with
SEBI. FIIs permitted to invest up to 10 percent in equity of any company, to invest in unlisted
companies, to set up pure (100 percent) debt funds, and to invest in government securities.
Foreign endowment funds, university funds, foundations and charitable trusts/societies are
allowed to register as FIIs.

3. Indian companies permitted to access international capital markets through various instruments
including euro-equity issues.

4. The Union Budget 1997-98 proposed the replacement of Foreign Exchange Regulation Act
(FERA), 1973 by a Foreign Exchange Management Act (FEMA) to facilitate easy capital flows.

5. Rupee made convertible on current account and a considerable progress made in introducing
capital account convertibility.

6. The rate of long-term capital gains tax on portfolio investments by NRIs reduced from 20 percent
to 10 percent and brought on par with the rate for FIIs.

7. NRIs, OCBs, FIIs permitted to invest up to 24 percent in equities of Indian companies engaged in
all activities except those of agriculture and plantation.
 8. In case of medium- and long-term external commercial borrowings (ECBs), on lending of the
proceeds of development finance institutions to different borrowers at different maturities
permitted.

9. Companies permitted to retain euro-issue proceeds as foreign currency deposits with banks and
public financial institutions in India. Further, companies permitted to remit funds into India in
anticipation of the use of funds for general corporate restructuring and working capital needs.

10. RBI made a single-window agency for receipt and disposal of proposals for overseas investments
by Indian companies. The Foreign Investment Promotion Board (FIPB) reconstituted and Foreign
Investment Promotion Council (FIPC) set up to promote foreign direct investment in India

Formal and Informal Financial Sectors

Financial sectors
The financial sector is a section of the economy made up of firms and institutions that provide financial
services to commercial and retail customers. This sector comprises a broad range of industries including
banks, investment companies, insurance companies, and real estate firms.

Classification of financial sectors

The Indian financial system can be classified into the formal financial sector and the informal financial
sector. The formal financial sector comprises of network of banks, other financial and investment institutions
and a range of financial instruments. The informal financial sector comprises of moneylenders, indigenous
bankers, lending pawn brokers, landlords, traders etc.,

FORMAL FINANCIAL SECTOR

 Formal financial institutions often ignore small farmers, lower income households, and small
scale enterprises in favor of large scale, well-off, literate clientele who can satisfy their stringent
loan conditions.

 Complex administrative services procedures are beyond the knowledge and understanding of
rural masses and small savers.

 Formal financial institutions do not mobilize rural savings or small scale deposits.

 Formal sectors of institutions are selective regarding their clients, so as to avoid any clients who
make small deposits.

 Loan application procedures are very complex and need reading and writing skills so that a file
on the borrower may be established.

 The transaction costs are high and the repayment costs are low.

 The formal sector regularly has loanable funds available.

 The formal sector keeps written records on the activities of the clients.

INFORMAL FINANCIAL SECTORS

 The informal financial sector provides savings and credit facilities for small scale farmers in
rural areas, and the lower income households and small scale enterprises in urban areas.

 The procedures of the informal schemes are usually simple and straightforward as they emanate
the local cultures and customs they are easily understood by the population.

 The informal sector mobilizes rural savings and small savings from low income urban
households.

 Informal groups operate on the days which are convenient for their members.

 Informal sector associations accept any amount of regular savings, even the most modest sums
 which a saver can afford to set aside. The financial techniques on which some informal groups
are based lend themselves to the management of a large number of small savings.

 Transaction costs are low and repayment costs are high.

 The interest paid on the deposits in the informal sector compares favorably with that paid in the
formal sector, thus providing an incentive for rural and small urban households to save.

Comparing Formal and Informal Financial Sectors

Financial Instrument
Financial instruments are contracts for monetary assets that can be purchased, traded, created, modified, or
settled for. In terms of contracts, there is a contractual obligation between involved parties during a financial
instrument transaction.

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.

Types of Financial Instruments

1. Cash Instruments
Cash instruments are financial instruments with values directly influenced by the condition of the markets.
Within cash instruments, there are two types; securities and deposits, and loans.

Securities: A security is a financial instrument that has monetary value and is traded on the stock market. When
purchased or traded, a security represents ownership of a part of a publicly-traded company on the stock
exchange.

Deposits and Loans: Both deposits and loans are considered cash instruments because they represent monetary
assets that have some sort of contractual agreement between parties.

2. Derivative Instruments
Derivative instruments are financial instruments that have values determined from underlying assets, such as
resources, currency, bonds, stocks, and stock indexes. The five most common examples of derivatives
instruments are synthetic agreements, forwards, futures, options, and swaps. This is discussed in more detail
below.

Synthetic Agreement for Foreign Exchange (SAFE): A SAFE occurs in the over-the-counter (OTC) market
and is an agreement that guarantees a specified exchange rate during an agreed period of time.

Forward: A forward is a contract between two parties that involves customizable derivatives in which the
exchange occurs at the end of the contract at a specific price.

Future: A future is a derivative transaction that provides the exchange of derivatives on a determined future
date at a predetermined exchange rate.

Options: An option is an agreement between two parties in which the seller grants the buyer the right to purchase
or sell a certain number of derivatives at a predetermined price for a specific period of time.

Interest Rate Swap: An interest rate swap is a derivative agreement between two parties that involves the
swapping of interest rates where each party agrees to pay other interest rates on their loans in different currencies.

3. Foreign Exchange Instruments

Foreign exchange instruments are financial instruments that are represented on the foreign market and primarily
consist of currency agreements and derivatives. In terms of currency agreements, they can be broken into three
categories.
Spot: A currency agreement in which the actual exchange of currency is no later than the second working day
after the original date of the agreement. It is termed “spot” because the currency exchange is done “on the spot”
(limited timeframe).
Outright Forwards: A currency agreement in which the actual exchange of currency is done “forwardly” and
before the actual date of the agreed requirement. It is beneficial in cases of fluctuating exchange rates that change
often.
Currency Swap: A currency swap refers to the act of simultaneously buying and selling currencies with
different specified value dates.

Asset Classes of Financial Instruments

Beyond the types of financial instruments listed above, financial instruments can also be categorized into two
asset classes. The two asset classes of financial instruments are debt-based financial instruments and equity-
based financial instruments.

1. Debt-Based Financial Instruments

Debt-based financial instruments are categorized as mechanisms that an entity can use to increase the amount
of capital in a business. Examples include bonds, debentures, mortgages, U.S. treasuries, credit cards, and line
of credits (LOC).
They are a critical part of the business environment because they enable corporations to increase profitability
through growth in capital.

2. Equity-Based Financial Instruments

Equity-based financial instruments are categorized as mechanisms that serve as legal ownership of an entity.
Examples include common stock, convertible debentures, preferred stock, and transferable subscription rights.
They help businesses grow capital over a longer period of time compared to debt-based but benefit in the fact
that the owner is not responsible for paying back any sort of debt. A business that owns an equity-based financial
instrument can choose to either invest further in the instrument or sell it whenever they deem necessary

NARASIMHAN COMMITTEE RECOMMENDATION

Narasimhan is the most powerful banker of India post-independence. The way his reports – Narasimham
Committee on Financial System (1991) and the Narasimham Committee on Banking Sector Reforms (1998)
transformed the functionality of the Indian Banking sector is commendable. He is also known for pioneering
historical events such as bank mergers, asset reconstruction firms and the emergence of new-generation private
banks.

History of the Committee

1. The banks were not functioning properly during India’s economic liberalisation in 1991.

2. India felt the need for an efficient banking system that is required for a nation’s economic
development.

3. That is why ex-Finance Minister of India Dr. Manmohan Singh established the Narasimham
committee to examine the functioning of banks.
 4. On 14th August 1991, Government of India appointed a nine-member team called the
Narasimham Committee I. Its chairman was Maidavolu Narasimham.

5. From 2nd May 1977 to 30th November 1977, Narasimham remained the 13th governor of RBI.

6. The first report was introduced on 17th December 1991 in the parliament.

Recommendations of Narasimham Committee I

Reduction in SLR and CLR
At that time, both Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) were extremely high. The
SLR was 38.5%, and CRR was 15%. To increase the bank’s productivity rates, the committee recommended
reducing these high proportions. Accordingly, they suggested reducing SLR rates from 38.5% to 25% and CRR
from 15% to 3-5%.

Phasing out Directed Credit Programme

The Government of India implemented credit programmes that compelled banks to set aside funds for the needy
and poor sectors at decreased rates. The committee suggested phasing out this program as it was not profitable
for them.

Interest Rate Determination

Narasimham committee insisted on determining interest rates based on market forces such as the supply and
demand for funds. Earlier it was regulated by the Government of India. They suggested eliminating this process.

Establishment of the ARF Tribunal

The proportion of Non-Performing assets and bad debts of the public sector banks and developmental institutions
was very alarming then. The committee suggested the establishment of an Asset Reconstruction Fund (ARF) to
take over the proportion of bad and doubtful debts from banks and financial institutions.

Removal of Dual Control

Both RBI and the Banking Division under the Ministry of Finance regulated the banks at that time. The
committee suggested removing this system and asked only RBI to regulate the banking sector.

More Freedom to Banks

The committee suggested more freedom for banks. It suggested that every bank should be free and perform
autonomously. Each bank should change its working technology to align with the evolving world. On the sole
basis of professionalism and integrity, the Chief Executive and board of directors will be appointed.

Reorganization of the Banking Sector

The committee proposed to reduce the number of public sector banks through the process of acquisition and
mergers. The broad pattern, according to the committee, should consist of:

 Three or four large public sector banks like SBI should become international. The rest should
remain local banks and operate in a specified region.

 The committee recommended national recognition of 8 to 10 banks nationwide.

 RBI will permit the establishment of new banks under the private sector if they conform to the
minimum start-up capital. But, on the other hand, no new banks would be called national banks.

 Foreign banks can operate in India as either subsidiaries or fully owned banks. Foreign banks can
also set up joint ventures with Indian banks regarding investment banking.

Narasimham Committee-II (1998)

In order to intimate the second generation of financial sector reforms a committee on Banking Sector Reforms
was formed in 1998 again under the chairmanship of [Link]. The committee was submitted its report
on 23rd April 1998 by the finance minister of Government of India. Many of them have been accepted and are
under implementation. These mainly concentrate on strengthening the foundation of the banking system by
structure, technological upgradation and human resource development.

Recommendations of Narasimham Committee II

1. Stronger banking system: The committee suggested that the public sector banks that are highlighted should
merge or join each other which will in turn help in boosting trade in international countries. They also gave a
warning for joining stronger banks with all the weaker banks.
2. Narrow Banking: The committee introduced this concept and after this banks were given the permission to
use their funds in assets for the short term and those which are free from risk because at that time banks
invested in assets that gave them no return and they did not perform.
3. Reform in the role of RBI: The committee laid down that as RBI is the only bank that regulates all other
banks, RBI should not buy any bank or have ownership of any other bank.
4. Government Ownership: The committee said that government ownership can lead to mismanagement and
the banks having government ownership should be reviewed.
5. NPAs: The committee gave the decision of bringing down the rate of NPA to 3% before 2002. It was also said
by the committee that we should build asset reconstruction companies and that was finally built in 2002.
6. Capital Adequacy Ratio: The committee also proposed that the capital adequacy ratio’s norms should
expand.
7. Foreign banks: The previous capital that was required to start a foreign bank was $10 Million and then it was
increased to $25 Million.