An Overview of Indian Financial System

Financial System of any country consists of financial markets, financial

intermediation and financial instruments or financial products. This paper
discusses the meaning of finance and Indian Financial System and focus on the
financial markets, financial intermediaries and financial instruments. The brief
review on various money market instruments are also covered in this study.

The term "finance" in our simple understanding it is perceived as equivalent to

'Money'. We read about Money and banking in Economics, about Monetary
Theory and Practice and about "Public Finance". But finance exactly is not
money, it is the source of providing funds for a particular activity. Thus public
finance does not mean the money with the Government, but it refers to sources
of raising revenue for the activities and functions of a Government. Here some
of the definitions of the word 'finance', both as a source and as an activity i.e. as
a noun and a verb.

The American Heritage® Dictionary of the English Language, Fourth Edition

defines the term as under-

1:"The science of the management of money and other assets.";

2: "The management of money, banking, investments, and credit. ";
3: "finances Monetary resources; funds, especially those of a government or
corporate body"
4: "The supplying of funds or capital."

Finance as a function (i.e. verb) is defined by the same dictionary as under-

1:"To provide or raise the funds or capital for": financed a new car
2: "To supply funds to": financing a daughter through law school.
3: "To furnish credit to".

Another English Dictionary, "WordNet ® 1.6, © 1997Princeton University "

defines the term as under-

1:"the commercial activity of providing funds and capital"

2: "the branch of economics that studies the management of money and other
assets"
3: "the management of money and credit and banking and investments"

The same dictionary also defines the term as a function in similar words as
under-

1: "obtain or provide money for;" " Can we finance the addition to our home?"
2:"sell or provide on credit "

All definitions listed above refer to finance as a source of funding an activity. In

this respect providing or securing finance by itself is a distinct activity or
function, which results in Financial Management, Financial Services and
Financial Institutions. Finance therefore represents the resources by way funds
needed for a particular activity. We thus speak of 'finance' only in relation to a
proposed activity. Finance goes with commerce, business, banking etc. Finance
is also referred to as "Funds" or "Capital", when referring to the financial needs
of a corporate body. When we study finance as a subject for generalising its
profile and attributes, we distinguish between 'personal finance" and "corporate
finance" i.e. resources needed personally by an individual for his family and
individual needs and resources needed by a business organization to carry on its
functions intended for the achievement of its corporate goals.

INDIAN FINANCIAL SYSTEM

The economic development of a nation is reflected by the progress of the
various economic units, broadly classified into corporate sector, government
and household sector. While performing their activities these units will be
placed in a surplus/deficit/balanced budgetary situations.

There are areas or people with surplus funds and there are those with a
deficit. A financial system or financial sector functions as an intermediary and
facilitates the flow of funds from the areas of surplus to the areas of deficit. A
Financial System is a composition of various institutions, markets, regulations
and laws, practices, money manager, analysts, transactions and claims and
liabilities.

Financial System;

The word "system", in the term "financial system", implies a set of complex and
closely connected or interlined institutions, agents, practices, markets,
transactions, claims, and liabilities in the economy. The financial system is
concerned about money, credit and finance-the three terms are intimately related
yet are somewhat different from each other. Indian financial system consists of
financial market, financial instruments and financial intermediation. These are
briefly discussed below;

FINANCIAL MARKETS

A Financial Market can be defined as the market in which financial assets are
created or transferred. As against a real transaction that involves exchange of
money for real goods or services, a financial transaction involves creation or
transfer of a financial asset. Financial Assets or Financial Instruments represents
a claim to the payment of a sum of money sometime in the future and /or
periodic payment in the form of interest or dividend.

Money Market- The money market ifs a wholesale debt market for low-risk,
highly-liquid, short-term instrument. Funds are available in this market for
periods ranging from a single day up to a year. This market is dominated
mostly by government, banks and financial institutions.

Capital Market - The capital market is designed to finance the long-term

investments. The transactions taking place in this market will be for periods
over a year.

Forex Market - The Forex market deals with the multicurrency requirements,
which are met by the exchange of currencies. 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.

Credit Market- Credit market is a place where banks, FIs and NBFCs purvey
short, medium and long-term loans to corporate and individuals.

Constituents of a Financial System

FINANCIAL INTERMEDIATION

Having designed the instrument, the issuer should then ensure that these
financial assets reach the ultimate investor in order to garner the requisite
amount. When the borrower of funds approaches the financial market to raise
funds, mere issue of securities will not suffice. Adequate information of the
issue, issuer and the security should be passed on to take place. There should be
a proper channel within the financial system to ensure such transfer. To serve
this purpose, Financial intermediaries came into existence. Financial
intermediation in the organized sector is conducted by a widerange of
institutions functioning under the overall surveillance of the Reserve Bank of
India. In the initial stages, the role of the intermediary was mostly related to
ensure transfer of funds from the lender to the borrower. This service was
offered by banks, FIs, brokers, and dealers. However, as the financial system
widened along with the developments taking place in the financial markets, the
scope of its operations also widened. Some of the important intermediaries
operating ink the financial markets include; investment bankers, underwriters,
stock exchanges, registrars, depositories, custodians, portfolio managers, mutual
funds, financial advertisers financial consultants, primary dealers, satellite
dealers, self regulatory organizations, etc. Though the markets are different,
there may be a few intermediaries offering their services in move than one
market e.g. underwriter. However, the services offered by them vary from one
market to another.

Intermediary Market Role

Secondary Market to
Stock Exchange Capital Market
securities
 Corporate advisory
Capital Market, Credit
Investment Bankers services, Issue of
Market
securities

Capital Market, Money Subscribe to unsubscribed

Underwriters
Market portion of securities

Issue securities to the

Registrars, Depositories, investors on behalf of the
Capital Market
Custodians company and handle
share transfer activity

Primary Dealers Satellite Market making in

Money Market
Dealers government securities

Ensure exchange ink

Forex Dealers Forex Market
currencies

FINANCIAL INSTRUMENTS

Money Market Instruments

The money market can be defined as a market for short-term money and
financial assets that are near substitutes for money. The term short-term means
generally a period upto one year and near substitutes to money is used to denote
any financial asset which can be quickly converted into money with minimum
transaction cost.

Some of the important money market instruments are briefly discussed below;

1. Call/Notice Money
2. Treasury Bills

3. Term Money

4. Certificate of Deposit

5. Commercial Papers

1. Call /Notice-Money Market

Call/Notice money is the money borrowed or lent on demand for a very short
period. When money is borrowed or lent for a day, it is known as Call
(Overnight) Money. Intervening holidays and/or Sunday are excluded for this
purpose. Thus money, borrowed on a day and repaid on the next working day,
(irrespective of the number of intervening holidays) is "Call Money". When
money is borrowed or lent for more than a day and up to 14 days, it is "Notice
Money". No collateral security is required to cover these transactions.

2. Inter-Bank Term Money

Inter-bank market for deposits of maturity beyond 14 days is referred to as the

term money market. The entry restrictions are the same as those for Call/Notice
Money except that, as per existing regulations, the specified entities are not
allowed to lend beyond 14 days.

3. Treasury Bills.

Treasury Bills are short term (up to one year) borrowing instruments of the
union government. It is an IOU of the Government. It is a promise by the
Government to pay a stated sum after expiry of the stated period from the date
of issue (14/91/182/364 days i.e. less than one year). They are issued at a
discount to the face value, and on maturity the face value is paid to the holder.
The rate of discount and the corresponding issue price are determined at each
auction.

4. Certificate of Deposits

Certificates of Deposit (CDs) is a negotiable money market instrument nd

issued in dematerialised form or as a Usance Promissory Note, for funds
deposited at a bank or other eligible financial institution for a specified time
period. Guidelines for issue of CDs are presently governed by various directives
issued by the Reserve Bank of India, as amended from time to time. CDs can be
issued by (i) scheduled commercial banks excluding Regional Rural Banks
(RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial
Institutions that have been permitted by RBI to raise short-term resources within
the umbrella limit fixed by RBI. Banks have the freedom to issue CDs
depending on their requirements. An FI may issue CDs within the overall
umbrella limit fixed by RBI, i.e., issue of CD together with other instruments
viz., term money, term deposits, commercial papers and intercorporate deposits
should not exceed 100 per cent of its net owned funds, as per the latest audited
balance sheet.

5. Commercial Paper

CP is a note in evidence of the debt obligation of the issuer. On issuing

commercial paper the debt obligation is transformed into an instrument. CP is
thus an unsecured promissory note privately placed with investors at a discount
rate to face value determined by market forces. CP is freely negotiable by
endorsement and delivery. A company shall be eligible to issue CP provided -
(a) the tangible net worth of the company, as per the latest audited balance
sheet, is not less than Rs. 4 crore; (b) the working capital (fund-based) limit of
the company from the banking system is not less than Rs.4 crore and (c) the
borrowal account of the company is classified as a Standard Asset by the
financing bank/s. The minimum maturity period of CP is 7 days. The minimum
credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies.
(for more details visit www.indianmba.com faculty column)

Capital Market Instruments

The capital market generally consists of the following long term period i.e.,
more than one year period, financial instruments; In the equity segment Equity
shares, preference shares, convertible preference shares, non-convertible
preference shares etc and in the debt segment debentures, zero coupon bonds,
deep discount bonds etc.

Hybrid Instruments

Hybrid instruments have both the features of equity and debenture. This kind of
instruments is called as hybrid instruments. Examples are convertible
debentures, warrants etc.

Conclusion

In India money market is regulated by Reserve bank of India (www.rbi.org.in)

and Securities Exchange Board of India (SEBI) [www.sebi.gov.in ] regulates
capital market. Capital market consists of primary market and secondary
market. All Initial Public Offerings comes under the primary market and all
secondary market transactions deals in secondary market. Secondary market
refers to a market where securities are traded after being initially offered to the
public in the primary market and/or listed on the Stock Exchange. Secondary
market comprises of equity markets and the debt markets. In the secondary
market transactions BSE and NSE plays a great role in exchange of capital
market instruments