ore NuUbLsat After studying the chapter you s] > Financial Markets Meaning/and J > Financial System & Economie D > Financial Intermediation > Interdependence of Finan > Role Played by Financial > An overview of Indian Finan > Recent Reforms in the Fit Introduction . Theresources required for developing any economy aregenerated through the process of savings. These sa\ remain unutilized or underutilized .d. The size of the if the financial system of the economy is under develope: savings and its appropriate utilization for investment in industries can help economic growth. However, this channelizing of savings from savers to the industry requires the presence, ‘of vibrant, active and reliable financial markets system that aids in mobilization and appropriate channelization. bilizat The efficiency of the financial markets, decides the speed of the economic growth of a country. ia = 7A financial systema is a system through which the exchange of funds is enabled through various institutions like banks, insurance companies, and stock exchanges. It helps to channelize the surplus funds from lenders and ‘There are three major functions of the Financial routed to the borrowers. t aeerem caving function, policy cH yn, and credit function. Figure 1 shows ial system, There are two routes of the flow of funds through the fin li the flow of funds between the lenders-savers and the borrowers-spenders:2 AN INTRODUCTION TO FINANCIAL SYSTEM Direct finance and Indirect finance. In Indirect rinanes, intermediary anactive role by enabling he exchange of unds oa ie lend eS ang them tothe borrowers. In the case of dir ance, thercis no inter, 9% ; sclli 5 aes ed and the borrowers directly borrow Funes by selling. the Securit iy) financial markets. ; ; . GURE 1: Flow of Funds through the Financial System Financial EL eas Paes ee Pao Cee Source: Mishkin, F. $. (2007). The economics of money, banking, and financial markets, Pearson education. 27 Financialmarkets are markets through which funds required by the us are supplied by the savers of funds. It(helps in exchange)of financial assets between those who have the funds and those who require these fun Owners of funds would save more when they have incentive to save, which depends upon variety of financial instruments available and the returnon the financial instruments, Savings can be easily multiplied if the savers or investors invest in different instruments depending upon the return corresponding risk. The efficiency in the creation of various inst in financial markets to meet the different requirements of savers’aS as the users of funds decides the size of funds mobilized. ‘TAXMANN®7 AN INTRODUCTION TO FINANCIAL SYSTEM 3 Financial markets lo help in providing liquidity)price discovery) andfa mechanism through which the risk can be transferred from hedgers t speculators.) With thedevelopment of the financialmarkets thesavingsthatare generated by financial surplus units can beallocated to prefer investment outlets. Ina complex modern economy, the syst i itates | the transfer of resources from financial surplus units to financial /deficit unjis and thereby helps the funds’ appropriate usage for develop an economy. Hei: ‘ Development of an economy is therefore highly dependent upon a we regulated and efficient financialsystem. An efficient, vibrant and developed financial system is essential for rapid economic growth. The instituti structure, operational policies and regulatory framework of a financial market are largely influenced)by th ailing economic environment as well as the governmental policies. cial system is fully « the savings surplus units like househc of contracts, bonds or equity shares is into creation of shares or bon¢ funds through this method is] players becomes large on bothisi repeated, the size of the direct finan manageable. Therefore the system req are of intermediaries These servic kers, underwriters, secondai insurers, and mutual funds), In order to reconcile the inter cial intermediaries purchase th users and, in turn, acquire fu tailored to the needs of ultima funds do this acfivity of convers, ties, These institutions help to indirectly ant the markets.4 AN INTRODUCTION TO FINANCIAL SYSTEM d access to funds for expanding facil ining adequate cash reserves, ote jal intermediaries to meg, ik iy Existing economic units nec for financing inventories, for maintai é emergencies. They shall approach financi requirement of funds. aie : Financial markets also serve the function of Rouaing financial Surply, uw ke houscholds the access to carning assets likes ares, bonds or, Ms without requiring them to purchase real assets. If saving i incre by income generating financial claims, the accumulation o! ¢ plants, D ments, and materials that contribute to the growth, economies: Producti capacity gets enhanced. This results into economic growth. . its Indian Financial System Till the early nineties, the planned economic development in India h, | greatly influenced the course of financial development. In the POSt-1999, the financial system that emerged was in response to the imperatives of | a liberalized, globalised and deregulated economic era. This has helpeg the Indian economy to mobilize more funds for appropriate investments The financial system of a country consists of financial institutions, instry, ments, services and markets. “| INDIAN FINANCIAL SYSTEM Organised ¢ Intermediary ‘© Unorganised ‘¢ Non Intermediary» Primary Market $ Others # Secondary Market ¢. The evaluation three phases: © The financial system up to 1951 (Phase 1) ¢ The financial system from 1 951 to mid-Eighti ¢ The financial System from 1960 cnn enties (Phase 1) 990 onwards (Phage Im) ranAN INTRODUCTION TO FINANCIAL SYSTEM 5 stem up to 1951 (Phase 1) Indian financial system (IFS) before 1951 was largely closed-circle char: ia) SMrreprencurship; wherein 2 Pet organtzeil and fiarrow satwas devoid of issuing institutions. There aie a virtual abs ‘ejpation by financial intermediaries for,the long- term financing © it -y, Such a system was not responsive to oppor- for industrial investment. During this period the industrial sector snment. The growth of the period showed a at reflected in low per capita income, al income and purchasing capacity. 2. The financial system from 1951, mid-Eighties (Phase Il) Post-1951 period evolvedinresponsetothe imperatives’ of planned economic nt. Planning signified the distribution of credit and finance in ity with the planned priorities, W ich, in turn, implied. Government y Whe financial system. Te funds therefore, funneled towards sectors by the government. ‘During this period the financial: system. were: ancial institutions: ancial Institutions was itutions [e.8- 1, The financial s¥! control over thi the pre-meditated priority the major characteristics of (a) Public ownership of fin Public ownership of Fin: sh nationalization ate Indi ), Co banks (1969) and GIC (1972)] and partly through the cre ion oF new institutions, famely, special-purpose jenmlending institutions (development banks) and UTI. 4a eat (b) Fortification of the institution: ‘The fortification bf the institutional System was partly the result 0 “modification in th policies of the existing Finan ‘al Institutions and also anking policies and practices were dition of new institutions. The ba in tune i policies and practices.: brought about partly sank of structure E structure of the Indian Financial structured to be al policies towards Banks were encourat ed to reori nt their operation: inancing' otindstys againstcomm ‘cand trade. They were also encouraged to enter into ne industrial financing, namely, er an:lending for pure short underwriting and term-lendi term loan. The banks also enlarged the of small scale industries, rage and fill the credit rol was introduc coveragein, terms of financ- id agriculture, To expand the priority sector, a scheme of ing followed up by nationalisa- cove social cont aie go TAR aeAN. INTRODUCTION TO FINANCIAL SYSTEM. tion of the banks to meet the needs of development of th national priorities and objectives, the ¢ nee a in conformity Wl ne (°) Protection of Investors ; Along with the measures being taken to strengthen and diversig institutional structure of the Indian financial system, extensiyg} Me reforms were carried out during this period to provide pa ey to investors so as to restore their confidence in i i ction CUrit} The main elements 0) tig f the elaborate legislative code adopted b the Government were; Companies Act; Capital Issues (Control Act now repealed and rép! laced by the SEBI Act; Securitice Couns ) (Regulation) Act (SCRA); MRTP Act (now replaced by Competiti Act) and; Foreign Exchange Regulation Act (FERA), now replace’ by Foreign Exchange Management Act (FEMA). ed Participation of Financial Institutions (FIS) in Corporate. Managemen, i Asignificant feature of the Indian Financial System in this Phase was the participation by the Financial Institutions in the management and control of companies to which finance was provided, in marked contrast to the time-honoured tradition of not getting involved in the control and management of assisted companies. This change in approach of the Fls could be ascribed to three factors{ Government policy;structure of the industrial securities; and the deepinvolvement of the Financial Institutions in the fortune of thé companies thro lending operations for protecting their funding in these compari 3. The Financial System from 1990 onwards (Phase III) The post-nationalization period yielded significant changesin the operational policies and practices of banks. This resulted in an acceleration of credit availability to the priority sector and consequent declinein the share of large industry in the total bank credit, due to regulations and credit rationing. The backbone of the institutional structure of the Indian Financial System during this phase was the variegated structure of development banks, namely, IDBI, SIDBI, IFCI, ICICI, SFCs, SIDCs, SICs and so on. They were conceived as instruments of the State policy of directing capital into a chosen area of industry, in conformity with the planned priorities, and of generally securing the development of private industry along the desired path, to facilitate effective public control of private enterprise. They were also the agency through which specific socio-economic objectives of State policy, such as encouragement to new entrepreneurs and small enterprises and the development of backward regions to broad base the growth of industry, were being realized. @AN INTRODUCTION TO FINANCIAL SYSTEM 1 The setting UP of the LIC, as a result of an amalgamation of 245 life in- surance companies into a single monolithic state-owned institution, was a part of the deliberate and conscious attempt to mould the Indian Financial System according to the requirements of planned development. It not only transferred ‘an important saving institution from private to i ship, but also brought about a massive concent in the hands ‘of LIC, which emerged as the largest savings in the country. Similarly, the setting UP of th ‘eed of the Indian Financial System tities by the public by polstering uP in the securities markets. An ove! Indian financi: few decades wit banking and asset systemand intensificati Pave led to a decline in interest rates. The regulators: of the various segments of the: dof India and the Insurance PFRDA have become it India. The Government of India has started the process ©! ¢ sector banks to survive the distressed public secto} Non Performing Assets and weak balance sheet, been started. Recently, in 2021 the number of public sé reduced to twelve from twenty-seven after the me banks to the four major banks. Notwithstanding the dominance of the Public set sector banks are gradually gaining strong foothold India. The Government is also proposing to reduc to 33 per cent. This can ultimately lead to privati As part of the liberalisation process, the RBI new private sector banks, Restructuring of pI started with a few banks merging in order to of Rajasthan has been taken over by ICICI bank of Punjab has been taken over by HDFC bank. banks have far better managerial capability a pared to public sector banks and therefore are & TAXMANN®io STEM, FINANCIAL RODUCTION 10 FIN ANN 4 8 (DF) Finance Instituttons ( Development WN as Ss Were largely kn IDB and ICICI which we DI DVI suchas ki et coon, vices such as lal services g f financial o egments off sae mel insura "1 ah inner and ing, set banking, og y tee rough Separate Ventus i att really caught wy tham hs soma : q eee tenn ea a " = 4 wks now taking up ne itd = ~ : . Several measutes i a ania rae {India , mune Hi : ss ae oe of dated = ities and Teasury Megan ts open throug, 5 Primary dealers bid for is the pri Mies and ale trade in a i DFAT st ri ndary mar} t mes ia SU bills. Th ssc it wh Tererepo the Indi ‘Ymark it treme 1s Marky | See | or dee ites hag Tedced thei ith nthe Mutual funds has ment en as W Years, ratte utderthes teens 996 and etd theret Bling the industry had a fh More Players both The, itty Wil sce OT for le “tablish of many Ndian, and foreign Players Yo th malin POs fsa in Mutual fung y Teeny Years hag been Ativen by the Clsang — UNIAN INTRODUCTION TO FINANCIAL SYSTEM 9 The growih of Mutual fund segment got a further fillip with the entry of foreign owned AMCs. They were instrumental with the introduction of new products, setting new standards of customer service, improved disclosure standards and experimenting with new types of distribution. The Indian insui » thrown open to competi- tion from the private sector including foreign players. As per rules, foreign companies can only enter joint venture: with Indian companies) with par- ticipation restricted to 49 per cent of equity. ie tions The major improvements in the working of various financial markets have | been taken up gradually with a step-by-step approach, not a big bang one. The entry of foreign players has assisted in the introduction of interna-. tional practices and systems. Technological developments have improved customer service. Some gaps, however, still remain like an'active corporate debt market. On the whole, the cumulative effect of the developments since 1991 has been quite encouraging. passisoola BOI Foreign companies are already allowed to hold a majority ‘stake in as management companies and NBFCs, up to 49 per cent ‘banks: maximum of 49 per cent in insurance companies. Banking system An indication of the strength of the reformed Indian financial system. be seen from the way India was not affected by the Southeas sian crisis and subprime crisis. ete. Major changes in the banking system in recent years in duction of Prudential norms for income recognition, ass provisioning for delinquent loans and capital adequacy. the stipulated capitaladequacy norms, substantial capital! by the Government to PSBs. a The Government pre-emption of banks’ resources through stat liquidity ratio (SLR) and cash reserve ratio (CRR) was also brought down in two stages. Sane Other prominent measures include: @ Interest rates on deposit and lending: ‘sides almost entire @ New private sector banks allowed to promote compt PSBs were encouraged to approach the public tor + Bank lending norms were liberalised and a loan’syst better control over credit was introduced. risks. TAXMANN®~/ 10 AN INTRODUCTION TO FINANCIAL sygrpqy ¥ Derivative products such as forward rate agreements (Fy Fate swaps (IRSs) and credit default swaps introduec Ras) ang ing Indian Capital Market significant changes were introduc, Tey, ulation of the Indian Capital Markets, Some of the promin, for ete Capital Issues (Control) Act, 1947 was repealed, Office of et Ones ant, Capital Issues abolished and initial share pricing decony, i tro th) the capital market regulator, was established in 1992, Tolled, The sn ener BR Forcign institutional investors (FIIs) were allowed to invest I, Seren pengers inves : markets after registration with the SEBL shan Indian, oe Indian companies permitted toaccess international: ital n api euro issues, mall markets throy, The National Stock Exchange (NSE), with nationwide Stock trag: electronic display, clearing and settlement facilities was establish otine ang regional stock exchanges changed over from floor based trading eVeral based trading, iE to scree! SEBI regulations governing substantial acquisition of sh; Nid pa : ares including conditions under which disclosures and mandatory pata rover, are to be made to shareholders were issued offers Private mutual funds were permitted. The Depositories Act provides a legal framework for the establishme, depositories torecord| ownership dealsin book. entry form. Dematerialisa st of stocks was introduced to encourage Paperless trading, - = Companies were required to disclose all material fact: factors associated with their projects while making pul To reduce the cost of issue, subject to conditions. The practice of making preferential allotment of shares at prices unrelated tothe prevailing market prices stopped and fresh guidelines issued by SEBL SEBI reconstitutes governing boards of the stock exchanges, introduces capital adequacy norms for brokers, and makes rules for making client/ broker relationship more transparent, including separation of client and broker accounts. 's and specific risk, iblic issues, underwriting by the issuer made optional One time permission to stock brokers extended to corporatize their busi- ness, without attracting capital gains tax, Buy-back of shares was permitted. i ’s financial system and To introduce greater transparency of the country’s financial y dealings, the SEBI is working to bring about greater corporate disclosures. ‘TAXMANN®AN INTRODUCTION TO FINANCIAL SYSTEM 1 1 sare being taken to improve corporate governance of lis eed ‘on the report of a committee. isted companics nce of detailed employee stock option scheme and empl arehase scheme for listed companies. ployee stock inati ity shares of & 10 and 10 . dard denomination for equity shar ! eens eae the freedom to issue dematerialised shares in any denomination, 7 Introduction of derivative trading with index optionsan and options: ; Ma Introduction of a system of rolling settler SEBI empowered to register and regulate ven e The SEBI (Credit Rating Agencies) Regulations, ‘was lating new credit ral i for all credit rating age! Financial Intermediation ae rmediation as defined by OECD) unit incurs liabilities on" lenders to borrows Asperthe economic view of monetary OP are or can act as financial intermedia Savings banks, Building societies, Credit! kers, Insurance companies, Collective int Cooperative societies, Stock exchanges. The financial intermediaries perform \ functions;4% 1. They provide a line of credit to q struments such as loans for financin§ homes, cards, small businesses, and person term liabilities to long term asset their conflicting needs by dealing borrowers. . Risk transformation: The financial] lending to multiple borrowers wi ich’ investments into relatively less risky 3. Convenience denomination: financial institutions undertake. It ‘TAXMANN'