INDIAN

FINANCIAL
SYSTEMS
 INTRODUCTION

An efficient, articulate and developed financial system is

indispenabale for rapid economic growth. The process of
economic development is invariably accompanied by a
corresponding and parallel growth of financial systems/
organisations. However, their institutional structure,
operational policies and regulatory framework differ
widely and are largely influenced by the prevailing
politico-economic environment. Planned economic
development in India had greatly influenced the course of
financial development till the early nineties. In the post-
1990s, the financial system has emerged in response to
the imperatives of a liberalised/globalised/deregulated
economic phase/era.
 Pre-1951 Organisation

The main features of the pre-1951 organisation of

the Indian financial system (IFS) were: closed-
circle character of industrial entrepreneurship; a
semi-organised and narrow industrial securities
market devoid of issuing institutions; and the
virtual absence of participation by intermediary
financial institutions in the long-term finance of
industry. Such a system was naturally not
responsive to opportunities for industrial
investment
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 Organisation Upto Mid-
eighties
The organisation of the IFS during the post-1951 period
evolved in response to the imperatives of planned
economic development. Planning signified the
distribution of credit and finance in conformity with the
planning priorities, which, in turn, implied Government
control over the financial system. The main elements
of the IFS were: public/government ownership of
financial institutions; fortification of the institutional
structure; protection to investors; and participation of
financial institutions (FIs) in corporate management.

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 Public Ownership of FIs

Public ownership of FIs was brought about partly

through nationalisation of existing institutions
[e.g. State Bank of India (1956), LIC (1956),
Commercial banks (1969) and GIC (1972)] but
mainly through the creation in the public sector,
of new institutions, namely, special-purpose
term-lending institutions/development banks and
UTI.

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 Fortification of Institutional
Structure

The fortification of the institutional structure of the

IFS was partly the result of modification in the
structure and policies of the existing FIs, but mainly
due to the addition of new institutions. The banking
policies and practices were moulded so as to be in
tune with the planning practices.
Banks were encouraged to reorient their operational
policies towards the financing of industry, as against
commerce and trade. They were also encouraged to
enter into new forms of industrial financing, namely,
underwriting and term-lending.
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The banks also enlarged their functional coverage in
terms of financing of small scale industries, exports
and agriculture. To expand the coverage and credit
remedy gaps to the priority sector, a scheme of
social control was introduced, followed by
nationalisation of the banks to control the heights of
the economy and meet progressively and serve
better the needs of development of the economy in
conformity with national priorities and objectives.

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The post-nationalisation period yielded significant
changes in operational policies and practices of
banks. This resulted in an acceleration of credit
availability to the priority sector and consequent
decline in the share of large industry in the total bank
credit, due to regulation and credit rationing.

The backbone of the institutional structure of the IFS

during this phase was the variegated structure of
development banks, namely, IDBI, IFCI, ICICI, SFCs,
SIDCs, SIICs and so on.

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They were conceived as instruments of the state
policy of directing capital into a chosen area of
industry, in conformity with the planning 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 in order to
broadbase the growth of industry, were being
realised

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The setting up of the LIC, as a result of an amalgamation
of 245 life insurance companies into a single monolithic
state-owned institution, was a part of the deliberate and
conscious attempt to mould the IFS according to the
requirements of planned development. It not only
transferred an important saving institution from private to
public ownership, but also brought about a massive
concentration of long-term funds in the hands of LIC,
which emerged as the largest reservoir of long-term
savings in the country.
Similarly, the setting up of the UTI was the culmination of
a long overdue need of the IFS to encourage indirect
holding of securities by the public.

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 Protection to Investors
Alongwith the measures being taken to strengthen
and diversify the institutional structure of the IFS,
extensive legal reforms were carried out to provide
protection to investors so as to restore their
confidence in industrial securities. The main
elements of the elaborate legislative code adopted by
the Government were: Companies Act; Capital Issues
(Control) Act (now repealed and replaced by the SEBI
Act); Securities Contracts (Regulation) Act; MRTP
Act (now replaced by Competition Act) and; Foreign
Exchange Regulation Act (now replaced by Foreign
Exchange Management Act).
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 Participation in Corporate
Management

A significant feature of the IFS was the participation

by the FIs, 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 FIs could
be ascribed to three factors: Government policy;
structure of the industrial securities itself; and the
deep involvement of the FIs in the fortune of the
companies through lending operations.

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 Lacking/Deficiency
A serious lacuna in the organisation of the IFS during
the pre-1990 period, related to its institutional
structure, which was dominated by the development
banks, which depended for resources on their
sponsors (RBI, Government). The IFS did not have
the ability to autonomously mobilise savings and had
degenerated into a distributive mechanism. It had
also resulted in a lop-sided capital structure of
corporates with a heavy component of borrowed
capital. The crying need of the IFS around the early
nineties was the integration of the distributive
mechanism with the savings pool of the community.
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 Post-90s Organization
In the post-1991 period, with a decline in the role of
the Government in economic management and, as a
logical corollary, in the distribution of finance and
credit, the capital market has emerged as the main
agency for the allocation of resources for all the
sectors of the economy. The IFS has naturally
undergone major transformation. The notable
developments contributing to this transformation
are: privatisation of FIs; reorganisation of the
institutional structure; and introduction of an
investor protection framework.
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 Privatisation of FIs
Beginning with the conversion of the IFCI into a
company and the offer of equity shares to private
investors by the IDBI, steps were initiated to privatise
important financial institutions. The private sector
financial institutions that had come into being are the
new generation of banks under the RBI guidelines;
mutual funds under SEBI regulations, sponsored by
FIs, FIIs, banks and insurance organisations; and
insurance companies sponsored by both domestic
and foreign promoters, under IRDA guidelines.
Pension funds are poised to be opened for private
entities with the setting up of the PRDA.
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 Reorganisation of the
Structure
The institutional structure of the IFS has
undergone an outstanding transformation in its
evolution to reflect its capital market-orientation.
The components which witnessed the
transformation are the development banks/term-
lending FIs/public financial institutions,
commercial banks, insurance companies, mutual
funds, NBFCs and securities/capital market and
money market.

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With the impending reorganisation/liquidation of
the IFCI Ltd. and the IIBI Ltd. and the conversion
of the ICICI and the IDBI into banks, the
development banks which constituted the
backbone of the organisation of the IFS, have
virtually disappeared from the Indian financial
scene, the only surviving institution being the
SFCs

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 Banks

Indian banking is characterised by prudential/viable

banking. By the early nineties, a geographically wide
and functionally diverse banking system had
emerged, as reflected in the phenomenal branch
expansion, especially in the rural and semi-urban
and unbanked areas, the phenomenal growth in
deposits and the increase in the share of priority
sector in total bank lending. This impressive
progress of Indian banking in achieving social goals
had indeed been a major developmental input.

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However, serious weaknesses developed in the form
of decline in the efficiency of the banking system and
consequently, a serious erosion of its profitability,
with adverse implications for its viability itself.
The first generation of reforms, as a follow-up to the
Narsimham Committee I recommendations, focused
on arresting the qualitative deterioration in the
functioning of the banking system in terms of
directed investments; directed credit programmes;
the interest rate structure; capital adequacy norms;
income recognition, asset classification and
provisioning norms and so on.

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The second generation of reforms, as a follow-up to the
Narsimham Committee II recommendations, addressed the
issue of making the banking system internationally
competitive. The focus shifted to internal financial
management of banks, in contrast to the regulatory
compliances until then. The major components of internal
financial management are: (1) rigorous prudential norms
relating to credit/investment portfolio and capital adequacy; (2)
management of non-performing assets (NPAs) to ensure
speedy/effective recovery in terms of DRTs, corporate debt
restructuring and securitisation of financial assets and
enforcement of security interest, and (3) management of risk to
which banks are exposed, namely, asset liability management,
credit risk, operational risk and management.

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With the entry of private insurance companies, the
monopoly of the public sector LIC and GIC has been
dismantled.
Mutual funds have emerged as the most preferred
route of institutionalisation of security investments
for the relatively small investors.
NBFCs broaden the range of financial services, both
fund-based and free-based. They operate within the
rigorous framework of RBI’s directions relating to
acceptance of public deposits, prudential norms and
auditors, reports.

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 Capital Market

The securities/capital market has witnessed the most

profound transformation. From being a marginal
institution in the mid-eighties, it has come to occupy
the centreage in the IFS. The structure of both the
primary and the secondary market is characterised
by significant changes. The reforms of the
intermediaries as well as the pre and post-issue
procedure and activities, are indeed thorough going,
as a consequence of which the primary market
organisation has assumed, highly developed

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character, capable of catering to the requirements of
the sophisticated and articulate securities market.
The secondary market, which represented an
institutional mechanism that was inadequate, non-
transparent, hardly regulated and rarely geared to
investor protection, has been truly transformed. The
notable developments relate to intermediaries,
reorganisation of stock exchanges, trading and so
on.

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 Money Market

The money market in India, had a narrow base and a

limited number of participants; there were no participants
who would alternate between lending and borrowing to
develop an active market; there was a paucity of
instruments in the market; and interest rates were
regulated. A sophisticated and articulate money market
has now emerged. Along with deregulation of interest
rates and enlargement of participants, there are a number
of inter-related sub-markets: call market, T-bills market,
commercial bills market, CPs market, CDs market, repo
and so on. The money market intermediaries are PDs and
MFs.
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 Investor Protection Framework
Although a fairly comprehensive legislative code had
been built up earlier, the focus was on control. The
framework was fragmented, both in terms of the
laws/acts under which the regulatory function fell
and the agencies/government departments that
administered them. The need for a focused/
integrated regulatory framework, administered by an
independent/autonomous body, found expression in
the establishment of the SEBI. Its main function is to
protect the interest of the investors in securities and
to promote the development and regulation of the
securities market. The SEBI exercises power under
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the SEBI Act, SCRA, Depositories Act and delegated
powers under the Companies Act. It regulates and
supervises the securities market through a number
of regulations/guidelines and schemes.

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