Submitted by : Saraswathi Chandrashekhar PGPMX 2011-13, Term II Assignment 1

Submitted to : Dr Yogesh Maheshwari Financial System and Resources (Aug Dec11) October 3, 2011

Evolution of Indian Financial System : A Critical Review

Contents Page no What is a Financial system Three phases in evolution of Indian financial system Present day financial system of India Financial Markets Financial intermediation Financial Instruments Regulatory Environment 2 2 5 6 6 7 11

What is a Financial System ? The word System means an ordered, organized and comprehensive assemblage of facts, principles or components relating to a particular field and working for a specified purpose. The word system in the term financial system represents a set of closely held financial institutions, financial services and financial instruments or Claims. The financial system of a country can be defined as a set of organizations, instruments, markets, services and methods of operations, procedures that are closely interrelated with each other. A financial system is an Integral Part of a Modern Economy. The economic development of a nation is reflected by the progress of the various economic units, broadly classified into corporate sector, government and household sector. While performing their activities these units will be placed in a surplus/deficit/balanced budgetary situations. There are areas or people with surplus funds and there are those with a deficit. A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit.

The basic requirements for any financial system to be efficient are; Efficient Monetary System - indicates an efficiency medium of exchange for goods and services. Facilities for the creation of the capital- to meet the demands of the economy. The capital will be necessary to undertake the production activities. The financial system helps to meet such demands by mobilizing the savings of the surplus units to the demanding units. Efficient financial markets- and methodologies, which facilitate the process of transfer of resources and the conversion of financial claims into money. Complexities in the functions of the financial system, especially when the requirements of the savers and those of the borrowers did not match, created a need to enhance the financial system. THREE PHASES IN THE EVOLUTION OF INDIAN FINANCIAL SYSTEM I. PRE 1951 ORGANISATION Before 1951,the industry had minimum access to the savings of the savings-surplus units. It was due to weak financial system which was incapable of sustaining high rate of industrial growth basically for the new & innovating enterprises.

The Indian Financial System before independence closely resembled the model given by RL Benne in his theory of financial organization in a traditional economy. According to him in a traditional economy the per capita output is low and constant. Some principal features of the Indian Financial system before independence were: closed-circle character of industrial entrepreneurship; a narrow industrial securities market, absence of issuing institutions and no intermediaries in the long-term financing of the industry. Outside savings could not be invested in industry. That is, the savings of the financial system could not be channeled to investment opportunities in industrial sector. India's independence marked the end of a regime of the Laissez-faire for the Indian banking. The Government of India initiated measures to play an active role in the economic life of the nation, and the Industrial Policy Resolution adopted by the government in 1948 envisaged a mixed economy. This resulted into greater involvement of the state in different segments of the economy including banking and finance. The major steps to regulate banking included: The Reserve Bank of India, India's central banking authority, was nationalized on January 1, 1949 under the terms of the Reserve Bank of India (Transfer to Public Ownership) Act, 1948 (RBI, 2005b).[Reference www.rbi.org.in] In 1949, the Banking Regulation Act was enacted which empowered the Reserve Bank of India (RBI) "to regulate, control, and inspect the banks in India." The Banking Regulation Act also provided that no new bank or branch of an existing bank could be opened without a license from the RBI, and no two banks could have common directors.

II. 1951 to MID EIGHTIES Around 1951,Government adopted mixed economics pattern of industrial development. Hence, there was an introduction of planned economic development. Thus, distribution of credit & finance was under Government's control. The main element of the financial organisation in planned economic development are (1) Public/Government ownership of financial institution (2) Fortification of the institutional structure. (3) Protection to investors (4) Protection of financial institutions in corporate management. The evolution of the Indian financial system is from somewhat of a constricted and an undersized one to a more open, deregulated and market oriented one. The process of financial development in independent India hinged effectively on the development of commercial banking, with the impetus given to industrialisation based on the initiatives provided in the five year plans. Financing of emerging trade and industrial activities during the 'fifties, and the 'sixties reflected the dominance of banking as the critical source. The number of banks and branches had gone up, notwithstanding the consolidation of small banks, and the support given to co-operative credit movement

Functionally, banks catered to the needs of the organised industrial and trading sectors. The primary sector consisting of 'agriculture, forestry and fishing' which formed more than 50 per cent of GDP during this period had to depend largely on own financing and on sources outside the commercial banks. It is against this backdrop that the process of financial development was given impetus with the adoption of the policy of social control over banks in 1967, reinforced in 1969 by the nationalisation of 14 major scheduled commercial banks. Since then, the banking system has formed the core of the Indian financial system. With the second dose of nationalization in 1980, the Government of India controlled around 91% of the banking business of India. Driven largely by the public sector initiative and policy activism, commercial banks have a dominant share in total financial assets and are the main source of financing for the private corporate sector. They also channel a sizeable share of household savings to the public sector. Besides, in recent years, they have been performing most of the payment system functions. With increased diversification in recent years, banks in both public and private sectors have been providing a wide range of financial services. Development Financial Institutions Development financial institutions (DFIs) were established in India to resolve a typical market inadequacy problem, viz., the shortage of long-term resources and the perceived risk aversion of savers and creditors to part with funds for long gestation projects. In view of the inadequate provision of long-term finance through banks and/or markets, many of these institutions were set up by the Government. The endorsement of planned industrialisation at the national level provided the critical inducement for establishment of DFIs at both the all-India and state levels. Besides DFIs at the national and state levels, there are also investment institutions and specialised financial institutions. These institutions provided financial assistance in the form of term loans, underwriting/direct subscription to shares/debentures and guarantees. There has been a secular increase in the disbursements of financial institutions. Non-Banking Financial Companies Non-banking financial companies (NBFCs) have emerged as an important part of the Indian financial system. These companies have grown rapidly in the second-half of the 'eighties and the first-half of the 'nineties. III. POST NINETIES New economic policy was introduced in 1991.Development process was shifted from mixed economics to free market economics & the consequent globalisation of the economy. Major economic policies were changed which had effected structure of the corporate industrial sector in India. Hence the influence of the Government began to decline over the distribution of finance & credit. There was capital market oriented developments. Hence, the notable developments during this phase (1) Privatisation of financial institutions (2) Reorganisation of institutional structure (3) Investor's Protection In this period, the then Narasimha Rao government embarked on a policy of liberalization, licensing a small number of private banks. These came to be known as New Generation techsavvy banks, and included Global Trust Bank (the first of such new generation banks to be set

up), which later amalgamated with Oriental Bank of Commerce, Axis Bank(earlier as UTI Bank), ICICI Bank and HDFC Bank. This move, along with the rapid growth in the economy of India, revitalized the banking sector in India, which has seen rapid growth with strong contribution from all the three sectors of banks, namely, government banks, private banks and foreign banks. The next stage for the Indian banking has been set up with the proposed relaxation in the norms for Foreign Direct Investment, where all Foreign Investors in banks may be given voting rights which could exceed the present cap of 10%,at present it has gone up to 74% with some restrictions. The new policy shook the Banking sector in India completely. Bankers, till this time, were used to the 4-6-4 method (Borrow at 4%;Lend at 6%;Go home at 4) of functioning. The new wave ushered in a modern outlook and tech-savvy methods of working for traditional banks. All this led to the retail boom in India. People not just demanded more from their banks but also received more. In the past 60 years the Indian financial system has shown tremendous growth in terms of quantity, diversity, sophistication, innovations and complexity of operation. Indicators like money supply, deposits and credit of banks, primary and secondary issues, and so on, have increased rapidly. India has witnessed all types of financial innovations like diversification, disintermediation, securitization, liberalization, and globalization etc. As a result, today the financial institutions and a large number of new financial instruments lead a fairly diversified portfolio of financial claims. PRESENT DAY FINANCIAL SYSTEM OF INDIA Indian financial system consists of financial market, financial instruments and financial intermediaries. Constituents of a Financial System

Segments of the Financial System The Financial System is segmented into two Parts namely, the Organized and the Un Organized. The Organized system represents the Structure or nationalized banking, Cooperative banks and development banks set by the government through various enactments and regulations. This includes the private sector also. The Government/RBI controls this sector. The Unorganized sector comprises of individual money lenders, bankers, pawn brokers and traders, etc. Indian Financial System FINANCIAL MARKETS A Financial Market can be defined as the market in which financial assets are created or transferred. As against a real transaction that involves exchange of money for real goods or services, a financial transaction involves creation or transfer of a financial asset. Financial Assets or Financial Instruments represents a claim to the payment of a sum of money sometime in the future and /or periodic payment in the form of interest or dividend. Money Market- The money market is a wholesale debt market for low-risk, highly-liquid, shortterm instrument. Funds are available in this market for periods ranging from a single day up to a year. This market is dominated mostly by government, banks and financial institutions. Capital Market - The capital market is designed to finance the long-term investments. The transactions taking place in this market will be for periods over a year. Forex Market - The Forex market deals with the multicurrency requirements, which are met by the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market. This is one of the most developed and integrated market across the globe. Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short, medium and long-term loans to corporate and individuals. FINANCIAL INTERMEDIATION Having designed the instrument, the issuer should then ensure that these financial assets reach the ultimate investor in order to garner the requisite amount. When the borrower of funds approaches the financial market to raise funds, mere issue of securities will not suffice. Adequate information of the issue, issuer and the security should be passed on to take place. There should be a proper channel within the financial system to ensure such transfer. To serve this purpose, Financial intermediaries came into existence. Financial Intermediaries are Classified into two types namely, Depository and Non-Depository Institutions. Depository Institutions include Commercial banks, Savings & loans institutions and credit unions. Depository institutions directly lend these funds to consumers and businesses for a full range of purposes. They also lend them indirectly by investing in securities. Nondepository institutions include Finance Companies, Mutual Funds, Security firms Investment bankers, Brokers and Dealers, Pension funds and Insurance companies. Finance companies cater to the wide and varied segments of society. They cater in multiple ways to both the business as well as to the consumer communities. In a way they are called as department

stores of consumer and business credit. Finance companies handle a range of business, which include, automobile finance, purchase of business equipment, home appliances, etc. Financial intermediation in the organized sector is conducted by a wide range of institutions functioning under the overall surveillance of the Reserve Bank of India. In the initial stages, the role of the intermediary was mostly related to ensure transfer of funds from the lender to the borrower. This service was offered by banks, FIs, brokers, and dealers. However, as the financial system widened along with the developments taking place in the financial markets, the scope of its operations also widened. Some of the important intermediaries operating in the financial markets include; investment bankers, underwriters, stock exchanges, registrars, depositories, custodians, portfolio managers, mutual funds, financial advertisers financial consultants, primary dealers, satellite dealers, self regulatory organizations, etc. Though the markets are different, there may be a few intermediaries offering their services in more than one market e.g. underwriter. However, the services offered by them vary from one market to another. Intermediary Role Secondary Market to Stock Exchange Capital Market securities Corporate advisory services, Investment Bankers Capital Market, Credit Market Issue of securities Subscribe to unsubscribed Underwriters Capital Market, Money Market portion of securities Issue securities to the Registrars, Depositories, investors on behalf of the Capital Market Custodians company and handle share transfer activity Primary Dealers Satellite Market making in government Money Market Dealers securities Ensure exchange ink Forex Dealers Forex Market currencies FINANCIAL INSTRUMENTS Money Market Instruments The money market can be defined as a market for short-term money and financial assets that are near substitutes for money. The term short-term means generally a period upto one year and near substitutes to money is used to denote any financial asset which can be quickly converted into money with minimum transaction cost. Some of the important money market instruments are briefly discussed below; 1. Call/Notice Money 2. Treasury Bills 3. Term Money 4. Certificate of Deposit 5. Commercial Papers Market

1. Call /Notice-Money Market Call/Notice money is the money borrowed or lent on demand for a very short period. When money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on the next working day, (irrespective of the number of intervening holidays) is "Call Money". When money is borrowed or lent for more than a day and up to 14 days, it is "Notice Money". No collateral security is required to cover these transactions. 2. Inter-Bank Term Money Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money market. The entry restrictions are the same as those for Call/Notice Money except that, as per existing regulations, the specified entities are not allowed to lend beyond 14 days. 3. Treasury Bills. Treasury Bills are short term (up to one year) borrowing instruments of the union government. It is an IOU of the Government. It is a promise by the Government to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e. less than one year). They are issued at a discount to the face value, and on maturity the face value is paid to the holder. The rate of discount and the corresponding issue price are determined at each auction. 4. Certificate of Deposits Certificates of Deposit (CDs) is a negotiable money market instrument nd issued in dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time. CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI. Banks have the freedom to issue CDs depending on their requirements. An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments viz., term money, term deposits, commercial papers and intercorporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet. 5. Commercial Paper CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper the debt obligation is transformed into an instrument. CP is thus an unsecured promissory note privately placed with investors at a discount rate to face value determined by market forces. CP is freely negotiable by endorsement and delivery. A company shall be eligible to issue CP provided - (a) the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; (b) the working capital (fund-based) limit of the company from the banking system is not less than Rs.4 crore and (c) the borrowal account of the company is classified as a Standard Asset by the financing bank/s. The minimum maturity period of CP is 7 days. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies. (for more details visit www.indianmba.com faculty column)

Capital Market Instruments The capital market generally consists of the following long term period i.e., more than one year period, financial instruments; In the equity segment Equity shares, preference shares, convertible preference shares, non-convertible preference shares etc and in the debt segment debentures, zero coupon bonds, deep discount bonds etc. In India money market is regulated by Reserve bank of India and Securities Exchange Board of India (SEBI) regulates capital market. Capital market consists of primary market and secondary market. All Initial Public Offerings comes under the primary market and all secondary market transactions deals in secondary market. Secondary market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Secondary market comprises of equity markets and the debt markets. In the secondary market transactions BSE and NSE plays a great role in exchange of capital market instruments. Hybrid Instruments Hybrid instruments have both the features of equity and debenture. This kind of instruments is called as hybrid instruments. Examples are convertible debentures, warrants etc. Evolution of The Indian Equity market The Indian Equity Market is more popularly known as the Indian Stock Market. The Indian equity market has become the third biggest after China and Hong Kong in the Asian region. A stock exchange has been defined by the Securities Contract (Regulation) Act, 1956 as an organization, association or body of individuals established for regulating, and controlling of securities.

The Indian equity market depends on three factors Funding into equity from all over the world Corporate houses performance Monsoons The stock market in India does business with two types of fund namely private equity fund and venture capital fund. It also deals in transactions which are based on the two major indices Bombay Stock Exchange (BSE) and National Stock Exchange of India Ltd. (NSE). The market also includes the debt market which is controlled by wholesale dealers, primary dealers and banks. The equity indexes are allied to countries beyond the border as common calamities affect markets. E.g. Indian and Bangladesh stock markets are affected by monsoons. The equity market is also affected through trade integration policy. The country has advanced both in foreign institutional investment (FII) and trade integration since 1995. This is a very attractive field for making profit for medium and long term investors, short-term swing and position traders and very intra day traders. The Indian market has 22 stock exchanges. The larger companies are enlisted with BSE and

NSE. The smaller and medium companies are listed with OTCEI (Over The counter Exchange of India). The functions of the Equity Market in India are supervised by SEBI (Securities Exchange Board of India). The history of the Indian equity market goes back to the 18th century when securities of the East India Company were traded. Till the end of the 19th century, the trading of securities was unorganized and the main trading centers were Calcutta (now Kolkata) and Bombay (now Mumbai).

Trade activities prospered with an increase in share price in India with Bombay becoming the main source of cotton supply during the American Civil War (1860-61). In 1865, there was drop in share prices. The stockbroker association established the Native Shares and Stock Brokers Association in 1875 to organize their activities. In 1927, the BSE recognized this association, under the Bombay Securities Contracts Control Act, 1925. The Indian Equity Market was not well organized or developed before independence. After independence, new issues were supervised. The timing, floatation costs, pricing, interest rates were strictly controlled by the Controller of Capital Issue (CII). For four and half decades, companies were demoralized and not motivated from going public due to the rigid rules of the Government. In the 1950s, there was uncontrollable speculation and the market was known as 'Satta Bazaar'. Speculators aimed at companies like Tata Steel, Kohinoor Mills, Century Textiles, Bombay Dyeing and National Rayon. The Securities Contracts (Regulation) Act, 1956 was enacted by the Government of India. Financial institutions and state financial corporation were developed through an established network. In the 60s, the market was bearish due to massive wars and drought. Forward trading transactions and 'Contracts for Clearing' or 'badla' were banned by the Government. With financial institutions such as LIC, GIC, some revival in the markets could be seen. Then in 1964, UTI, the first mutual fund of India was formed. In the 70's, the trading of 'badla' resumed in a different form of 'hand delivery contract'. But the Government of India passed the Dividend Restriction Ordinance on 6th July, 1974. According to the ordinance, the dividend was fixed to 12% of Face Value or 1/3 rd of the profit under Section 369 of The Companies Act, 1956 whichever is lower. This resulted in a drop by 20% in market capitalization at BSE (Bombay Stock Exchange) overnight. The stock market was closed for nearly a fortnight. Numerous multinational companies were pulled out of India as they had to dissolve their majority stocks in India ventures for the Indian public under FERA, 1973. The 80's saw a growth in the Indian Equity Market. With liberalized policies of the government, it became lucrative for investors. The market saw an increase of stock exchanges, there was a surge in market capitalization rate and the paid up capital of the listed companies. The 90s was the most crucial in the stock market's history. Indians became aware of 'liberalization' and 'globalization'. In May 1992, the Capital Issues (Control) Act, 1947 was abolished. SEBI which was the Indian Capital Market's regulator was given the power and overlook new trading policies, entry of private sector mutual funds and private sector banks, free

prices, new stock exchanges, foreign institutional investors, and market boom and bust. In 1990, there was a major capital market scam where bankers and brokers were involved. With this, many investors left the market. Later there was a securities scam in 1991-92 which revealed the inefficiencies and inadequacies of the Indian financial system and called for reforms in the Indian Equity Market. Two new stock exchanges, NSE (National Stock Exchange of India) established in 1994 and OTCEI (Over the Counter Exchange of India) established in 1992 gave BSE a nationwide competition. In 1995-96, an amendment was made to the Securities Contracts (Regulation) Act, 1956 for introducing options trading. In April 1995, the National Securities Clearing Corporation (NSCC) and in November 1996, the National Securities Depository Limited (NSDL) were set up for demutualised trading, clearing and settlement. Information Technology scrips were the major players in the late 90s with companies like Wipro, Satyam, and Infosys. In the 21st century, there was the Ketan Parekh Scam. From 1st July 2001, 'Badla' was discontinued and there was introduction of rolling settlement in all scrips. In February 2000, permission was given for internet trading and from June, 2000, futures trading started. REGULATORY ENVIRONMENT Reserve Bank of India : Managing the governments banking transactions is a key RBI role. Like individuals, businesses and banks, governments need a banker to carry out their financial transactions in an efficient and effective manner, including the raising of resources from the public. As a banker to the central government, the Reserve Bank maintains its accounts, receives money into and makes payments out of these accounts and facilitates the transfer of government funds. RBI also acts as the banker to those state governments that have entered into an agreement with RBI. The RBIs Regulatory Role Banks are fundamental to the nations financial system. The central bank has a critical role to play in ensuring the safety and soundness of the banking systemand in maintaining financial stability and public confidence in this system. As the regulator and supervisor of the banking system, the Reserve Bank protects the interests of depositors, ensures a framework for orderly development and conduct of banking operations conducive to customer interests and maintains overall financial stability through preventive and corrective measures. As the nations financial regulator, the Reserve Bank handles a range of activities, including: Licensing Prescribing capital requirements Monitoring governance Setting prudential regulations to ensure solvency and liquidity of the banks Prescribing lending to certain priority sectors of the economy Regulating interest rates in specific areas Setting appropriate regulatory norms related to income recognition, asset classification, provisioning, investment valuation, exposure limits and the like Initiating new regulation

SEBI The Securities and Exchange Board of India (abbreviated SEBI) is the regulator for the securities market in India. SEBI was formed officially by the Government of India in 1992 with SEBI Act 1992[2] being passed by the Indian Parliament. SEBI is headquartered in the business district of Bandra-Kurla complex in Mumbai, and has Northern, Eastern, Southern and Western regional offices in New Delhi, Kolkata, Chennai and Ahmedabad. Controller of Capital Issues was the regulatory authority before SEBI came into existence; it derived authority from the Capital Issues (Control) Act, 1947. Initially SEBI was a non statutory body without any statutory power. However in 1995, the SEBI was given additional statutory power by the Government of India through an amendment to the securities and Exchange Board of India Act 1992. In April, 1998 the SEBI was constituted as the regulator of capital market in India under a resolution of the Government of India. Functions and responsibilities SEBI has to be responsive to the needs of three groups, which constitute the market: the issuers of securities the investors the market intermediaries. SEBI has three functions rolled into one body: quasi-legislative, quasi-judicial and quasiexecutive. It drafts regulations in its legislative capacity, it conducts investigation and enforcement action in its executive function and it passes rulings and orders in its judicial capacity. Though this makes it very powerful, there is an appeals process to create accountability. There is a Securities Appellate Tribunal which is a three-member tribunal. A second appeal lies directly to the Supreme Court. SEBI has enjoyed success as a regulator by pushing systemic reforms aggressively and successively (e.g. the quick movement towards making the markets electronic and paperless rolling settlement on T+2 basis). SEBI has been active in setting up the regulations as required under law. EFFECTS OF LIBERALISATION ON INDIAN FINANCIAL SYSTEM Liberalization and globalization have breathed new life into the Indian financial system, Foreign exchange markets, while had come alive, it is also besotted with new challenges. Commodity trading, particularly trade in commodity futures, have practically started from scratch to attain scale and attention. The banking industry has moved from an era of rigid controls and government interference to a more market-governed system. New private banks have made their presence felt in a very strong way and several foreign banks have entered the country. Over the years, microfinance has emerged as an important element of the Indian financial system increasing its outreach and providing much-needed financial services to millions of poor Indian households.