Module 1 - Overview of

Indian Financial System

 Module 1 - Overview of Indian Financial System

• Introduction to Financial System – Features,

• Constituents of Financial System;
• Financial Institutions; Financial Services;
• Financial Markets and Financial Instruments,
• Financial Regulators (a brief profile of RBI, SEBI, IRDAI).
The term "finance" in our simple understanding, is perceived as equivalent
to 'Money'. But finance exactly is not money; it is the source of providing
fund for a particular activity.

Finance is a facility that built the Gap between deficit sectors to surplus
sector by shifting funds. Finance as a function is defined by the dictionary
as under-

1:"To provide or raise the fund or capital”

2: "To supply fund ".

3: "To furnish credit ".

Introduction

• Financial managers and investors don’t operate in a vacuum; they make

decisions within a large and complex financial environment.

• This environment includes financial markets and institutions, tax and

regulatory policies, and the state of the economy.

• The environment both determines the available financial alternatives

and affects the outcomes of various decisions. Thus, it is crucial that
investors and financial managers have a good understanding of the
environment in which they operate.
• History shows that a strong financial system is a necessary ingredient for a
growing and prosperous economy.

• Companies raising capital to finance capital expenditures as well as

investors saving to accumulate funds for future use require well functioning
financial markets and institutions.

• A financial system (within the scope of finance) is a system that allows the
exchange of funds between lenders, investors, and borrowers.

• Financial systems operate at national, global, and firm-specific levels.

• They consist of complex, closely related services, markets, and institutions

intended to provide an efficient and regular linkage between investors and
depositors.
Money, credit, and finance are used as media of exchange in financial
systems. They serve as a medium of known value for which goods and
services can be exchanged as an alternative to bartering.

A modern financial system may include banks (operated by the government

or private sector), financial markets, financial instruments, and financial
services.

Financial systems allow funds to be allocated, invested, or moved between

economic sectors. They enable individuals and companies to share the
associated risks.
The formal financial system consists of four components:

1. Financial institutions,
2. Financial markets,
3. Financial instruments and
4. Financial services.

The financial system acts as a connecting link between savers of money and users
of money and thereby promotes faster economic and industrial growth.

Thus financial system may be defined as “a set of markets and institutions to

facilitate the exchange of assets and risks.”

Efficient functioning of the financial system enables proper flow of funds from
investors to productive activities which in turn facilitates investment.
Definition of Financial System

• “It is a set of institutions , instruments and markets which fosters saving

and channels them to their most efficient use”.-(H.R. Machiraju)

• In the worlds of Van Horne, “financial system allocates savings efficiently

in an economy to ultimate users either for investment in real assets or for
consumption”.

• According to Prasanna Chandra, “financial system consists of a variety of

institutions, markets and instruments related in a systematic manner and
provides the principal means by which savings are transformed into
investments”
Functions/important and role of financial system

1. It links the savers and investors. It helps in mobilizing and allocating the
savings efficiently and effectively. It plays a crucial role in economic
development through saving-investment process. This savings – investment
process is called capital formation.

2. It helps to monitor corporate performance.

3. It provides a mechanism for managing uncertainty and controlling risk.

4. It provides a mechanism for the transfer of resources across geographical

boundaries
5. It offers portfolio adjustment facilities (provided by financial markets and
financial intermediaries).

6. It helps in lowering the transaction costs and increase returns. This will
motivate people to save more.

7. It promotes the process of capital formation.

8. It helps in promoting the process of financial deepening and broadening.

• Financial deepening means increasing financial assets as a percentage of

GDP and financial broadening means building an increasing number and
variety of participants and instruments.

• In short, a financial system contributes to the acceleration of economic

development. It contributes to growth through technical progress.
Growth and Development of Indian Financial System

• At the time of independence in 1947, there was no strong financial

institutional mechanism in the country.

• The industrial sector had no access to the savings of the community.

• The capital market was primitive and shy. The private and unorganised
sector played an important role in the provision of liquidity.

• On the whole, there were chaos and confusions in the financial system.
After independence, the government adopted mixed economic system.

• A scheme of planned economic development was evolved in 1951 with a

view to achieve the broad economic and social objective.
• The government started creating new financial institutions to supply
finance both for agricultural and industrial development.

• It also progressively started nationalizing some important financial

institutions so that the flow of finance might be in the right direction.

The following developments took place in the Indian financial system:

1. Nationalisation of financial institutions:
2. Establishment of Development Banks:
3. Establishment of institution for housing finance:
4. Establishment of Stock Holding Corporation of India (SHCIL):
5. Establishment of mutual funds and venture capital institutions:
6. New Economic Policy of 1991
FEATURES OF INDIAN FINANCIAL SYSTEM:

• It plays a vital role in economic development of a country.

• It encourages both savings and investment.
• It links savers and investors.
• It helps in capital formation.
• It helps in allocation of risk.
• It facilitates expansion of financial markets.
1) Financial Market: -

It is a system through which funds are transferred from surplus sector to

the deficit sector.

On the basis of the duration of financial Assets and nature of product

money market can be classified into 3 types:

a) Money Market: - It is the institutional arrangement of borrowing and

lending into 2 sectors i.e. organised sector headed by RBI and
unorganized sector no way related with RBI.

Further depending upon the type of instrument used money is divided

into various sub market
b) Capital Market: - It deals with long term lending’s and borrowings. It is a
market for long term instruments such as shares, debentures and bonds. It also
deals with term loans. This market is also dividend into 2 types:-

A) Primary or New Issue Market

B) Secondary Market of Stock exchange.

c) Foreign Exchange market: -It deals with foreign exchange. It is a market

where the exchanging of currencies will takes places. It is the market where
currencies of different country are purchased and sold. Depending on the
exchange rate that is applicable, the transfer of funds takes place in this market.
This is one of the most developed and integrated market across the globe.

d) Credit Market- Credit market is a place where banks, FIs and NBFCs purvey
short, medium and long-term loans to corporate and individuals.
ii) Financial Institution: -

It is classified into categories:-

a. Banking Institution:- It includes commercial banks, private bank and foreign

banks are operating in India. There are 27 Commercial Banks of Public Sector
further, we have Development Banks (ICICI, IDBI), Agriculture Bank (RRB,
Cooperative Banks, NABARD).

b. Non-Banking Institution: - These are established to mobilise saving in

different modes. These institutions do not offer banking services such as
accepting deposit and Lending Loans.
For example LIC, UTI, GIC. Financial institutions are financial intermediaries. They
intermediate between savers and investors. They lend money. They also mobilise
savings. The various financial intermediaries, their performing areas and
respective roles are given in following table:
iii) Financial Instruments: -

It includes through these instruments financial Institution mobilise

saving.

These are of 2 type’s i.e.

a)Long Term : - Shares, Debenture, Mutual Funds, Term Loans.

b) Short Term: - Call Loan (money market), Promissory Notes, Bills of

exchange etc.
iv) Financial Services: -

a) Banking service provided by Commercial banks and Development banks.

Accepting Deposits and lending loans.

b) Non-Banking Services: - These services are provided by Non-Banking

Companies such as LIC and GIC. They accept saving in different modes and
mobiles to various channels of investments.

c) Other Services: - In modern days banks are providing various new services
such as ATM, Credit Cards, Debit Cards, Electronic Transfer of
Funds(ETF),Internet Banking, E- Banking, off shore Banking.
 TYPES OF FINANCIAL SERVICES:
• Financial Services is a term used to refer to the services provided by the
finance market. Financial Services is also the term used to describe
organizations that deal with the management of money.

• Examples are the Banks, investment banks, insurance companies, credit card
companies and stock brokerages. Some basic types of financial services are as
following.

• Banking
• Insurance
• Securities brokerage or financial advisory services
• Investment banking
• Securities trading
• Investment management or money management
• Securities analysis
• Financial planning
THREE TYPES OF FINANCIAL SERVICES
• Stocks: Which are sold by Stock Exchanges

• Insurance: This is sold by Insurance Companies

• Money: This is lent by the commercial banks and other financial institutions

NEED FOR REGULATORS:

• The institutions selling financial services may indulge in fraudulent practices adversely
affecting the general public.

• Financial regulation is a form of regulation or supervision, which subjects financial

institutions to certain requirements, restrictions and guidelines, aiming to maintain the
integrity of the financial system.

• This may be handled by either a government or non-government organization.

• Financial regulation has also influenced the structure of banking sectors by increasing the
variety of financial products available.
AIMS OF REGULATION

The objectives of financial regulators are usually,

• market confidence – to maintain confidence in the financial system

• financial stability – contributing to the protection and enhancement of
stability of the financial system
• Consumer protection – securing the appropriate degree of protection for
consumers.
THREE MAIN REGULATORS:
RBI is the main regulator in case of Money Market.

The central bank of the country is the Reserve Bank of India (RBI). It was established in April
1935 with a share capital of Rs. 5 crores on the basis of the recommendations of the Hilton
Young Commission.

The share capital was divided into shares of Rs. 100 each fully paid which was entirely
owned by private shareholders in the beginning.

The Bank was constituted for the need of following:

• To regulate the issue of banknotes.

• To maintain reserves with a view to securing monetary stability and,
• To operate the credit and currency system of the country to its advantage IRDA (Insurance
Regulatory Development Authority) is the main regulator in case of Insurance sector where
as SEBI is the main regulator in case of stock exchanges.
NEED FOR RBI AS A REGULATOR
• The Reserve Bank regulates and supervises the nation’s financial system.

• Different departments of the Reserve Bank oversee the various entities that comprise India’s
financial infrastructure.

• They direct Commercial banks and all-India development financial institutions, Urban
cooperative banks, Regional Rural banks (RRB), Non-Banking Financial Companies (NBFC)
etc.

• Financial Institutions accept deposits from the general public and lend it to the corporates.

• The Banks may lend money to wrong people and this may result into loss of public money.

• So there was a need for some regulator which can monitor and control the decisions of the
banks. RBI is such a regulator.

• The ‘Board for Financial Supervision’ oversees the RBIs role as a regulator.
STEPS TAKEN BY RBI AS A REGULATOR:
The preamble of the Reserve Bank of India describes it main functions as:

..to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary
stability in India and generally to operate the currency and credit system of the country to its
advantage.

Accordingly, RBI takes several steps as a regulator of money market. The steps are as following.

1. On Site Inspection
2. Off Site Surveillance by making reporting compulsory
3. Periodic meetings with management of the financial institutes Licensing
4. Prescribing Minimum capital and cash requirements
5. Monitoring the Governance of the Banks
6. Prescribing lending requirements to the priority sector
7. Prescribing conditions for lending
 STOCK EXCHANGE BOARD OF INDIA:
Functions and Objectives

Under the SEBI Act, 1992, the SEBI has been authorized to conduct inspection of stock
exchanges.

The SEBI has been scrutinizing the stock exchanges once every year since 1995-96. During
these inspections, a review of the market operations, organizational structure and managerial
control of the exchange is made to ascertain whether:

1. the exchange provides a fair, equitable and growing market to investors

2. the exchange’s organization, systems and practices are in accordance with the Securities
Contracts (Regulation) Act (SC(R) Act), 1956 and rules framed there under
3. the exchange has implemented the directions, guidelines and instructions issued by the SEBI
from time to time
4. the exchange has complied with the conditions, if any, imposed on it at the time of renewal/
grant of its recognition under section 4 of the SC(R) Act, 1956.
The main objectives of SEBI are:

(1) Regulation of Stock Exchanges: The first objective of SEBI is to regulate stock exchanges so
that efficient services may be provided to all the parties operating there.
(2) Protection to the Investors
(3) Checking the Insider Trading
(4) Control over Brokers

Steps taken by SEBI as Regulator of Stock Market Since the establishment of SEB in 1992, the
Indian securities market has developed enormously in terms of volumes, new products and
financial services. SEBI takes the following steps for controlling the stock-exchanges of the
country.

1. Educate the Investors

2. SEBI is authorized to call for information, Investigation, Audit Registration of intermediaries
like brokers, underwriters, merchant bankers etc.
3. Cancelling their licenses if they violate the rules
4. Regulating acquisition of substantial shares by a company
5. Issuing guidelines for issuing shares
 INSURANCE REGULATION DEVELOPMENT ACT:
NEED FOR IRDA

The Insurance Regulatory and Development Authority of India (IRDAI) is an autonomous,

statutory body tasked with regulating and promoting the insurance and re-insurance industries in
India.
It was constituted by the Insurance Regulatory and Development Authority Act, 1999, an Act of
Parliament passed by the Government of India. The agency's headquarters are in Hyderabad,
Telangana, where it moved from Delhi in 2001.

It was constituted by Parliament of India Act called IRDA after the formal declaration of Insurance
Laws (Amendment) Ordinance 2014, by the President of India Pranab Mukherjee on December
26, 2014.
Its main objectives are as under :
1. To promote the interest and rights of policy holders.
2. To promote and ensure the growth of Insurance Industry.
3. To ensure speedy settlement of genuine claims and to prevent frauds and malpractices
4. To bring transparency and orderly conduct of in financial markets dealing with insurance.
FUNCTIONS OF IRDAI
The functions of the IRDAI are defined in Section 14 of the IRDAI Act, 1999, and include:

• Issuing, renewing, modifying, withdrawing, suspending or cancelling registrations

• Protecting policyholder interests
• Specifying qualifications, the code of conduct and training for intermediaries and agents
• Specifying the code of conduct for surveyors and loss assessors
• Promoting efficiency
• Promoting and regulating professional organizations connected with the insurance and re-
insurance industry
• Levying fees and other charges
• Inspecting and investigating insurers, intermediaries and other relevant organizations
• Regulating rates, advantages, terms and conditions which may be offered by insurers not
covered by the Tariff Advisory Committee under section 64U of the Insurance Act, 1938
• Specifying how books should be kept
• Regulating company investment of funds
• Regulating a margin of solvency
• Adjudicating disputes between insurers and intermediaries or insurance intermediaries
• Supervising the Tariff Advisory Committee
• Specifying the percentage of premium income to finance schemes for promoting and
regulating professional organisations
• Specifying the percentage of life- and general-insurance business undertaken in the rural
or social sector
• Specifying the form and the manner in which books of accounts shall be maintained, and
statement of accounts shall be rendered by insurers and other insurer intermediaries
Steps taken by IRDA

IRDA has put forth many measures to protect the policyholders’ interests. Insurers have been told to
strengthen their grievance redress procedures, consumer complaint resolving procedures where they are
found weak. It takes following steps for regulating the insurance sector.

1. Registration of Insurance Companies (Giving them Licenses)

2. Cancelling the licenses in case they act against the IRDA Act
3. Imposing penalty on those insurance companies which violate the provisions of the Act.
4. Prescribing Minimum Qualification & Training etc for becoming an intermediary
5. Registration of Insurance Agents etc. and Cancelling their license
6. Inspection and Audit of Insurance companies
7. Prescribe the manner in which the insurance company should maintain the books (Financial
Reporting)

8. The way in which the funds should be invested

9. Targets for covering insurance in rural areas

10. Allowing Private and Foreign Insurance companies in India (to boost competition)

11. Regulation and supervision of premium rates and terms

12. Maintenance of Solvency Margin

CONCLUSION:

• The financial system in India is regulated by independent regulators in the field of

banking, insurance, capital market, commodities market, and pension funds.

• However, Government of India plays a significant role in controlling the financial system
in India and influences the roles of such regulators at least to some extent.

• However there is a dire need of stringent laws and harsh punishments in cases of scams
to curb the frauds and violations.

• "The most urgent and most debated area of regulation has to do with that which affects
the operation of the economic machine itself. Adverse conduct here can be deeply
damaging, but even when it is visibly destructive, action to correct it can be strongly
resisted," wrote John Kenneth Galbraith.