What is a 'Financial System'

A financial system is the system that covers financial transactions and the
exchange of money between investors, lender and borrowers. A financial system
can be defined at the global, regional or firm specific level. Financial systems are
made of intricate and complex models that portray financial services, institutions
and markets that link depositors with investors.

Financial system functions as an intermediary between savers and investors. It

facilitates the flow of funds in the economy. It is concerned about money, credit
and finance. These three parts are closely interrelated with each other and depend
on each other.

Financial System aims at establishing and providing a regular, smooth, efficient

and cost effective linkage between depositors and investors. A well developed
financial system allows for the transfer of resources from surplus spending units to
deficit spending units and thus plays a crucial role in the functioning of the
economy. Therefore, financial system is generally defined as the one engaged in
the creation of different types of assets that creditors wish to hold, and financial
liabilities that debtors are willing to incur. Thus, the variations in the size and
composition of assets and liabilities of financial institutions, and the type of
financial services offered alter the portfolios of other sectors as well as decisions
on savings and investments.

According to Van Horne, "financial system allocates savings efficiently in an

economy to ultimate users, either for investment in real assets or for consumption".

According to Prasanna Chandra, "financial system consists of a variety of

institutions, markets and instruments related in a systematic manner and provides
the principal means by which savings are transformed into instruments.

Thus, a financial system comprises of financial institutions, financial markets,

financial instruments and financial services and a large regulatory body - a Central
Bank, which oversees and supervises the operations of these intermediaries.

Financial system as a sector in the economy utilizes productive resources to

facilitate capital formation through the provision of a wide-range of financial
instruments to meet the different requirements of borrowers and lenders. The
financial system mobilizes and intermediates savings, and ensures that resources
are allocated efficiently to productive sectors.
Evolution of Financial System in India
In the 1950s and 1960s, Gurley and Shaw (1955, 1960) and Goldsmith (1969)
discussed the stages in the evolution of financial systems. According tothem, there
is a link between per capita income and the development of a financial system. At
low levels of development, most investment is self-financed and financial
intermediaries do not exist, as the costs of financial intermediation are relatively
high compared to benefits. As countries develop and per capita income increases,
bilateral borrowing and lending take place, leading to the birth of financial
intermediaries. The number of financial intermediaries grows with further
increases in per capita income. Among the financial intermediaries, banks tend to
become larger and prominent in financial investment. As countries expand
economically, non-bank financial intermediaries and stock markets grow in size
and tend to become more active and efficient compared to banks. There is a
general tendency for a financial system to become more market-oriented as
countries become richer.

The evolution of the Indian financial system from somewhat of a constricted and
an undersized one to a more open, deregulated and market oriented one and its
interface with the growth process is due to the turning points in its history.

The evolution of financial system in India owes much to its locational advantage
providing geopolitical and commercial avenues. During the colonial days too, it
served as an entrecote for regions and for the flourishment of trade. 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 First Five Year Plan Document15 emphasised
that as part of price policy, both financial and physical controls were necessary. It
also recognized the importance of the creation of financial infrastructure by the
central bank in the development process. The First five Year Plan Document stated
that "Central banking in a planned economy can hardly be confined to the
regulation of overall supply of credit or to a somewhat negative regulation of the
flow of bank credit. It would have to take on a direct and active role, firstly in
creating or helping to create the machinery needed for financing developmental
activities all over the country and secondly ensuring that the finance available
flows in the direction intended”

Role/ Functions of Financial System

A financial system performs the following functions:

* It serves as a link between savers and investors. It helps in utilizing the mobilized
savings of scattered savers in more efficient and effective manner. It channelises
flow of saving into productive investment.

* It assists in the selection of the projects to be financed and also reviews the
performance of such projects periodically.

* It provides payment mechanism for exchange of goods and services.

* It provides a mechanism for the transfer of resources across geographic

boundaries.

* It provides a mechanism for managing and controlling the risk involved in

mobilizing savings and allocating credit.

* It promotes the process of capital formation by bringing together the supply of

saving and the demand for investible funds.

* It helps in lowering the cost of transaction and increase returns. Reduce cost
motives people to save more.

* It provides you detailed information to the operators/ players in the market such
as individuals, business houses, Governments etc.
Components/ Constituents of Indian Financial system:

The following are the four main components of Indian Financial system

1. Financial institutions

2. Financial Markets

3. Financial Instruments/Assets/Securities

4. Financial Services.

Financial institutions:

Financial institutions are the intermediaries who facilitates smooth functioning of

the financial system by making investors and borrowers meet. They mobilize
savings of the surplus units and allocate them in productive activities promising a
better rate of return. Financial institutions also provide services to entities seeking
advices on various issues ranging from restructuring to diversification plans. They
provide whole range of services to the entities who want to raise funds from the
markets elsewhere. Financial institutions act as financial intermediaries because
they act as middlemen between savers and borrowers. Were these financial
institutions may be of Banking or Non-Banking institutions.
Financial Markets:

Finance is a prerequisite for modern business and financial institutions play a vital
role in economic system. It's through financial markets the financial system of an
economy works. The main functions of financial markets are:

1. to facilitate creation and allocation of credit and liquidity;

2. to serve as intermediaries for mobilization of savings;

3. to assist process of balanced economic growth;

4. to provide financial convenience

Financial Instruments

Another important constituent of financial system is financial instruments. They

represent a claim against the future income and wealth of others. It will be a claim
against a person or an institutions, for the payment of the some of the money at a
specified future date.

Financial Services:

Efficiency of emerging financial system largely depends upon the quality and
variety of financial services provided by financial intermediaries. The term
financial services can be defined as "activites, benefits and satisfaction connected
with sale of money, that offers to users and customers, financial related value".
Types of Indian Financial system
Functions of Indian Financial System
The principal function of financial intermediaries is to purchase primary securities
from ultimate borrowers and to issue indirect debt for the portfolios of ultimate
lenders. Although primary securities are their principal asset, financial
intermediaries also hold the indirect debt of other intermediaries and own tangible
assets as well.
However, the financial system of a country performs certain valuablefunctions for
the economic growth of that country. The main functions of a financial system may
be briefly discussed as below:

1.Saving Function: An important function of a financial system is to mobilize

savings and channelize them into productive activities. It is through financial
system, savings are transformed into investments.

2. Liquidity Function: The most important function of a financial system is to

provide money and monetary assets for the production of goods and services.
Monetary assets are those assets which can be converted into cash or money easily
without loss of value. All activities in a financial system are related to liquidity-
either provision of liquidity or trading in liquidity.

3. Payment Function: The financial system offers a very convenient mode of

payment for goods and services. The cheque system and credit card system are the
easiest methods of payment in the economy. The cost and time of transactions is
considerably reduced.

4. Risk Function: The financial markets provide protection against life, health and
income risks. These guarantees are accomplished through the sale of life, health
insurance and property insurance policies.

5. Information Function: A financial system makes available price-related

information. This is a valuable help to those who need to take economic and
financial decisions. Financial markets disseminate information for enabling
participants to develop an informed opinion about investment, disinvestment,
reinvestment or holding a particular asset.
6. Transfer Function: A financial system provides a mechanism for the transfer of
the resources across geographic boundaries.

7. Reformatory Functions: A financial system undertakes the functions of

developing, introducing innovative financial assets/instruments services and
practices and restructuring the existing assets, services etc, to cater to the emerging
needs of borrowers and investors (financial engineering and reengineering).

8. Other Functions: It assists in the selection of projects to be financed and also

reviews performance of such projects periodically. It also promotes the process of
capital formation by bringing together the supply of savings and the demand for
investible funds.
What is NBFC?
o A Non-Banking Financial Company (NBFC) is a company registered
under the Companies Act, 1956 and is engaged inthe business of Loans,
Advances, Acquisition of shares/stock/bonds/debentures/ securities
issued by Government or local authority or other securities of like
marketable nature, Leasing, Hire-purchase, Insurance business, Chit
business.

o A non-banking institution which is a company and which has its principal

business of receiving deposits under any scheme or arrangement or any other
manner, or lending in any manner is also a non-banking financial company
(Residuary non-banking company).
HISTORICAL BACKGROUND

The Reserve Bank of India Act, 1934 was amended on 1st December, 1964 by the
Reserve Bank Amendment Act, 1963 to include provisions relating to non-banking
institutions receiving deposits and financial institutions.

With a view to review the existing framework and address these shortcomings,
various committees were formed and reports were submitted by them.
THE COMMITTEES

 James Raj Committee (1974)

 It was formed by the Reserve Bank of India in 1974.
 Suggested for a ban on Prize chit and other schemes.
 Based on these suggestions, the Prize Chits and Money Circulation
Schemes (Banning) Act, 1978 was enacted.

 Dr. A.C. Shah Committee (1992)

 Agenda for reforms in the NBFC sector.
 Wide ranging recommendations covering
 compulsory registration of large sized NBFCs,
 prescription of prudential norms for NBFCs
 more statutory powers to Reserve Bank for better regulation
Of NBFCs.

 Vasudev Committee (1998)

 RBI should consider measures for easing the flow of credit from banks to
NBFCs
 Consider prescribing a suitable ratio as between secured and unsecured
deposits for NBFCs.
 Appointment of depositors’ grievance redressal authorities with
specified territorial jurisdiction.
 A separate instrumentality for regulation and supervision of NBFCs
under the aegis of the RBI should be set up, so that there is a great focus in
regulation and supervision of the NBFC sector.
REGULATIONS
 In terms of Section 45-IA of the RBI Act, 1934, it is mandatory that every
NBFC should be registered with RBI to commence or carry on any business
of non-banking financial institution. However, to obviate dual regulation,
certain categories of NBFCs which are regulated by other regulators are
exempted from the requirement of registration with RBI viz. Venture Capital
Fund/Merchant Banking companies/Stock broking companies registered
with SEBI.

 Should have a minimum net owned fund of Rs 25 lakh (raised to Rs 200

lakh wef April 21, 1999).

 NBFC have to maintain 10 and 15 per cent of their deposits in liquid assets
effectively from January 1 and April 1,1998, respectively.

 All NBFCs are not entitled to accept public deposits. Only those NBFCs
holding a valid Certificate of Registration with authorization to accept
Public Deposits can accept/hold public deposits.

 They have to create reserve fund and transfer not less than 20 per cent of
their net deposits to it every year.

 The NBFCs are allowed to accept/renew public deposits for a minimum

period of 12 months and maximum period of 60 months. They cannot accept
deposits repayable on demand.

 NBFCs cannot offer interest rates higher than the ceiling rate prescribed by
RBI from time to time. The present ceiling is 11 per cent per annum.

 They have to obtain a minimum credit rating from anyone of the three credit
rating agencies.

 NBFCs cannot offer gifts/incentives or any other additional benefit to the

depositors.
Role of NBFCs
o Development of sectors like Transport & Infrastructure
o Substantial employment generation
o Help & increase wealth creation
o Broad base economic development
o Major thrust on semi-urban, rural areas & first time buyers / user.
o To finance economically weaker sections
IMPORTANCE OF NBFCs

In the present economic environment it is very difficult to cater need of

society by Banks alone so role of Non Banking Finance Companies and Micro
Finance Companies become indispensable.

The role of NBFCs as effective financial intermediaries has been well

recognised as they have inherent ability to take quicker decisions, assume
greater risks, and customise their services and charges more according to the
needs of the clients.

At present, NBFCs in India have become prominent in a wide range of

activities like hire-purchase finance, equipment lease finance, loans,
investments, etc.

To help in developing the large number of industries as well as entrepreneur in

different sectors of different areas.

To cover all the areas which is being untouched or uncovered by RBI or

other FCIs.
Types of NBFC
Asset Finance Company(AFC)

Investment Company (IC)

Loan Companies (LC)

Infrastructure Finance Company (IFC)

Systemically Important Core Investment Company (CIC-ND-SI)

Infrastructure Debt Fund (IDF-NBFC)

Non-Banking Financial Company – Micro Finance Institution (NBFC-MFI)

Non-Banking Financial Company – Factors (NBFC-Factors)

1. Asset Finance Company(AFC)-
The main business of these companies is to finance the assets such as
machines, automobiles, generators, material equipments, industrial
machines etc.

2. Investment Company (IC)-

The main business of these companies is to deal in securities.

3. Loan Companies (LC)

The main business of such companies is to make loans and advances (not for
assets but for other purposes such as working capital finance etc. )

4. Infrastructure Finance Company (IFC)

A company which has net owned funds of at least Rs. 300 Crore and has
deployed 75% of its total assets in Infrastructure loans is called IFC
provided it has credit rating of A or above and has a CRAR of 15%.

5. Systemically Important Core Investment Company (CIC-ND-SI)

A systematically important NBFC (assets Rs. 100 crore and above) which
has deployed at least 90% of its assets in the form of investment in shares or
debt instruments or loans in group companies is called CIC-ND-SI. Out of
the 90%, 60% should be invested in equity shares or those instruments
which can be compulsorily converted into equity shares. Such companies do
accept public funds.

6. Infrastructure Debt Fund (IDF-NBFC)

A debt fund means an investment pool in which core holdings are fixed
income investments. The Infrastructure Debt Funds are meant to infuse
funds into the infrastructure sector. The importance of these funds lies in the
fact that the infrastructure funding is not only different but also difficult in
comparison to other types of funding because of its huge requirement, long
gestation period and long term requirements.

Factoring business refers to the acquisition of receivables by way of

assignment of such receivables or financing, there against either by way of
loans or advances or by creation of security interest over such receivables
but does not include normal lending by a bank against the security of
receivables etc.

An NBFC-Factoring company should have a minimum Net Owned Fund

(NOF) of Rs. 5 Crore and its financial assets in the factoring business should
constitute at least 75 percent of its total assets and its income derived from
factoring business should not be less than 75 percent of its gross income.
FINANCIAL SECTOR REFORMS

NBFCs having foreign investment more than 75% and up to 100%, and with a
minimum capitalisation of US$ 50 million, can set up subsidiaries for specific
NBFC activities, without any restriction on the number of operating subsidiaries
and without bringing in additional capital :RBI

NBFC-MFI norms modified: In order toprovide encouragement to NBFCs

operating in the north-eastern region, the minimum NOF is to be maintained at
Rs.1 crores by March 31, 2012, and at Rs.2 crores by March 31, 2014.

Operational flexibility : To allow operational flexibility, the RBI has asked the
NBFCs to ensure that the average interest rate on loans during a financial year
does not exceed the average borrowing cost during that financial year plus the
margin, within the prescribed cap.
Overview of Present Position
NBFCs are highly heterogeneous, continue to offer wide range of niche and
tailor-made financial services.

In terms of relative importance of various activities financed by them, hire

purchase finance is the largest activity, accounting for greater than 1/3rd of total
assets, followed by loans and equipment leasing.

The number of NBFCs have declined after 2000 due to mergers, closures,
cancellation of licenses, regulatory strictness.

The maximum rate of interest that NBFCs can pay on their deposits has been
reduced from 12.5 % to 11% per annum March 4, 2003.

The NPAs of NBFCs has not shown a clear decline over the years.

There has been a decline in the shares of deposits in their total sources of
funds which has made them rely more on market borrowings which has
ultimately caused increase in their cost of funds.

RBI has decided to impose penalties on NBFCs having deposits of Rs. 50 crores &
above if they don’t submit periodic returns to RB.
Data Analysis
Research Methodology
Recommendation
CONCLUSION
The NBFCs have not been very much profitable. The operating cost of NBFCs
has increased and it stands much higher than co-operative banks. This is one area
in which improvement is needed.

Enhancing the credit delivery mechanisms: The credit delivery mechanism

needs to be more transparent and hassle free. There should be more stringent
norms for the defaulters.

Strengthening the professionalism of NBFC sector through education and

training, making them more organised, RBI needs to educate people about
NBFC,to reduce interest cost and hence benefit the ultimate consumer.
Bibliography
https://www.gktoday.in/academy/article/types-of-non-banking-financial-
companies-nfbc/