INDAIN FINACIAL SYSTEM

An Indian financial system serves as an intermediary between investors and savers. It

makes it easier for money to move from areas of surplus to areas of deficit. It is related
to finances, credit, and money. These three components are interdependent and have a
close relationship with one another.

Structure of the Indian Financial System and Markets

The term “financial structure” describes the structure, components, and order of the
financial system. A formal (organized) financial system and an informal (unorganized)
financial system can be used to broadly categorize the Indian financial system and
Markets.

• Informal Indian Financial System: Informal financial institutions have the

characteristics of high flexibility and is not regulated by government. Individual
lenders, groups of people acting as funds or associations, partnership firms
made up of local brokers, Zamindars and pawnbrokers (a person who lends money
to people when they leave something of value with him/her) as well as non-banking
financial intermediaries like finance, investment, and chit-fund enterprises, make
up the informal financial system.
• Formal Indian Financial System: The formal financial sector such as banking
institutions and cooperatives are institutions that are subject to government
regulation. Financial markets, financial instruments, financial services, and
financial institutions make up the formal financial system.

The Ministry of Finance, the RBI, the SEBI, and other regulating organizations make up
the official Indian financial system. Regulatory bodies of different financial institutions
are: IRDA (Insurance), SEBI (STOCK MARKET AND MUTUAL FUNDS) & RBI (Banks)
 A. FINANCIAL INSTITUTIONS
Banking Institutions:

Commercial Banks

Commercial banks are financial institutions that offer services such as accepting
deposits, providing loans, and basic investment products. The motto of Commercial
banks is to earn profits.
These include Public Sector Banks (e.g., State Bank of India), Private Sector Banks
(e.g., ICICI Bank), Regional Rural Banks (RRBs), and Foreign Banks (e.g., HSBC).
Regional Rural Banks (RRBs) are government owned scheduled commercial banks of India that
operate at regional level in different states of India. Few examples are: Punjab Gramin Bank
(Sponsoring bank: PNB), Maharashtra Gramin Bank (Sponsoring bank: Bank of Maharashtra) etc
RRB: 50:15:35 (Central govt: State Govt: sponsoring Bank) establish in any rural area
for development

Cooperative Banks

Cooperative banks are owned and operated by their customers to provide banking
services to members. The motto of Cooperative banks is to provide services.
These are financial entities that operate on a cooperative basis, catering to the financial
needs of the members.

Non-Banking Institutions

Organized Financial Institutions

Organized financial institutions are licensed entities that offer financial services and
products, often regulated by government authorities.
Examples: It includes insurance companies and pension funds. Like: LIC Housing
Finance Ltd., Aditya Birla Finance Ltd. Bajaj Finance Ltd. etc.

Unorganized Financial Institutions

Unorganized financial institutions operate informally, often without legal recognition,

providing financial services within communities.
These are informal financial entities such as moneylenders and community savings
groups.

B. FINANCIAL MARKETS

Money Market

The money market is a segment of the financial market in which financial instruments
with high liquidity and short maturities are traded.
It consists of the Primary Market & Secondary Market

This includes the Call Money Market, Treasury Bills, Commercial Bills, CD &
Commercial Paper

Call Money Market & Notice Money (between financial institutions)

The call money market facilitates short-term borrowing and lending, often among banks,
with transactions usually within a day whereas in notice money, money is borrowed or
lend for period between 2 days and 14 days
Treasury Bills
Treasury Bill is issued by Government of India through RBI. The bill is issued as a
promissory note of repayment in the future. The purpose of a treasury note is to secure
funds to meet the short-term fund requirements.
Commercial Bills
Commercial bill is a bill of exchange used to finance the credit sales of firms. It is a short
term, negotiable and self-liquidity instrument. In case of goods sold on credit, the buyer
is liable to make the payment on a specific date in future.
Certificate of Deposit
A certificate of deposit (CD) is a savings account that holds a fixed amount of money
for a fixed period of time, such as six months, one year, or five years, and in exchange,
the issuing bank pays interest. When one redeem his/her CD, he/she receive the money
originally invested plus any interest.
Commercial Paper
Commercial paper is an unsecured, short-term debt instrument issued by corporations.
It's typically used to finance short-term liabilities such as payroll, accounts payable, and
inventories.
A CD is issued by financial institutions and banks. Commercial papers
are issued by primary dealers, large corporations and All-India
Financial Institutions.

Capital Market
It deals in Primary market, Secondary market & derivative market.
Primary Market
The primary market, often referred to as the "new issue market," is where companies
issue new securities to the public for the first time. In the case of equity, this process is
known as an Initial Public Offering (IPO), while for debt instruments, it involves issuing
bonds or debentures.
Secondary Market
The secondary market, on the other hand, is where already issued securities are bought
and sold by investors.
Derivative Market:
Derivatives are financial contracts, and their value is determined by the value of an
underlying asset or set of assets. Stocks, bonds, currencies, commodities, and market
indices are all common assets. The underlying assets' value fluctuates in response to
market conditions.
 C. FINANCIAL INSTRUMENTS

Based on Term:
Short-Term Financial Instruments

• Easy to convert to cash within one year

• Highly liquid and flexible
• Offer lower returns than other types of investments

Examples: Treasury bills, Commercial bills, Call money market instruments

Medium-Term Financial Instruments

• Easy to convert to cash within one to five years

• Offer a balance of risk and return
• Good option for investors who are looking for moderate growth over a medium
period

Examples: Some bonds, Some notes

Long-Term Financial Instruments

• Easy to convert to cash after five years or more

• Typically offer higher returns than other types of investments
• Also, involves higher risks

Examples: Stocks, Long-term bonds

Based on Types
Primary Securities

Primary securities are financial instruments offered for the first time to investors,
typically through an initial public offering (IPO) or bond issuance. These include stocks
and bonds issued directly to investors.

Secondary Securities

Secondary securities are financial instruments that have already been issued and are
traded among investors in the secondary market. Examples are stocks traded on stock
exchanges.

Innovative Instruments

Innovative instruments include sophisticated financial products designed to cater to

specific investment strategies and risk appetites. These involve complex financial
products like derivatives and ETFs.
 D. Financial Services

Fund-Based Financial Services

Fund-based financial services involve providing capital to businesses for various

purposes, often tied to specific assets or transactions.
Leasing, Hire Purchase, and Factoring: These services involve providing funds for asset
acquisition and working capital needs.

Fee-Based Financial Services

Fee-based financial services generate revenue through fees charged for services like
advisory, credit assessment, and facilitating mergers and acquisitions.
Merchant Banking, Credit Rating, and Mergers: These services charge fees for
advisory, rating, and transactional services.

FUCTIONS OF EFFECIENT FINANCIAL SYSTEM:

1. Intermediation & Mobilization of savings

Financial systems act as intermediaries between savers and borrowers, channeling

funds from those who have excess funds (savers) to those who need funds (borrowers).
This intermediation process facilitates the efficient allocation of capital and promotes
economic growth. Through banks, investment funds, and other financial institutions,
savings are pooled together and made available for productive investments.

2. Facilitation of investments & Capital Formation

Financial systems enable individuals, businesses, and governments to access the

capital needed for investment in productive activities. They provide various investment
options such as stocks, bonds, and venture capital, allowing entities to raise funds to
expand operations, launch new projects, or develop infrastructure which helps in
economic development.

3. Price discovery

Financial markets provide a platform for trading financial instruments, allowing buyers
and sellers to determine fair prices based on supply and demand dynamics. Price
discovery is the central function of a marketplace. It is the process through which buyers
and sellers agree on the current value of a financial asset or commodity. Price depends
on a variety of tangible and intangible factors, from market structure to liquidity to
information flow.
4. Facilitation of payments

Financial systems enable the smooth and secure transfer of funds between individuals,
businesses, and institutions. They provide payment systems, such as electronic funds
transfer, credit cards, and digital wallets, which facilitate the settlement of transactions
and support economic activities.

5. Monetary policy implementation

Central banks implement monetary policy as part of the financial system by controlling
the economy’s money supply, interest rates, and liquidity. They regulate and stabilize
the financial system, ensuring price stability and fostering macroeconomic stability. The
RBI controls inflation and deflation by employing a variety of monetary policy tools such
as: Repo rate, Reverse repo rate, Bank rate, Open market operations, Statutory liquidity
ratio (SLR), Cash reserve ratio (CRR), Liquidity adjustment facility (LAF), and Market
stabilization scheme.

6. Financial inclusion

Financial systems aim to promote financial inclusion by providing access to financial

services for individuals and businesses, including those in underserved or marginalized
communities. This fosters economic participation, poverty reduction, and social
development.

7. Provision of Liquidity: The most important function of a financial system is

to provide money and monetary assets for the production of goods and services.
Monetary assets are those assets that can be converted into cash or money easily
without loss of value.

8. Size Transformation function: Collecting deposits from a vast majority of small

customers and giving them as loan of a sizeable quantity.

9. Maturity Transformation function: Financial intermediaries accept deposits from

public in different maturities according to their liquidity preference and lend them to
borrowers in different maturities according to their need & promotes economic activities
of a country.

10. Risk Transformation function As the small investors are risk averse with theIr
small holdings of savings. So, they hesitate to invest directly in stock market. Financial
intermediaries collect savings from individual investors & distribute them over different
investment units with their knowledge & expertise. Thus the risk of individual investors
gets distributed. This function promotes industrial development. Moreover, various risk
mitigating tools are available in the financial system like hedging, use of derivatives,
insurance etc.
11. Safeguarding financial stability: The financial system maintains stability and
mitigates systemic risks. Regulatory authorities monitor and supervise financial
institutions, set prudential standards, and establish risk management frameworks to
safeguard the system’s stability and protect consumers.

12. Financial deepening and Broadening: Financial deepening refers to an increase

of financial assets as a percentage of the Gross Domestic Product (GDP). Financial
broadening refers to building an increasing number and a variety of participants and
instruments.

DEVELOPMENT OF FINANCIAL SYSTEM IN INDIA: During the post-

independence period there has been a significant growth in the Indian
Financial System in terms of quantitative indicators as well as in
diversification and innovations.
Development of the financial system in India involves outlining the key phases and
milestones in its evolution. Here’s a basic structure for such a flowchart:

1. Pre-Independence Era (Before 1947)

o Traditional banking system (moneylenders and indigenous bankers)
o Establishment of the Presidency Banks (Bank of Bengal, Bank of Bombay,
Bank of Madras)
o Formation of the Imperial Bank of India (1921) During the British rule in
India, The East India Company had established three banks: Bank of Bengal,
Bank of Bombay and Bank of Madras and called them the Presidential Banks. In
these banks, major stake was in the hands of private players. These three banks
were later merged into one single bank in 1921, which was called the “Imperial
Bank of India.”
o Formation of RBI (1935) to respond to economic troubles after the
First World War.
2. Post-Independence Era (1947-1969)
o Nationalization of the Reserve Bank of India (1949) To promote financial
inclusion by making banking services available to a larger population, especially
in rural and low-income areas. To limit the concentration of economic power in
the hands of a few wealthy individuals and families
o Enactment of the Banking Regulation Act (1949) To enable the Reserve Bank to
regulate, licence, and manage financial institutions to guarantee their seamless
and effective operation. To safeguard the interests of depositors as well as the
general public.
o Creation of State Bank of India (1955) Initially, the State Bank of India was a
private bank known as the Imperial Bank. In 1955, it was renamed as the State
Bank of India and converted to a public sector bank. The prime motive behind this
conversion was to stop its monopolistic power of controlling finances in India.
 o Establishment of development banks (ICICI, IDBI)
3. Nationalization Phase (1969-1991)
o First wave of nationalization of 14 major commercial banks (1969)
o Establishment of Regional Rural Banks (1975) with a view to developing the
rural economy by providing, for the purpose of development of agriculture, trade,
commerce, industry and other productive
o Second wave of nationalization of 6 more commercial banks (1980)
o In 1993 New bank of India was merged into Punjab national bank.
4. Liberalization and Reform Phase (1991-Present)
o Economic liberalization and financial sector reforms (1991)
o Introduction of private sector banks (HDFC Bank, ICICI Bank)
o Establishment of regulatory bodies (SEBI, IRDA, NSE-first online stock
exchange due to which flow of funds increased in banks)
o Introduction of technological advancements (internet banking, mobile
banking)
o Implementation of financial inclusion initiatives (Jan Dhan Yojana, PMMY)
5. Digital Revolution and Modernization (2010s-Present)
o Growth of fintech industry (Paytm, PhonePe)
o Introduction of UPI and digital payment systems
o Implementation of Goods and Services Tax (GST)
o Increasing use of AI and blockchain in financial services

Note : Mega merger 2020 resulted in merger of 19 nationalized banks and

formation of 12 nationalized banks , this consolidation will continue and
the government aims at having 6- 7 big nationalized banks only.

Why Mega Merger of banks announced?

India had many small banks operating as separate entities. They often depended
on the government's aid, which added to its burden. According to the Reserve
Bank of India, merging most of these banks would pave the way to building a
robust, well-funded, and global banking system.
FINANCIAL SYSTEM AND ECONOMIC DEVELOPMENT

The financial system plays a critical role in economic development by facilitating the
allocation of resources, promoting investment, and ensuring economic stability.

1. Mobilization of Savings & Creating Credit

o Channels individual and corporate savings into productive investments.
o Provides various financial instruments for saving, enhancing the savings
rate. As higher interest rates encourage more savings.

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. Thus, it accelerates economic growth by facilitating transactions
of trade, production and distribution on a larger scale.

2. Facilitation of Investments & Efficient Allocation of Resources

o Provides funds to businesses for expansion and new ventures.
o Encourages entrepreneurship by offering access to capital.

The financial system collects the savings and channels them into
investments which positively contributes towards economic development.

3. Promotion of Trade and Commerce & allocation of savings on the basis of

National priorities
o Facilitates domestic and international trade through various types of
finances like Payment-in-advance (pre-export trade finance type that
involves an advance payment or even full payment from the buyer before
the goods or services get delivered), Working capital loans or business
loans (can be used to finance the upfront cost of doing business and
can cover anything from the cost of raw materials to the cost of labour),
Forfaiting (type of financing that helps exporters receive immediate cash
by selling their receivables at a discount through a third party etc.
4. Support for Economic Policies
o Helps in the implementation of monetary and fiscal policies ( JAN DHAN
YOJANA, JEEVAN JYOTI BEEMA YOJANA, AND VARIOUS SOCIAL
DSECURITY SCHEMES) To avail social welfare schemes, an individual
needs to have bank account which leads to availability of banking services
to all.
o Central banks use financial institutions to manage money supply and
interest rates.
 5. Enhancement of Productivity
o Invests in human capital and technological advancements by Providing
funding for education, training, and innovation.
6. Encouraging investments in Financial Assets
o Encourages savings to flow in financial assets against physical assets.
Investments in financial assets would enhance economic growth.
o Investments in physical assets could lead to inflation & investments in
financial assets leads to transfer of financial assets from one person to
another. Inflation increases when money floats in an economy which leads
to high demand and rise in inflation. By purchasing physical assets,
money remain with people

7. Job Creation
o Stimulates business growth, leading to the creation of new jobs as more
financial institutions creates jobs in industry.
o Encourages the establishment of small and medium-sized enterprises
(SMEs).
8. Financial Inclusion
o Expands access to financial services for underserved populations.
o Promotes inclusive growth by integrating more people into the formal
economy.
9. Economic Stability
o Maintains stability through regulation and supervision of financial markets
as there are various regulatory bodies who keeps a check on investor’s
interest.
o Prevents financial crises by managing systemic risks and ensuring
liquidity.
10. International Integration
o Facilitates foreign direct investment (FDI) and portfolio investment.
o Integrates the domestic economy with the global financial system.

By performing these functions, the financial system significantly contributes to economic

growth, stability, and overall development.

WEAKNESSES OF INDIAN FINANCIAL SYSTEM

The Indian financial system, like any other, has its strengths and weaknesses. Here are
some of the key weaknesses:

1. Regulatory Challenges due to lack of coordination between Financial

institutions: The Indian financial system is regulated by multiple entities,
 including the Reserve Bank of India (RBI), Securities and Exchange Board of
India (SEBI), and Insurance Regulatory and Development Authority (IRDA). The
overlapping and sometimes conflicting regulations can create inefficiencies and
regulatory arbitrage.
2. Non-Performing Assets (NPAs): High levels of NPAs, especially in public
sector banks, have been a significant challenge. NPAs affect the profitability and
lending capacity of banks, leading to tighter credit conditions.
3. Financial Inclusion: Despite efforts, a significant portion of the population still
lacks access to formal financial services. Rural and semi-urban areas, in
particular, face challenges in accessing banking and financial products.
4. Infrastructure and Technology: While there have been improvements, the
financial infrastructure in India still lags in certain areas. Technological
advancements are not uniformly distributed, leading to disparities in service
quality.
5. Capital Market Development: The Indian capital markets are not as deep or
broad as those in more developed economies. There is limited participation from
retail investors, and the corporate bond market is underdeveloped.( STOCK
EXCHANGES DO NOT WORK 24 HOURS).
6. Shadow Banking Sector: The Non-Banking Financial Companies (NBFCs)
sector has faced issues related to liquidity and governance. The default of major
NBFCs like IL&FS ( Infrastructure Leasing & Financial Services) highlighted
vulnerabilities in the sector.
7. Corporate Governance: Issues related to corporate governance and
transparency have impacted investor confidence. Scandals and frauds have
occasionally undermined the trust in the financial system.
8. Interest Rate Volatility: Interest rates in India can be quite volatile, influenced by
inflation, fiscal policies, and external factors. This volatility can affect investment
decisions and economic stability.
9. Economic Dependence on Banking Sector: The Indian economy is heavily
reliant on the banking sector for financing, unlike more developed economies
where capital markets play a significant role. This creates systemic risks if the
banking sector faces challenges.
10. Credit Rating Mechanism: The credit rating mechanism in India has faced
criticism for not being robust enough, which can lead to mispricing of risk and
financial instability.
11. Legal and Judicial System: The slow judicial process in India can be a
hindrance to the swift resolution of financial disputes, impacting the efficiency
and effectiveness of the financial system.

Addressing these weaknesses requires a multi-pronged approach involving regulatory

reforms, technological advancements, improving financial literacy, and enhancing the
overall economic environment.