Indian Financial

System
Objectives :
• To provide the participants with an exposure and thorough
understanding of the Indian Financial systems and its components.
• Understand the concept and characteristics of Leasing, Hire purchase
Factoring and Forfeiting.
Books
• Prescribed Text:
• Pathak, B.V. (2012). The Indian Financial System, 3/e, New Delhi, Pearson.
• Reference Books:
• Madura, J. (2010). Financial Institutions & Markets, 9/e, New Delhi, Cengage
Learning.
• Kohn, M. (2013). Financial Institutions & Markets, 2/e, New Delhi,Tata Mc-Graw
Hill.
• Khan, M.Y. (2009). Indian Financial System, 6/e, New Delhi, Tata Mc-Graw Hill.
• Bhole, L.M. (2009). Financial Institutions and Markets, 5/e, New Delhi, Tata
McGraw Hill.
ICA
• Test Marks : 30
• Term Work Marks : 20
• Details of Term work :
• Class Test/ Assignment/Case Studies/Projects/ Presentations
Overview of Indian financial system
• Meaning of Financial System
“ The financial system or the financial sector of any country consists of specialised
and non-specialised financial institutions, of organised and unorganised financial
markets, of financial instruments and services which facilitate transfer of funds.”
• Financial system in developed countries:
• Are characterized by financial dualism-’formal and informal financial sectors’
• Formal sector(dealing with modern spheres of economy) have presence of
organised, institutional and regulated system
• Informal sector (dealing with traditional and rural spheres of the economy)- have
presence of unorganised, non-institutional and non-regulated system
• An institutional framework existing in a country to enable financial
transactions.
• It is crucial for the capital formation in a country, which is very crucial for
speedy economic development
Indian Financial System – An Overview
Process of Capital Formation
Involves three distinct, although inter-related activities.

(i) Savings: The ability by which resources are set aside and become
available for other purpose.

(ii) Finance: The activity by which claims to resources are either assembled
from those released by domestic savings, obtained from abroad,
or specially created usually as bank deposits or notes and then
placed in the hands of the investor.

(iii) Investments: The activity by which resources are actually committed to

production.

The financial system is a link between the savers (savings – surplus economic
units) and the investors (savings – deficit economic units). It is made up of all
those channels through which savings become available for investment.

6
Features of Financial system
• Provides linkage between depositors and investors through financial
intermediaries
• Facilitates expansion of financial markets over space and time
• Promotes efficient allocation of financial resources for socially
desirable and economically productive purposes
• Influences quality and pace of economic development
Main Components
• Financial markets (money market, capital market)
• Financial institutions (banks, non-banking, term finance, investment, state-level,
specialized, investment institutionsmutual funds, insurance companies, etc.)
• Financial instruments (loans, deposits, bonds, equities, etc.)
• Financial services (fund-based and fee based)
• Regulation is another aspect of the financial system (RBI, SEBI, IRDA, MOFs)
Indian Financial System
Financial System Designs
• Structure is the pattern of evolution and political, technical and
cultural differences that affect the design of financial system
• Bank dominated system
Banks play important role in savings, allocating capital, overseeing the
investment decisions and providing risk management facilities
• Market-dominated system
Markets share centre stage with banks in mobilizing the society’s savings for
firms
Bank-based system
• Advantages
• Close relationship with parties
• Provides tailor-made contracts
• Efficient intertemporal risk-sharing
• No free-rider problem
• Drawbacks
• Retards innovation and growth
• Impedes competition
Market-based system
• Advantages
• Provides attractive terms to both investors and borrowers
• Facilitates diversification
• Allows risk-sharing
• Allows financing of new technologies
• Drawbacks
• Prone to instability
• Exposure to market risk
• Free-rider problem
Interaction between different components
Key elements of well-functioning financial
system
• Strong legal and regulatory environment
• Stable money
• Sound public finance and public debt management
• Central bank
• Strong banking system
• Information system
• Well functioning securities market
 Financial Institutions (contd..)
• Function of financial institutions
To convert direct assets or instruments or securities into
indirect securities.
• Types
• Banking institutions
“ Banks are institutions whose debts-usually referred to as ‘bank
deposits’ are commonly accepted in final settlement of other people’s
debts”.
- Dr. H.L. Hart
Governed by Banking Regulation Act,1949
1. Organised Sector
2. Unorganised Sector
• Non-Banking Financial Entities
Financial Institutions (contd..)
• Three transformation services:
• Liability, asset and size transformation
• Maturity transformation
• Risk transformation
• Organised Sector
• Central Bank
• Commercial Banks
• Development Banks e.g. NABARD, EXIM
• Co-operative Banks
• Regional Rural Banks
• Foreign Banks
• Unorganised sector
 Financial Markets
❑Institutional arrangements facilitating the buying and
selling of financial claims, assets, services and
securities.
❑Functions:
Facilitate the transfer of funds
Enhances the liquidity mechanism for investor
Lowering the cost of transactions
Caters to credit needs of the individuals, firms and
institutions
Financial Markets (contd…)
• Players:
• Banking and NBFCs
• Dealers
• Borrowers
• Lenders
• Investors and depositors
• Agents
❑ Types of markets
 Money Market
 Capital Market
 Two segments:
 Primary
 Secondary
Types of markets
• Money market:
• Functions:
• Redistribution of cash balances in accordance with liquidity
• Management of liquidity and money in the economy
• Reasonable access to the users of short-term money
• Capital market:
• Purpose:
• Mobilise long-term savings
• Provide risk capital to entrepreneurs
• Provide liquidity to investors
• Improve the efficiency of capital allocation through competitive pricing
Linkage between both markets
• Financial institutions participate in both markets
• Funds in money market provide liquidity in capital market
• Development of money markets proceeds the development of capital
markets
Linkage between primary and secondary
market
• Returns in stock market influence the volume, pricing and volume in
primary market
• Determination of price of new issue is based on secondary market
• Depth of secondary market dependant on activities in primary market
Financial assets/instruments
• Enable channelising funds from surplus units to deficit
units
• There are instruments for savers such as deposits,
equities, mutual fund units, etc.
• There are instruments for borrowers such as loans,
overdrafts, etc.
• Like businesses, governments too raise funds through
issuing of bonds, Treasury bills, etc.
• Instruments like PPF, KVP, etc. are available to savers who
wish to lend money to the government
Different types of securities

 Debentures
 Shares
 Preference Shares
 Equity Shares
 Innovative Instruments
 Issued by Companies
◼ Participating Debentures
◼ Convertible Debentures with options
◼ Third Party Convertible Debentures
◼ Convertible Debentures Redeemable at Premium
◼ Debt Equity Swaps
◼ Zero-Coupon Convertible Notes
◼ Fully Convertible Debentures with Interest
◼ Zero Interest Fully Convertible Debentures
◼ Warrants
Financial Services
• Fund based services
• Fees based services
Nature of Financial Services
• Intangibility
• Inseperatibility
• Heterogeneous
• Perishability
• Advisory
• Marketing of Financial services
Characteristics
• Intangible
• Heterogeneity
• Fluctuation in demand
• Labour intensive
• Information-based
• Required skilled manpower
• Protect’s consumer interest
Reasons for growth
• Reforms
• Opening of insurance sector
• Growth of capital market
• NBFCs
• Strategic changes in corporate sector
• Regulatory changes 1992
Recent trends in Financial sector
• Financial crisis
• Financial convergence
• Financial Engineering
• Financial Inclusion
• Financial Sector stability
• More stable policies
• Integration with other countries
• Increase in online transactions
• Convergence to IFRS
• GST
Functions
• Enabling economic units to exercise their time preference
• Separation, distribution, diversification and reduction of risk
• Providing information about the companies
• Transformation of financial claims
• Enhancing liquidity of financial claims
• Providing portfolio management decisions
Characteristics
• Large volume of transactions
• Various segments of the market
• Instant arbitrage among various markets and types of instruments
• Markets are highly volatile and susceptiable to panic and distress
selling
• Markets dominated by financial intermediaries
• Application of negative externalities
• Integrations of domestic and foreign financial markets.
 Financial Institutions (contd..)
• Function of financial institutions
To convert direct assets or instruments or securities into
indirect securities.
• Types
• Banking institutions
“ Banks are institutions whose debts-usually referred to as ‘bank
deposits’ are commonly accepted in final settlement of other people’s
debts”.
- Dr. H.L. Hart
Governed by Banking Regulation Act,1949
1. Organised Sector
2. Unorganised Sector
• Non-Banking Financial Entities
Financial Institutions (contd..)
• Three transformation services:
• Liability, asset and size transformation
• Maturity transformation
• Risk transformation
• Organised Sector
• Central Bank
• Commercial Banks
• Development Banks e.g. NABARD, EXIM
• Co-operative Banks
• Regional Rural Banks
• Foreign Banks
• Unorganised sector
Financial Institutions (contd..)
• Organised Sector
• Central Bank
• Commercial Banks
• Industrial Banks
• Development Banks
• Co-operative Banks
• Regional Rural Banks
• Agricultural Banks
• Foreign Banks
• Local Area Banks
Indian Banking System
Central Bank (Reserve Bank of India)
Commercial banks (222)
Co-operative banks
Banks can be classified as:
Scheduled (Second Schedule of RBI Act, 1934) - 218
Non-Scheduled - 4
Scheduled banks can be classified as:
Public Sector Banks (28)
Private Sector Banks (Old and New) (27)
Foreign Banks (29)
Regional Rural Banks (133)
 Central Bank (RBI)
• Set up on April 1,1935
• RBI monitors the working of Money Market and to
some extent Capital Market
• Functions of RBI
• Issue of paper currencies
• Acting as a bankers of government
• Control over bank’s credit system
• Acting as lender of last resource for banks
 Commercial Banks
• Collect the money from the public in the form of savings account, current
account and term deposits
• Lending loans to the corporates to meet their working capital requirement
• Functions of commercial banks:
• Convert the bank deposits in cash and cash in bank deposits
• Transfer the funds among individuals and/or companies
• Underwrite capital issues
• Invest funds in capital market
• Provide counselling on portfolio management or investment opportunities
• Provide guarantee on behalf of its customers
• Provide advice on mergers and acquisitions
• Exchange deposits for bills of exchange
 Industrial Banks
• Also, called investment banks
• Provide long term loans, banking and other facilities including
consultancy services to industry
• Collect capital through the sale of shares, debentures and
banks. Also accepts deposits
• Provide financial, managerial and promotional assistance to
industrial units
• E.g. IDBI,ICICI,IFC
Development Bank

• Provides medium term and long-term assistance to business

units in the forms of loans, underwriting, investments and
guarantee options
• Development banks set up to:
• Provide medium and long term capital
• To subscribe the bonds and debentures of new industrial
concern
• Underwrite the shares of new industrial concern
• Grant loans in foreign countries and in the domestic money
market
Co-operative Banks
 Established under the Co-operative Societies Act of different states.
 Work in both rural and urban areas of the country
 Organisation structure of co-operative banks is as follows:

 Urban co-operative banks are required to maintain the entire 25% of

statutory liquidity ratio only in Govt. and other approved securities.
Similarly for Cash reserve ratio has also to be maintained
 Permitted banks to pay 0.5% to 1% interest rate on savings accounts, over
the rates prescribed for commercial banks
Regional Rural Banks
• Set up under the Regional Rural Banks Act,1976
• Was set-up to supplement the commercial banks and co-
operative banks in catering the credit requirements of the
rural sector
• Undertake the following types of businesses:
• Granting of loans and advances to small and marginal farmers and
agricultural labourers and to co-operative societies for agricultural
purposes
• Granting of loans and advances to artisans, small entrepreneurs etc…
 Agricultural Banks
• Common example would be NABARD, which would be
established on July 12, 1982
• Apex bank for rural credit.
• Responsible for formulate the development policy,
planning and operational matters relating to credit for
agriculture
Foreign Banks
• Foreign banks are permitted to enter in the Indian
banking sector with a ceiling of 49 percent of equity.
Development Oriented Banking
• Historically, close association between banks and some
traditional industries- cotton textiles in the west, jute
textiles in the east
• Banking has not been mere acceptance of deposits and
lending money; included development banking
• Lead Bank Scheme- opening bank offices in all important
localities
• Providing credit for development of the district
• Mobilising savings in the district. ‘Service area approach’
RBI and indigenous bankers

• Methods employed by the indigenous bankers are

traditional with vernacular system of accounting.
• RBI suggested that bankers give up their trading and
commission business and switch over to the western
system of accounting.
• It also suggested that these bankers should develop the
deposit side of their business
• Ambiguous character of the hundi should stop
• Some of them should play the role of discount houses
(buy and sell bills of exchange)
RBI and indigenous bankers (contd…)

• IB should have their accounts audited by certified

chartered accountants
• Submit their accounts to RBI periodically
• As against these obligations the RBI promised to provide
them with privileges offered to commercial banks
including
Being entitled to borrow from and rediscount bills with RBI
• The IBs declined to accept the restrictions as well as
compensation from the RBI
• Therefore, the IBs remain out of RBI’s purview
Profitability of Banks
• Reforms have shifted the focus of banks from being
development oriented to being commercially viable
• Prior to reforms banks were not profitable and in fact
made losses for the following reasons:
• Declining interest income
• Increasing cost of operations
Profitability of banks (contd..)
• Declining interest income was for the following
reasons:
– High proportion of deposits impounded for CRR and SLR,
earning relatively low interest rates
– System of directed lending
– Political interference- leading to huge NPAs
• Rising costs of operations for banks was because of
several reasons: economic and political
Profitability of Banks (contd..)
• As per the Narasimham Committee (1991) the reasons
for rising costs of banks were:
• Uneconomic branch expansion
• Heavy recruitment of employees
• Growing indiscipline and inefficiency of staff due to trade union
activities
• Low productivity
• Declining interest income and rising cost of operations of
banks led to low profitability in the 90s