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The economic development of any country depends on the presence of a well-structured and
organised financial system. The financial system ensures that it makes available the financial
resources for production of goods and services required for well-being and better standard of
living of people in the country.
FInancial system is a broad term which comprises a set of subsystems- Financial Institutions,
Financial Markets, Financial Instruments and Financial Services which help in the
formation and circulation of capital. It provides a mechanism by which savings are converted
into investments. Therefore, a financial system plays an important role in the economic growth
and development of the country by mobilising the surplus funds and employing them
effectively for productive purposes in the economy.
Definition:
A financial system may be defined as a set of institutions, markets, instruments and services
which promotes savings and channelise them to their most efficient use. It is a system that
allows the exchange of funds between savers (lenders), borrowers and investors.
The primary function of a financial system is to provide a link between savings and investment.
Financial system, apart from performing the primary function, renders a number of useful
services. A financial system performs the following functions:
1. Link between savers and investors: It serves as a link between savers and investors.
It helps in utilising the mobilised savings of the scattered savers in a more efficient and
effective manner. It channelises flow of savings into productive investment.
2. Assists in selection of projects: It assists in the selection of the projects to be financed
and also reviews the performance of such projects periodically.
3. Payment mechanism: It provides a payment mechanism for the exchange of goods and
services.
4. Transfer of resources: It provides a mechanism for the transfer of resources across
geographic boundaries.
5. Risk management and control: It provides a mechanism for managing and controlling
the risk involved in mobilising savings and allocating credit.
6. Capital formation: It promotes the process of capital formation by bringing together
the supply of savings and the demand for ingestible funds.
7. Reduces cost and increases returns: It helps in lowering the cost of transactions and
increases returns. Reduced cost motivates people to save more.
8. Provides detailed information: It provides detailed information to the
operators/players in the market such as individuals, business houses, government etc.
The following are the five major components that comprise the 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 facilitate smooth functioning of the
financial system by making investors and borrowers meet. They mobilise savings of the
surplus units and allocate them in productive activities promising a better rate of return.
● Financial institutions alo provide services to entities (individual, business, government)
seeking advice on various issues ranging from restructuring to diversification plans.
● They provide a whole range of services to the entities who want to raise funds from the
markets or elsewhere. Financial Institutions are also termed as Financial
Intermediaries because they act as middlemen between the savers (by accumulating
funds from them) and borrowers (by lending these funds).
● Banks also act as intermediaries because they accept deposits from a set of customers
(savers) and lend these funds to another set of customers (borrowers). Similarly,
investing institutions such as GIC, LIC, mutual funds etc. also accumulate savings and
lend these to borrowers, thus performing the role of financial intermediaries.
● Financial institution's role as an intermediary differs from that of a broker who acts as
an agent between buyer and seller of a financial instrument (equity shares, preference,
debt); thus facilitating the transaction but does not personally issue a financial
instrument. Whereas, financial intermediaries mobilise savings of the surplus units and
lend them to borrowers in the form of loans and advances (fe. by creating a financial
asset).
A. Banking Institutions
Indian banking industry is subject to the control of the Central Bank (f.e. Reserve Bank of
India). The RBI as the apex institution organises, runs, supervises, regulates and develops the
monetary system and the financial system of the country. The main legislation governing
commercial banks in India is the Banking Regulation Act, 1949. The Indian banking
institutions can be broadly classified into two categories:
1. Organised Sector
2. Unorganised Sector
1. Organised Sector
The organised banking sector consists of Commercial banks, Co-operative banks and the
Regional Rural Banks.
Different types of Co-operative Credit societies are operating in the Indian economy. These
institutions can be classified into two broad categories:
(a) Rural credit societies: which are primarily agricultural;
(b) Urban credit societies: which are primarily non-agricultural.
For the purpose of agricultural credit there are different co-operative credit institutions to meet
different kinds of needs. For example, short and medium term credit is provided through a three
tier federal structure.
● At top is the apex body ie.,State Co-operative bank;
● In the middle there are District Co-operative banks or Central Co-operative banks,
● At the grass root level i.e., village level there are Primary Agricultural Credit
societies.
(c) Regional Rural Banks (RRBs). Regional Rural Banks were set by the state government
and the sponsoring commercial banks with the objective of developing the rural economy.
Regional rural banks provide banking services and credit to small farmers, small entrepreneurs
in the rural areas. The regional rural banks were set up with a view to provide credit facilities
to weaker sections. They constitute an important part of the rural financial architecture in India.
There were 196 RRBs at the end of June 2002, as compared to 107 in 1981 and 6 in 1975.
RBI extends refinance assistance at a concessional rate of 3 percent below the bank rate. IDBI,
NABARD and SIDBI are also required to provide managerial and financial assistance to RRBs
under the Regional Rural Bank Act.
(d) Foreign Banks: Foreign Banks have been in India from British days. ANZ Grindlays Bank,
The Standard and Chartered Bank and Hong Kong Bank. These banks have concentrated on
corporate clients and have been specialising in areas relating to international banking. With the
deregulation of banking in 1993, a number of foreign banks are entering India or have got the
licences.
Some new foreign banks are-
(1) Barclays Bank (2) Bank of Ceylon
(3) Bank Indonesia International Bank of Mauritius (4) State Commercial
(5) Development Bank of Singapore (6) Chase Manhattan Bank
(7) Dresdner Bank Ltd. (8) Overseas Chinese Bank Corporation
(9) Chinatrust Commercial Bank (10)Krung Thai Banking Public Co.
(11)Cho Hung Bank (12) Commerz Bank
(13) Fuji Bank (14) Toronto Dominion Bank
2. Unorganised Sector
In the unorganised banking sector are the Indigenous bankers, Money lenders, Seths, Sahukars
carrying out the function of banking.
(b) Money Lenders: Money lenders depend entirely on their own funds for the working
capital. Money lenders may be rural or urban, professional or non-professional. They include
large farmers, merchants, traders, arhatias, goldsmiths, village shopkeepers, sardars of
labourers, etc. The methods and areas of operation differ from money lender to money lender.
B. NON-BANKING INSTITUTIONS
The non-banking institutions may be categorised broadly into two groups:
2. Investment Institutions. These include those financial institutions which mobilise savings
of the public at large through various schemes and invest these funds in corporate and
government securities. These include LIC, GIC, UTI, and mutual funds
NBFCs mobilise public funds and provide loanable funds. There has been a remarkable
increase in the number of such companies since 1990's. The regulatory framework of NBFCs
are prescribed by RBI.
Financial Markets:
Meaning:
Finance is the prerequisite for modern business and financial institutions play a vital role in the
economic system. It is through financial markets and institutions that the financial system of
an economy works. The financial markets, in a nutshell, are the credit markets catering to the
various credit needs of the individuals, firms and institutions. Credit is supplied both on a short
as well as a long term basis.
Definition: Financial markets refer to the institutional arrangements for dealing in financial
assets and credit instruments of different types such as currency, cheques, bank deposits, bills,
bonds, etc.
1. Negotiated loan markets: The negotiated loan market is a market in which the lender
and the borrower personally negotiate the terms of the loan agreement, eg, a
businessman borrowing from a bank or from a small loan company
2. Open market: Open market is an impersonal market in which standardised securities
are traded in large volumes. The stock market is an example of an open market.
The financial markets can be classified in a number of ways. The broad classification of
financial market is given below:
1. Money Market
2. Capital Market
3. Derivatives Market
4. Debt Market
5. Insurance Market
6. Foreign Exchange Market
On the basis of credit requirement for short-term and long term purposes, financial markets are
divided into two categories:
1. Money Market
2. Capital Market
1. MONEY MARKET
The term money market is used in a composite sense to mean financial institutions which deal
with short-term funds in the economy. In a money market, funds can be borrowed for a short
period varying from a day, a week, a month, or 3 to 6 months and against different types of
instruments, such as bill of exchange, bankers' acceptances. bonds, etc., called 'Near Money’.
Definition:
The borrowers in the money market are generally merchants, traders, manufacturers, business
concerns, brokers and even government institutions. The lenders in the money market, on the
other hand, include the Central Bank of the country, the commercial banks, insurance
companies and financial concerns.
The organisation of the money market is formed. There is no definite place or location where
money is borrowed and lent by the parties concerned, it is not necessary for the borrowers and
the lenders to have personal contact with each other. Negotiations between the parties may be
carried through telephone, telegraph or mail. Thus, money market is simply an arrangement
that brings about a direct or indirect contact between the lender and the borrower.
1. The basic function of the money market is to facilitate adjustment of liquidity position
of commercial banks, business corporations and other non-bank financial institutions.
2. It provides outlets to commercial banks, business corporations, non-bank financial
concerns and other investors for their short-term surplus funds.
3. It provides short-term funds to various borrowers such as businessmen, industrialists,
traders etc.
4. Money market provides short-term funds even to government institutions.
5. The money market constitutes a highly efficient mechanism for credit control. It serves
as a medium through which the Central Bank of the country exercises control on the
creation of credit.
6. It enables businessmen to invest their temporary surplus for a short-period.
7. It plays a vital role in the flow of funds to the most important uses.
The money market is not homogeneous in character. This is a loosely organised institution with
a number of divisions and subdivisions. Each particular division or subdivision deals with a
particular type of credit operation. All the sub-markets deal in short term credit. The following
are the important constituents or sectors of money market
Call money market refers to the market for a very short period. Bill brokers and dealers in the
stock exchange usually borrow money at call from the commercial banks. These loans are given
for a very short period not exceeding seven days under any circumstances, but more often from
day-to-day or for overnight only i.e. 24 hours. There is no demand for collateral securities
against call money. They possess high liquidity, the borrowers are required to pay the loan as
and when asked for, re. at a very short notice. It is on account of this reason that these loans are
called 'Call Money' or ‘Call loans’. Thus, Call Money Market is an important component of
the money market.
The investment of funds in the call market meets the need of liquidity but not that of
profitability because the rate of interest on call loans is very low and changes several times
during the course of the day.
Call loans are useful to the commercial banks because these can be converted into cash at any
time. They are almost like cash. It is a form of secondary cash reserves for the commercial
banks from which they earn some income too.
It is another specialised sector of the money market. The market for loans is geographically
dispersed and most loosely organised. The loans are generally advanced by the commercial
banks to private parties in the market. The collateral loans are backed by the securities, stocks
and bonds. The collateral securities may be in the form of some valuable, say government
bonds which are easily marketable and do not fluctuate much in prices. The collateral money
is returned to the borrower when the loan is repaid. Once the borrower is unable to repay the
loan, the collateral becomes the property of the lender. These loans are given for a few months.
The borrowers are generally the dealers in stocks and shares. But even smaller commercial
banks can borrow collateral loans from the bigger banks.
Banker's acceptances are a very old form of commercial credit. Acceptance market refers to
the market for banker's acceptances involved in trade transactions.
This market deals with bankers acceptances which may be defined as a draft drawn by a
business firm upon a bank and accepted by it. It is required to pay to the order of a particular
party or to the bearer a certain specific amount at a specific date in the future. These acceptances
emerge out of commercial transactions both within the country and abroad. The market where
the bankers' acceptances are easily sold and discounted is known as the Acceptance Market. A
banker's acceptance is payable at a specified future date whereas a cheque is payable on
demand. Banker's acceptances can be easily discounted in the money market because they carry
the signature of the bankers.
The Discount Market refers to a market place where short-term instruments such as
Commerical Bills or Treasury Bills are discounted by financial intermediaries such as
commercial banks. When the goods are sold on credit, the seller draws a bill on the buyer who
accepts it promising to pay the specified sum at a specified date. The seller, instead of waiting
for the maturity of the bill, gets it discounted with a commercial bank. The bank after deducting
the discount charges makes the payment of the bill to the seller. On the date of maturity the
bank will claim the amount of the bill from the person who accepted the bill.
In the UK, there are specialised institutions called Discount Houses which specialise only in
the field of discounting bills and papers. They operate as principals, jobbers, brokers and
commission agents and earn income from these activities. Discount houses help to stabilise the
money market rates and prevent monetary losses.
4. Bill Market
It is a market in which short term papers or bills are bought and sold. The important types of
short term papers are:
(a) Bills of Exchange: Bills of exchange are commercial papers. A bill of exchange is a written
unconditional order which is signed by the drawer requiring the drawee to pay on demand or
at a fixed future time, a definite sum of money Once the buyer signifies his acceptance on the
bill itself, it becomes a legal document. Such bills are discounted or rediscounted by
commercial banks to lend credit to the bill-holders or to borrow from the central bank
(b) Treasury Bills: The treasury bills are government paper securities for a short period usually
of 91 days' duration. The treasury bills are the promissory notes of the government to pay a
specified sum after a specified period. These are sold by the Central Bank on behalf of the
government. Since the treasury bills are government papers, they inspire public confidence in
the minds of the investors. As no risk is involved in their purchase, they become good papers
for the commercial banks to invest their short term funds. Since discounting is the main process
of exchange, it is also called 'Discount Market' also.
As per the Reserve Bank of India, Certificate of Deposit (CD) “ is a negotiable money market
instrument and issued in dematerialized form or as a Usance Promissory Note against funds
deposited at a bank or other eligible financial institutions for a specified time period."
Certificate of Deposits are marketable receipts in bearer or registered form of funds deposited
in a bank or other eligible financial institution for a specified period at a specified rate of
interest. They are different from the fixed deposits in the sense that they are freely transferable,
can be sold to someone else and can be traded on the secondary market. They are liquid and
riskless in terms of default of payment of interest and principal.
Originally, the CDs were issued in multiples of 25 lakh subject to the minimum size of each
issue being 1 crore, having a maturity period of 3 months to 1 year and a lock-in period of 45
days after the date of issue. The Reserve Bank of India has modified its guidelines from time
to time. At present the minimum amount of a CD should be 1 lakh and in multiples of 1 lakh
thereafter. The maturity period of certificate of deposit, at present, should not be less than 7
days and not more than one year, from the date of issue, in case of CD issued by a bank.
Although, the financial institutions can issue CDs for a period not less than one year and not
exceeding three years from the date of issue.
CPs are short-term usance promissory notes issued by reputed companies with good credit
standing and having sufficient tangible assets. CPs are unsecured and are negotiable by
endorsement and delivery. CPs are normally issued in a bearer form on discount to face value
basis. The issuing companies normally can buy-back CPs if the need arises.
CPs are normally issued by the banks, public utilities, insurance and finance companies. The
buyers of CP's include banking and non-banking financial institutions. CPs in India were
launched by the RBI's notification in January, 1990 with a view to enable highly reputed
companies to diversify their sources of short-term borrowings and also to provide an additional
instrument to investors.
Initially, CPs were allowed to be issued at a discount to their face value and the discount rate
was freely determined by the company issuing the CPs. The issuing company is required to
meet the stamp duty, credit rating agency fees, stand by facility charges etc. The maturity period
of CPs was 30 days.
The following are the instruments that are available in the money market.
1. Commercial Bills
2. Treasury Bills (TBS)
3. Call and Short Notice Money Market
4. Certificate of Deposits (CDs)
5. Commercial Paper (CP)
6. Repurchase Agreement (REPO)
7. Inter Bank Participation Certificate
2. CAPITAL MARKET
The term 'capital/security market' refers to the institutional arrangements for facilitating the
borrowing and lending of long-term funds. In a broad sense, it consists of a series of channels
through which the savings of the community are made available for industrial and commercial
enterprises and public authorities. It is concerned with those private savings, individual as well
as corporate, that are turned into investments through new capital issues and also new public
loans floated by government and semi-government bodies.
Definition: A capital market may be defined as “An organised mechanism for effective and
efficient transfer of money capital or financial resources from the investing parties, i.e.,
individuals or institutional savers to the entrepreneurs (individuals or institutions) engaged in
industry or commerce in the business either be in the private or public sectors of an economy”.
1. Ensures best possible coordination and balance between the flow of savings on the one
hand and the flow of investment leading to capital formation on the other;
2. Directs the flow of savings into most profitable channels and thereby ensures optimum
utilisation of financial resources.
Thus, an ideal capital market is one where finance is used as a hand-maid to serve the needs of
industry. Finance is available at a reasonable rate of return for any investment purpose which
offers a proposed yield, sufficient to make borrowing worthwhile, the development of savings,
proper organisation of intermediary institutions and the entrepreneurial qualities of the people.
The capital market must facilitate the movement of capital to the point of highest yield.
1. Helps in capital formation: The capital market plays an important role in mobilisation
of savings and channelises them into productive investments for the development of
commerce and industry. As such, the capital market helps in capital formation and
economic growth of the country.
2. Act as link between savers and investors: The capital market acts as an important link
between savers and investors. The savers are lenders of funds while investors are
borrowers of funds. The savers who do not spend all their income are called. "Surplus
units' and the borrowers are known as "deficit units". The capital market is the
transmission mechanism between surplus units and deficit units. It is a conduit through
which surplus units lend their surplus funds to deficit units.
3. Helps in increasing national income: Funds come into the capital market from
individuals and financial intermediaries and are used by commerce, industry and
government. It thus facilitates the transfer of funds to be used more productively and
profitability to increase the national income.
4. Facilitates buying and selling: Surplus units buy securities with their surplus funds and
deficit units sells securities to raise the funds they need. Funds flow from lenders to
borrowers either directly or indirectly through financial institutions such as banks, unit
trusts, mutual funds, etc. The borrowers issue primary securities which are purchased by
lenders either directly or indirectly through financial institutions.
5. Channelizes funds from unproductive to productive resources: The capital market
provides a market mechanism for those who have savings and to those who need funds
for productive investments. It diverts resources from wasteful and unproductive channels
such as gold, jewellery, real estate, conspicuous consumption, etc. to productive
investments
6. Minimises speculative activities: It does so by providing capital to the needy at
reasonable interest rates and helps in minimising speculative activities.
7. Brings stability in value of stocks: A well-developed capital market comprising expert
banking and non-banking intermediaries brings stability in the value of stocks and
securities.
8. Promotes economic growth: The capital market encourages economic growth. The
various institutions which operate in the capital market give quantitative and qualitative
direction to the flow of funds and bring rational allocation of resources. They do so by
converting financial assets into productive physical assets. This leads to the development
of commerce and industry through the private and public sector, thereby inducing
economic growth.
9. Play an important role in an underdeveloped country: In an underdeveloped country
where capital is scarce, the absence of a developed capital market is a great problem to
capital formation and economic growth. Even though the people are poor, yet they do not
have any inducements to save. Others who save, invest their savings in wasteful and
unproductive channels, such as gold, jewellery, real estate, conspicuous consumption, etc
.Such countries can induce people to save more by establishing banking and non-banking
financial institutions for the existence of a developed capital market. Such a market can
go a long way in providing a link between savers and investors, thereby leading to capital
formation and economic growth.
New Issue Market also called Primary Market refers to the market where new securities
such as equity shares or bonds are offered to the public for issue for the first time. Both the new
companies and the existing companies can raise capital on the new issue market. New issue
market facilitates the transfer of funds from the willing investors to the entrepreneurs setting
up new firms or going in for expansion, diversification or modernisation etc. It helps in
channelising the savings of individuals and others into investments. The players in new issue
market include individuals, banks, insurance organisations, UTI, foreign and domestic
financial institutions. There are various financial intermediaries like merchant bankers, brokers,
sub-brokers, underwriters, portfolio managers etc. who facilitate the issue of securities.
The corporate securities that are dealt in new issue/primary market include
Stock market represents the secondary market where existing securities (shares and debentures)
are purchased and sold, stock exchanges provide an organised mechanism for purchase and
sale. It is an organised and regulated market for various listed securities issued by the corporate
sector and other institutions. It allows trading in securities both to the genuine investors and
speculators. Stock exchanges play an important role in the economic development of a country.
1. It provides a place where shares and stock are converted into cash.
2. It provides a ready market for trading in securities.
3. The investors can evaluate the worth of their holdings from the prices quoted at different
exchanges for those securities.
4. Stock Exchanges play an important role in mobilising surplus funds of investors.
5. Stock Exchanges ensure safety in dealings which brings confidence in the minds of all
concerned parties and helps in increasing various dealings.
6. Duly listed securities can be purchased at stock exchanges.
7. Stock exchanges provide a platform for raising public debts. The stock exchanges are
also organised markets of government securities.
The capital market should be distinguished from the money market. The capital market is the
market for long-term funds. On the other hand money market is primarily the market for short-
term funds However, the two markets are closely related as the same institution many a times
deals in both types of funds, ie short-term as well as long-term
The main points of distinction between the two markets are as under:
It provides finance/money capital for long- term It provides finance/money for shon-term
investment. investment.
The finance provided by the capital market may be The finance provided by the money market is
used both for fixed and working capital. utilised, usually for working capital.
Mobilisation of resources and effective utilisation of Lending and borrowing are its principal
resources through lending are its main functions. functions to facilitate adjustment of liquidity
position.
It's one of the constituents, Stock Exchange acts as It does not provide such facilities. The main
an investment market for buyers and sellers of components include the call loan market,
securities. collateral loan market, bill market and
acceptance houses.
It acts as a middleman between the investor and the It acts as a link between the depositor and the
entrepreneur. borrower.
Its investment institutions raise capital from the It provides outlets to commercial banks,
public and invest in selected securities so as to give businesses, corporations, non-bank financial
the highest possible return with the lowest risk. concerns and others for their short-term surplus
funds.
It provides long-term funds to Central and State It provides short-term funds to the Government
Governments, public and local bodies for by purchasing treasury bills and to others by
development purposes. discounting bills of exchange, etc.
3. Derivatives Market
In other words, a derivative is a financial product, which has been derived from another
financial product or commodity. Derivatives are financial contracts which derive their value
off a spot price time series, which is called the "underlying". For example, a wheat farmer may
enter into an agreement to sell his harvest at a future date to eliminate the risk of a change in
prices by that date. Such a transaction would take place through a forward or futures market.
This market is the "derivative market", and the prices on this market are guided by the spot
market price of wheat which is the "underlying". The derivatives do not have independent
existence without the underlying product and market.
4. Debt Market
It is a market for trading, ie, buying or selling of fixed income instruments such as government
securities and corporate bonds.
Creditors/Suppliers of funds are always at risk of non-payment of loans by the debtors. In order
to minimise the risk, they always insist on some guarantee by the third person so that in case,
the principal debtors make a default in the repayment of loans, the guarantor becomes the
debtor i.e. the guarantor becomes liable for repayment of loan capital. The guarantor can be a
renowned person or special state guarantee organisation. Guarantee can be oral or written but
mostly creditors insist on written guarantee.
Government securities are the instruments issued by Central government, State governments,
Semi-government bodies, public sector corporations and financial institutions such as IDBI,
IFCI, State Financial Corporations (SFCS) etc. in the form of marketable debt. Government
securities form an important part of the stock market in India.
Funds mobilised are used to meet the short-term and long-term needs of the government.
Central government securities are considered to be the safest amongst all type of securities as
regard to the payment of interest and repayment of principal amount. They are also called Gilt-
Edged Securities. They are free of default-risk or credit risk. They are considered to be more
liquid assets and ensure certainty of capital value not only at maturity but also before maturity.
Since the date of maturity is mentioned in the securities, these are also known as Dated
Government Securities.
6. Commodity Markets
Commodity trading in India has a long history. In fact, commodity trading in India started much
before it started in many other countries. However, years of foreign rule, droughts and periods
of scarcity and Government policies caused the commodity trading in India to diminish.
Commodity trading was, however, restarted in India recently. Today, apart from numerous
regional exchanges, India has four national commodity exchange namely:
7. Insurance Market
A healthy and developing insurance sector is of vital importance to every modern economy, it
encourages the savings habit, provides a safety net to rural and urban enterprises and productive
individuals, and generates long-term funds for infrastructure development. The insurance
industry plays a significant role in India's modern economy. Insurance is necessary to protect
enterprises against risks such as fire and natural disasters. Individuals require insurance
services in such areas as health care, life, property and pension. Development of insurance is
therefore necessary to support continued economic transformation. Social security and pension
reforms also benefit from a mature insurance industry.
International transactions involve payments or receipts in currencies other than the home
currency of trading countries. This results in the need for buying and selling of foreign
exchange. The market in which international currency trade takes place is called the Foreign
Exchange Market. It is the organisational framework within which banks, firms, individuals
and government buy and sell foreign currencies. It is the vehicle that makes possible the
exchange of different national currencies. International trade and investment would not have
been possible without the foreign exchange market because rupee is not the international means
of exchange.
Financial Instruments/Assets/Securities
1. Primary Securities: These are also termed as 'Direct Securities' as these by the ultimate
borrowers of funds to the ultimate savers or investors. Primary securities include equity shares,
preference shares and debentures.
2. Secondary Securities: These securities are also termed as 'Indirect Securities' as these are
not issued directly by the ultimate borrowers, rather, these are issued by financial
intermediaries to ultimate savers. Insurance policies, units of the mutual funds, bank deposits
etc. are the examples of secondary securities. Financial instruments are 'Monetary Contracts'
between parties. These are assets that can be traded, modified and settled.
Depending upon the nature of claim or return, financial instruments may be classified as:
3. Derivatives: whose value is derived from the value of an underlying financial instrument.
These include forwards, futures, options, swaps or a mix of these.
Financial instruments may also be classified as cash instruments and derivative instruments.
The most important financial instruments include:
a) Cash or currency.
(b) Equity shares
(c) Preference shares
(d) Debentures or bonds
(e) Derivatives.
Financial instruments perform a significant role in transferring funds from lenders to borrowers
through financial markets and financial intermediaries. Each instrument differs from each other
in terms of its marketability, risk, return, liquidity and transaction costs. The following are
some of the new innovative financial instruments devised for raising funds:
Financial Services
Efficiency of an emerging financial system largely depends upon the quality and variety of
financial services provided by financial intermediaries.
Definition:
The term financial services can be defined, "Activities, benefits and satisfactions, connected
with the sale of money, that offer to users and customers, financial related value".
Financial service organisations render services to industrial enterprises and ultimate consumer
markets. Within the financial services industry the main sector are banks, financial institutions
and non-banking financial companies.
1. Equipment Leasing/Finance
2. Hire-Purchase and Consumer Credit
3. Bill Discounting
4. Venture Capital
5. Housing Finance
6. Insurance Services
7. Factoring etc.
1. Issue Management
2. Portfolio Management
3. Corporate Counselling
4. Loan Syndication
5. Merger and Acquisition
6. Capital Restructuring
7. Credit Rating
8. Stock Broking and so on.
The scope of financial services is very large as they cover a wide range of activities which can
be classified as:
1. Traditional Activities
2. Modern Activities
Financial services provided by various financial institutions, commercial banks and merchant
bankers can be broadly classified into two categories.
Securitisation
FINANCIAL INTERMEDIARIES
A financial intermediary is an entity (a firm or an institution) that acts as the facilitator between
the savers of money and the borrowers. The financial intermediaries channelise funds between
lenders and borrowers. That is, savers give funds to intermediary institutions (banks), and that
institution gives those funds to users, spenders or borrowers. Thus, a financial intermediary is
a firm or an institution that acts as an intermediary between a provider of service and a
consumer. Financial intermediaries channelise savings into investments. They work conduits
between the borrowers and lenders and work in the savings-investment cycle of economy.
There are a number of financial intermediaries who provide asset based or fee based service
such as:
Asset based services are provided by institutions such as banks and insurance companies
whereas fee based financial intermediaries provide portfolio management and syndicate
services
Financial institutions are the intermediaries who facilitate smooth functioning of the financial
system by making investors and borrowers meet. They mobilise savings of the surplus units
and allocate them in productive activities promising a better rate of return. Financial institutions
also provide services to entities (individual, business, government) seeking advice on various
issues ranging from restructuring to diversification plans. They provide a whole range of
services to the entities who want to raise funds from the markets or elsewhere.
Financial Institutions are also termed as financial intermediaries because they act as
middlemen between the savers (by accumulating funds from them) and borrowers (by
lending these funds) banks also act as intermediaries because they accept deposits from a
set of customers (savers) and lend these funds to another set of customers (borrowers).
Like-wise investing institutions such GIC, LIC, mutual funds etc. also accumulate savings
and lend these to borrowers, thus performing e role of financial intermediaries.
The financial intermediaries can be classified in a number of ways depending upon the
objective of classification. The most common classification is shown below:
1. Banks
2. Banking Finance Companies
Non-Banking Intermediaries
1. Insurance Companies
2 Pension Funds)
3. Mutual Funds
4. Financial Advisors
5. Consultants, etc.
There are a number of functions or services provided by financial intermediaries. The important
functions are:
3. Providing storage facilities: Financial intermediaries provide safe storage facilities for
surplus cash and other liquid assets like gold. A person may park his surplus funds with
intermediaries (banks) and earn income as interest also. Thus, they grow their money via
investments.
4. Short term and long-term loans: Financial intermediaries help in providing short-term as
well as long-term loans to meet different requirements of various firms and institutions.
5. Customise services for clients: Financial intermediaries customize their services to various
clients to meet their specific requirements.
6. Reducing the risk: Financial intermediaries reduce the risk of various investors on money,
An individual may not have the necessary information and resources to the financial viability
of the borrower.
Financial institution's role as intermediary differs from that of a broker who acts as an between
buyer and seller of a financial instrument (equity shares, preference, debt); thus facilitating the
transaction but does not personally issue a financial instrument. Whereas, financial
intermediaries mobilise savings of the surplus units and lend them to the borrowers in the form
of loans advances (i.e. by creating a financial asset). They earn profit from the difference
between res interest charged on loans and rate of interest paid on deposits (savings). In short,
they repackage depositor's savings into loans to the borrowers. As financial intermediaries,
they meet the str term as well as long-term needs of the borrowers and provide liquidity to the
savers.
Financial intermediaries have a very important role in the economy for efficient allocation of
resources. They have a key role to play in the financial system of a country. They are the
lubricants that keep the financial system growing. As financial intermediaries have become a
very important part of the financial system, there is a need for their regulation.
1. Value Transformation: With the process of pooling savings of small investors the
intermediaries can meet the requirements of borrowers of large sums of money. This creates
value transformation.
3. Risk Diversification : The financial intermediaries diversify the risk of savers by investing
their funds in various products and borrowers.
4. Reduction in Costs: Another advantage of financial intermediaries is that they reduce the
costs of transactions.
The financial system plays a significant role in the process of economic development of a
country. The financial system comprises of a network of commercial banks. Non-banking
companies, development banks and other financial and investment institutions offer a varieties
of financial products and services to fulfil the various needs of different categories of people.
Since they function in a fairly developed capital and money markets, they play a crucial role in
spurring economic growth in the following ways:
(i) Mobilising savings: The financial system mobilises the savings of the people by offering
attractive incentives offering a wide variety of instruments. In other words, the financial system
creates varieties of options for savings so that savings can take place according to the different
asset preferences of different classes of savers. In the absence of the financial system, all
savings would remain idle in the hands of the savers and they would not have flown into
productive ventures.
(ii) Promoting investments: For the economic growth of any nation, investment is absolutely
essential. This investment has to flow from the financial system. In fact, the level of investment
determines the increase in output of goods and services and incomes in the country. The
financial system collects the savings and channels them into investment which contributes
positively towards economic development.
(iii) Encouraging investment in financial assets: The dynamic role of the financial system in
the economic development is that it encourages savings to flow into financial assets (money
and monetary assets) as against physical assets (land, gold and other goods and services). The
investments in physical assets are speculative and would breed inflation. On the other hand,
investment in financial assets are non-inflationary in nature and would support growth in the
economy. The larger the proportion of the financial assets, the greater is the scope for economic
growth in the long run.
(iv)Allocating savings on the basis of national priorities: The financial system allocates the
savings in a more efficient manner so that the scarce capital may be more efficiently utilised
among the various alternative investments. In other words, it gives preference to certain sectors,
from the social and economic point of view, on the basis of national priorities.
(v) Creating credit: Large financial resources are needed for the economic development
of a nation. These resources are supplied by the financial system not only in the form of liquid
cash but also in the form of 'created money' or 'deposit money' by creating credit and thereby
making available large resources to finance trade, production, distribution, etc. Thus, it
accelerates economic growth by facilitating the transactions of trade, production and
distribution on a large-scale.
vi) Providing a spectrum of financial assets: The financial system provides a spectrum of
financial assets so as to meet the varied requirements and preferences of households. Thus, it
enables them to choose their asset portfolios in such a way as to achieve a preferred mix of
return, liquidity and risk. Thus, it contributes to the economic development of a country
(vii) Financing trade, industry and agriculture: All the financial institutions operating in a
financial system take all efforts to ensure that no worthwhile project, be it in trade or agriculture
or industry-suffers due to lack of funds. Thus, they promote industrial and agricultural
development which have a greater say on the economic development of a country.
(ix) Providing financial services: Innovations have started appearing in the area of financial
intermediation. The financial institutions play a very dynamic role in the economic
development of a country not only as a provider of finance, but also as a departmental store of
finance by offering varieties of innovative financial products and services to meet the ever-
increasing demands of their clients both corporates and individuals.
(x) Developing backward areas: The national development plans of every country
concentrates on the development of relatively less developed areas called backward areas. The
financial institutions provide a package of services, infrastructure and incentives conducive to
a healthy growth of industries in such backward areas and thus, they contribute for the uniform
development of all regions in a country.
1. Lack of coordination between different financial institutions: There are a large number
of financial intermediaries. Most of the important financial institutions are owned by the
Government. At the same time, the Government is also the controlling authority of these
institutions. In these circumstances, the problem of coordination arises. As there is
multiplicity of institutions in the Indian financial system, there is lack of coordination in
the working of these institutions.
2. Monopolistic market structures: In India, some financial institutions are so large that
they have created a monopolistic market structures in the financial system. For instance, a
major share of life insurance business is in the hands of LIC. The UTI has more or less
monopolised the mutual fund industry. The weakness of this large structure is that it could
lead to inefficiency in their working or mismanagement or lack of effort in mobilising
savings of the public and so on. Ultimately, it would retard the development of the financial
system of the country itself.
3. Dominance of development banks in industrial financing: The development banks
constitute the backbone of the Indian financial system occupying an important place in
the capital market. The industrial financing today in India is largely through the financial
institutions created by the Government both at the national and regional levels. These
development banks act as distributive agencies only, since, they derive most of their
funds from their sponsors. As such, they fail to mobilise the savings of the public. This
would be a serious bottleneck which stands in the way of the growth of an efficient
financial system in the country.
4. Inactive and erratic capital market: The important function of any capital market is to
promote economic development through mobilisation of savings and their distribution to
productive ventures. As far as industrial finance in India is concerned, corporate
customers are able to raise their financial resources through development banks. So, they
need not go to the capital market. Moreover, they do not resort to capital market since it
is very erratic and inactive. Investors too prefer investments in physical assets to
investments in financial assets. The weakness of the capital market is a serious problem
in our financial system.
However, in recent times, all efforts have been taken to activate the capital market. Integration
is also taking place between different financial institutions. For instance, the Unit Linked
Insurance Schemes of the UTI are being offered to the public in collaboration with the LIC.
Similarly, the refinance and rediscounting facilities provided by the IDBI aim at integration.
Thus, the Indian financial system has become a developed one.
The Reserve Bank of India (RBI) is the Central Bank of the country. It was established on
recommendations of Hilton Young Commission. It had been established as a body corporate
under the Reserve Bank of India Act, 1934 which came into effect from 1st April, 1935.
The Reserve Bank of India was started as share-holders bank with a paid-up capital of 5 crores,
divided in 5 lakh shares of Rs 100 each. After its establishment it took over the function of
management of currency from the Government of India and power of credit control from the
Imperial Bank of India.
Nationalisation Of Reserve Bank Of India
The Reserve Bank was nationalised in 1948 soon after independence. Some of the reasons for
nationalisation were as follows:
1. There was a trend towards nationalisation of the Central Bank of the country in all parts of
the world after the end of the Second World War.
2. To control the inflationary tendencies that had started right from the beginning of the
Second World War, it was thought proper to nationalise the Reserve Bank of India, which
was responsible for credit and currency management.
3. Nationalisation of the Reserve Bank of India was necessary to use it as an effective
instrument for planned economic development of the country.
The Reserve Bank of India (RBI) carries on its operations according to the provisions of
Reserve Bank of India Act, 1934. The Act has been amended from time to time.
Central Board: The general superintendence and direction of the bank's affairs is in the hands
of Central Board of Directors. It comprises of a Governor, 4 Deputy Governors and 15
Directors. All of these are appointed/nominated by the Central Government. The Governor and
Deputy Governors hold office for a period, not exceeding five years as may be fixed by the
Central Government at the time of their appointment and are eligible for re-appointment.
For the purpose of practical convenience, some of the functions have been delegated by the
Board to a committee called the Committee of the Central Board, consisting of the Governor,
Deputy Governors, the Directors representing or resident in the area in which the meeting is
held, the Government Director and oner Directors as may be present at the place at the relevant
time.
Local Board: There is a Local Board with headquarters at each of the regional areas of the
country ie., Western-Mumbai, Eastern-Kolkata, Northern- New Delhi and Southern- Chennai.
The Local Boards consists of five members each, appointed by the Central Government for
four years. The main functions of the Local Boards are:
i. To advise the Central Board on matters that are generally referred to them.
ii. To perform duties that are delegated by the Central Board.
The Governor is the chief executive authority and the Chairman of the Central Board
of Directors of the Bank. He has the powers of general superintendence and directing
the affairs and business of the Bank.
The Governor is assisted by 4 Deputy Governors and 4 Executive Directors in the
performance of his duties.
The Executive Directors come in between the Deputy Governors and the Chief
Manager. They are not members of the Central Board but attend Board meeting by
invitation. Central Board of Directors must hold at least 6 meetings in a year and at least
one meeting in 3 months.
The Head office of the Bank is located in Mumbai.
The bank has 14 branch offices located at Kanpur, Hyderabad, Nagpur, Jaipur,
Ahmedabad, Bhubaneshwar, Jammu/ Srinagar, Chandigarh, Bangalore, Patna,
Guwahati, Byculla (Bombay), Trivandrum and Indore.
The RBI has the following departments to carry out its functions smoothly and efficiently:
1. Issue Department
2. Banking Department
3. Department of Banking Development
4. Department of Banking Operation
5. Agricultural Credit Department
6. Exchange Control Department
7. Industrial Finance Department
8. Non-Banking Companies Department
9. Legal Department
10. Department of Research and Statistics
11. Department of Government and Bank Accounts
12. Department of Currency Management
13. Department of Expenditure of Budgetary Control
14. Rural Planning and Credit Department
15. Credit Planning Cell
16. Department of Economic Analysis and Policy
17. Inspection Department
18. Department of Administration and Personnel
19. Premises Department
20. Management Service Department
21. RBI Service Board
22. Central Records and Documentation Centre
23. Secretary's Department
24. Training Establishments
According to the Preamble of RBI Act, 1934, "The main functions of the bank are to regul
issue of bank notes and keeping of reserve with view to securing monetary stability in Inda
generally to operate the currency and credit system of the country to its advantage."
1. Traditional Functions
2. Developmental Functions
I. Traditional Functions
The traditional functions of RBI are further divided into three types-
1. Central Banking Functions
2. General Banking Functions.
3. Prohibitory Functions.
a) Issue of Paper Currency: RBI has the sole right to issue bank note of all denominations
except One rupee note, which is issued by the Government of India. RBI follows the
‘Minimum Reserve System’ for issue of bank notes. The minimum reserve is maintained at
Rs 200 crores in foreign currencies, gold coins and gold bullion under the system.
The Reserve Bank Of India (Amendment) Act, 1991, provides for the revaluation of the
gold held by RBI at the international market price. It makes adequate arrangements for
holding and distribution of currency notes and coins. The Issuing Department has its offices
in 17 various cities of the country. Moreover, it is maintaining currency chests all over the
country.
b) Regulation of Credit: It refers to control over the credit policy of commercial banks. As
the Apex Bank, RBI controls credit creation by commercial banks. According to Reserve
Bank of India Act, RBI can adopt different methods of credit control such as Bank rate,
Open Market operations, Change in CRR and selective methods to control the credit of
commercial banks.
c) Banker's Bank: The Reserve Bank of India acts as the bank of all banks in the country.
The scheduled banks are required to maintain with the Reserve Bank as cash balance, certain
percentage of their time and demand liabilities. It is also the lender of the last resort to the
scheduled banks. They can borrow money from the Reserve Bank on the basis of eligible
securities or get financial accommodation at the time of need or when sufficient money is
not available by rediscounting their bills of exchange. Hence RBI is the lender of the last
resort financial stringency
d) Banker of the Government: RBI acts as the banker, agent and adviser to the Government
of India. It accepts money for the account of Central and State Governments in India, it
makes payments on their behalf, carries out their exchange remittance and other banking
operations and manages the public debt. In simple words, it performs all banking functions
of the state and central government. It helps in making advances to the government for 90
days. It also advises the Government on all economic and monetary banking matters.
l)Training in Banking: RBI has opened following various training centres to train banking
officials. The following institutions offer banking training
Reserve Bank also performs certain general banking functions. These functions are as
follows
a) Accepting Deposits: RBI accepts deposits from Central Government, State
Governments and private individual without paying any interest on these deposits.
b) Bills Discounting: Reserve Banks buys, sells and rediscounts the 90 days duration
Bills, Promissory Notes etc.
c) Advancing Loans: Reserve Bank of India gives loans to the Central and State
Governments for the period of 90 days.
d) Dealing in Foreign Securities: RBI deals in all such foreign securities which are
encashable within 10 years from the date of purchase.
e) Deal in Costly Metals: Reserve Bank deals in the sale and purchase of gold, silver as
well as the coins of these metals.
f) Deal with other Countries' Banks: RBI establishes business relations with the banks
of other member countries, being a member of IMF.
Reserve Bank of India Act prohibits this bank from performing certain functions. They are
a) RBI cannot participate or provide any direct monetary support to any trade, commerce,
or industrial activities of the country.
b) It cannot purchase its own shares or shares of any other bank or a company. It cannot
grant loan on such shares.
c) It cannot purchase immovable property beyond its needs and cannot give any loan
against the security of any immovable property
d) RBI cannot pay any interest on its deposits.
e) Bank cannot advance loans without securities.
Reserve Bank of India performs certain developmental functions to promote the economic
growth of the country. These developmental functions are as follows:
c) Promotion of Finance for Exports: Reserve Bank of India has been instrumental in
providing refinance to banks against export credit to encourage exports. Export finance is
provided through various schemes like The Bill Market Scheme, Export Bills Credit
Schemes, Shipment Credit Scheme, Duty Drawback Credit Scheme and so on. In 1982,
The Government of India established Export-Import Bank (EXIM) as an apex bank for
financing the foreign trade. The main objective of this bank is to provide financial facilities
to boost export-import trade.
d) Promotion of Co-operative Banking: Co-operative banks play an important role to
play in India rural based economy. The credit for expansion of co-operative banking goes
to the Reserve Bank of India, which directly or indirectly source of funds for these co-
operative banks.
e) Strengthening of Banking Structure: The Reserve Bank has strengthened the banking
structure of the country by eliminating a large number of weak, unsound or improperly
managed banks.
f) Extension of Banking Facilities: The banking facilities have been extended throughout
the country, especially in small towns and rural areas so as to improve the geographical
coverage of banks.
h) Insurance of Deposits: The Deposit Insurance and Credit Guarantee Corporation has
been set up to provide protection to depositors and guarantee cards to eligible institutions.
i) Development of Bill Market: The RBI has introduced several schemes with a view to
encouraging the growth of a Bill Market in India.
j)Framing Monetary Policy: The another very important function of RBI is the framing
of monetary policy for the country.
The Securities and Exchange Board of India was constituted as a non-statutory body on
April 12, 1988 through a resolution of the Government of India. It was established as a
statutory body in 1992, as per the provisions of the Securities and Exchange Board of India
Act, 1992 (15 of 1992) and came into force as per the ordinance on January 30, 1992.
The purpose of the SEBI Act is to provide for the establishment of a Board called Securities
and Exchange Board of India.
The purpose of the Board as laid down in its preamble is as below:
As per section 4 of the SEBI Act, 1992 as amended by the Securities and Exchange Board of
India (Amendment) Act, 2002, the Board shall consist of the following members, namely:
a) A Chairman;
b) Two members from amongst the officials of the Ministry of the Central Government
dealing with Finance and Administration of the Companies Act, 1956;
c) One member from amongst the officials of the Reserve Bank;
d) Five other members of whom at least three shall be the whole-time members to be
appointed by the Central Government.
The Chairman and members referred to clauses (a) and (d) above shall be appointed by the
Central Government and the members referred to in clause (b) and (c) shall be nominated
by the Central Government and the Reserve Bank respectively. The Chairman and other
members shall be persons of ability, integrity and standing who have shown capacity in
dealing with problems relating to securities market or have special knowledge. The general
supervision, direction and management of the affairs of the Board is vested in the Board
which may exercise all powers and take up all things which may be exercised or done by
the Board. The Chairman of the Board can exercise all powers of the Board, except those
specified in the regulations.
The term of office and other conditions of service of the Chairman and the members
appointed by the Central Government shall be as may be prescribed. However, the
appointment can be terminated at any time before the expiry of the prescribed period by
giving not less than three months’ notice in writing or three months' salary and allowances
in lieu thereof (Section 5).
a) The Board meets at times and place and will observe the rules of procedure with regard to
the transaction of business as prescribed by regulations.
b) Decisions at the meeting are made by a majority vote of the members present. In case of
equality of votes, the Chairman or the presiding member has a second or casting vote
(Section 7 of SEBI Act).
c) In case any member who is a director of a company and who as such has any direct or
indirect interest in any matter coming up for consideration at a meeting of the Board should
reveal the nature of his interest at such meeting and such disclosure shall be recorded in
the proceedings of the Board, and the member shall not take any part in any deliberation
or decision of the board with respect to that matter.
11. Levying fees or other charges for carrying out the purposes of this section;
12. Conducting research for the above purposes;
13. Calling from or furnishing to any such agencies, as may be specified by the Board, such
information as may be considered necessary by it for the efficient discharge of its
functions,
14. Performing such other functions as may be prescribed.
The Government of India introduced Interim Insurance Regulatory Authority (IRA) bill in
Parliament in 1996. The Bill was rectified as Insurance Regulatory and Development Authority
and introduced again in 1999 along with 3 schedules containing amendments to the Insurance
Act, 1938, LIC Act, 1956 and GIC Act, 1972 and was passed.
Duties of IRDAI
a) The main responsibility of IRDA is to regulate, promote and ensure orderly growth of
insurance business.
b) It must comply with the directions of the Central Government.
c) It must maintain proper accounts and relevant records and get them audited. The audited
balance sheet will be submitted to the Central Government.
d) The Authority will have to scrutinize all existing and new insurance products, terms
and conditions offered and the rates charged by keeping in view the interests of the
consumers.
e) It has a duty to protect the interests of policy holders in matters concerning assignment,
nomination, settlement of insurance claims, etc.
Powers of IRDA
Insurance Regulatory and Development Authority has the following powers:
a) IRDA has the general supervisory and administrative powers over insurance industry.
b) It can delegate some general powers to the Chairperson or members for smooth conduct
of work.
c) It may also form committee of members and delegate powers to them.
d) It has the powers to acquire movable and immovable property.
e) The authority has the powers to issue certificate of registration, renew, modify,
withdraw, suspend or cancel such registration to the insurer.
f) It has the powers to prepare code of conduct for the agents, surveyors and loss assessors
and other intermediaries associated with insurance business.
g) It has the powers to call information from insurers, inspect accounts and other
documents from the organisations connected with insurance business
h) The Authority can also exercise powers given by other insurance laws of the country or
by other notifications issued by Central Government from time to time.
i) It can levy fees and other charges for carrying out the purposes of this Act.
j) IRDA has the power to regulate the margin of solvency and investments of funds by
insurance companies.
FUNCTIONS OF IRDA