MODULE – 1

Unit – 1:

Indian Financial System

Structure of Indian Financial System

The following are the four major components that comprise the Indian Financial System:

 Financial Institutions
 Financial Markets
 Financial Instruments/Assets/Securities
 Financial Services.

1. Financial Institutions

Financial institutions are the intermediaries who facilitate the smooth functioning of the
financial system by making investors and borrowers meet. They mobilize savings of the
surplus units and allocate them in productive activities promising a better rate of return.
Structure of Indian Financial System also provides services to entities (individual, business,
government) seeking advice on various issues ranging from restructuring to diversification
plans. They provide whole range of services to the entities who want to raise funds from the
markets or elsewhere. The financial Institutions is very important for the function of a
financial system

Types of Financial Institutions

Financial institutions can be classified into two categories

 Banking Institutions
 Non-Banking Financial Institutions

2. Financial Markets

Financial markets may be broadly classified as negotiated loan markets and open The
negotiated loan market is a market in which the lender and the borrower personally negotiate
the terms of the loan agreement, e.g. a businessman borrowing from a bank or from a small
loan company. On the other hand, the open market is an impersonal market in which
standardized securities are treated in large volumes. The stock market is an example of an
open market. The financial markets, in a nutshell, the credit markets catering to the various
credit needs of the individuals, links and institutions. Credit is supplied both on a short as
well as a long
On the basis of the credit requirement for short-term and long term purposes, financial
markets are divided into two categories

Types of the financial market

  Money Market
 Capital Market

3. Financial Instruments/ Assets/ Securities

This is an important component of the financial system. Financial instruments are

monetary contracts between parties. The products which are traded in a financial market are
financial assets, securities or other types of financial instruments. There is a wide range of
securities in the markets since the needs of investors and credit seekers are different.
Financial instruments can be real or virtual documents representing a legal agreement
involving any kind of monetary value. Equity-based financial instruments represent
ownership of an asset. Debt-based financial instruments represent a loan made by an investor
to the owner of the asset.

Types of Financial Instruments

 Cash Instruments
 Derivative Instrument

4. Financial Services

It consists of services provided by Asset Management and Liability

Management Companies. They help to get the required funds and also make sure that they
are efficiently invested. They assist to determine the financing combination and extend their
professional services up to the stage of servicing of lenders.

Types of Financial Services

 Banking
 Wealth Management
 Mutual Funds
 Insurance

The Structure of Indian Financial System is about A financial system is a system that system
which allows the exchange of funds between investors, lenders, and borrowers. Indian
Financial systems operate at national and global levels. They consist of complex, closely
related services, markets, and institutions intended to provide an efficient and regular linkage
between investors and depositors.

What is Financial System?

A 'financial system' is a system that allows the exchange of funds between financial market
participants such as lenders, investors, and borrowers. Financial systems operate at national
and global 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 medium 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 (public sector 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.

Functions of Financial System:

1. Provision of Liquidity: The major function of the financial system is the provision of
money and monetary assets for the production of goods and services. There should not be any
shortage of money for productive ventures. In financial language, the money and monetary
assets are referred to as liquidity. The term liquidity refers to cash or money and other assets
which can be converted into cash readily without loss. Hence, all activities in a financial
system are related to liquidity – either provision of liquidity or trading in liquidity. In fact, in
India the RBI has been vested with the monopoly power of issuing coins and currency notes.
Commercial banks can also create cash (deposit) in the form of ‘credit creation’ and other
financial institutions also deal in monetary assets. Over supply of money is also dangerous to
the economy. In India the RBI is the leader of the financial system and hence it has to control
the money supply and creation of credit by banks and regulate all the financial institutions in
the country in the best interest of the nation. It has to shoulder the responsibility of
developing a sound financial system by strengthening the institutional structure and by
promoting savings and investment in the country.

2. Mobilisation of Savings: Another important activity of the financial system is to mobilise

savings and channelise them into productive activities. The financial system should offer
appropriate incentives to attract savings and make them available for more productive
ventures. Thus, the financial system facilitates the transformation of saving into investment
and consumption. The financial intermediaries have to play a dominant role in this activity. 3.

3. Size Transformation Function: Generally, the savings of millions of small investors are
in the nature of a small unit of capital which cannot find any fruitful avenue for investment
unless it is transformed into a perceptible size of credit unit. Banks and other financial
intermediaries perform this size transformation function by collecting deposits from a vast
majority of small customers and giving them as loan of a sizeable quantity. Thus, this size
transformation function is considered to be one of the very important functions of the
financial system.

4. Maturity Transformation Function: Another important function of the financial system

is the maturity transformation function. The financial intermediaries accept deposits from
public in different maturities according to their liquidity preference and lend them to the
borrowers in different maturities according to their need and promote the economic activities
of a country.

5. Risk Transformation Function: Most of the small investors are risk-averse with their
small holding of savings. So, they hesitate to invest directly in stock market. On the other
hand, the financial intermediaries collect the savings from individual savers and distribute
them over different investment units with their high knowledge and expertise. Thus, the risks
of individual investors get distributed. This risk transformation function promotes industrial
development. Moreover, various risk mitigating tools are available in the financial system
like hedging, insurance, use of derivatives, etc.
What is Financial Assets?

A financial asset is a non-physical asset whose value is derived from a contractual claim,
such as bank deposits, bonds, and stocks. Financial assets are usually more liquid than
other tangible assets, such as commodities or real estate, and may be traded on financial
markets.

Financial assets are opposed to non-financial assets, property rights which include
both tangible property (sometimes also called real assets) such as land, real estate or
commodities and intangible assets such as intellectual property, like copyrights, patents,
Trademarks etc.

Classification of Financial Assets:

Financial assets can be classified differently under different circumstances. One such
classification is:

(i) Marketable assets

(ii) Non-marketable assets

Marketable Assets: Marketable assets are those which can be easily transferred from one
person to another without much hindrance. Examples: Shares of Listed Companies,
Government Securities, Bonds of Public Sector Undertakings, etc.

Non-marketable Assets: On the other hand, if the assets cannot be transferred easily, they
come under this category. Examples: Bank Deposits, Provident Funds, Pension Funds,
National Savings Certificates, Insurance Policies, etc.

Yet another classification is as follows:

(i) Money or cash asset

(ii) Debt asset
(iii) Stock asset

Cash Asset

In India, all coins and currency notes are issued by the RBI and the Ministry of Finance,
Government of India. Besides, commercial banks can also create money by means of creating
credit. When loans are sanctioned, liquid cash is not granted. Instead an account is opened in
the borrower’s name and a deposit is created. It is also a kind of money asset.

Debt Asset

Debt asset is issued by a variety of organisations for the purpose of raising their debt capital.
Debt capital entails a fixed repayment schedule with regard to interest and principal. There
are different ways of raising debt capital. Example: Issue of debentures, raising of term loans,
working capital advance, etc.

Stock Asset
Stock is issued by business organisations for the purpose of raising their fixed capital. There
are two types of stock namely – equity and preference. Equity shareholders are the real
owners of the business and they enjoy the fruits of ownership and at the same time they bear
the risks as well. Preference shareholders, on the other hand get a fixed rate of dividend (as in
the case of debt asset) and at the same time they retain some characteristics of equity.

What is Financial Intermediaries?

The term financial intermediary includes all kinds of organisations which intermediate and
facilitate financial transactions of both individuals and corporate customers. Thus, it refers to
all kinds of financial institutions and investing institutions which facilitate financial
transactions in financial markets. They may be in the organised sector or in the unorganised
sector. They may also be classified into two:

(i) Capital market intermediaries

ii) Money market intermediaries

Capital Market Intermediaries: These intermediaries mainly provide long-term funds to

individuals and corporate customers. They consist of term lending institutions like financial
corporations and investing institutions like LIC.

Money Market Intermediaries: Money market intermediaries supply only short-term funds
to individuals and corporate customers. They consist of commercial banks, cooperative banks,
etc.

What is Financial Market?

Definition: Financial Market refers to a marketplace, where creation and trading of financial
assets, such as shares, debentures, bonds, derivatives, currencies, etc. take place. It plays a
crucial role in allocating limited resources, in the country’s economy. It acts as an
intermediary between the savers and investors by mobilising funds between them.

Function of Financial Market:

The functions of the financial market are explained with the help of points below:

Intermediary functions: The intermediary functions of financial markets include the

following:

 Transfer of resources: Financial markets facilitate the transfer of real economic

resources from lenders to ultimate borrowers.
 Enhancing income: Financial markets allow lenders to earn interest or dividend on
their surplus invisible funds, thus contributing to the enhancement of the individual
and the national income.
 Productive usage: Financial markets allow for the productive use of the funds
borrowed. The enhancing the income and the gross national production.
  Capital formation: Financial markets provide a channel through which new savings
flow to aid capital formation of a country.
 Price determination: Financial markets allow for the determination of price of the
traded financial assets through the interaction of buyers and sellers. They provide a
sign for the allocation of funds in the economy based on the demand and to the supply
through the mechanism called price discovery process.
 Sale mechanism: Financial markets provide a mechanism for selling of a financial
asset by an investor so as to offer the benefit of marketability and liquidity of such
assets.
 Information: The activities of the participants in the financial market result in the
generation and the consequent dissemination of information to the various segments
of the market. So as to reduce the cost of transaction of financial assets.

Financial Functions

 Providing the borrower with funds so as to enable them to carry out their investment
plans.
 Providing the lenders with earning assets so as to enable them to earn wealth by
deploying the assets in production debentures.
 Providing liquidity in the market so as to facilitate trading of funds.
 Providing liquidity to commercial bank
 Facilitating credit creation
 Promoting savings
 Promoting investment
 Facilitating balanced economic growth
 Improving trading floors

Classification of Financial Market:

1. By Nature of Claim

i. Debt Market: The market where fixed claims or debt instruments, such as debentures
or bonds are bought and sold between investors.
 ii. Equity Market: Equity market is a market wherein the investors deal in equity
instruments. It is the market for residual claims.

2. By Maturity of Claim

i. Money Market: The market where monetary assets such as commercial paper,
certificate of deposits, treasury bills, etc. which mature within a year, are traded is
called money market. It is the market for short-term funds. No such market exists
physically; the transactions are performed over a virtual network, i.e. fax, internet or
phone.
ii. Capital Market: The market where medium- and long-term financial assets are traded
in the capital market. It is divided into two types:
 Primary Market: A financial market, wherein the company listed on an exchange,
for the first time, issues new security or already listed company brings the fresh issue.
 Secondary Market: Alternately known as the Stock market, a secondary market is an
organised marketplace, wherein already issued securities are traded between investors,
such as individuals, merchant bankers, stockbrokers and mutual funds.

3. By Timing of Delivery

i. Cash Market: The market where the transaction between buyers and sellers are settled
in real-time.
ii. Futures Market: Futures market is one where the delivery or settlement of
commodities takes place at a future specified date.

4. By Organizational Structure

i. Exchange-Traded Market: A financial market, which has a centralised organisation

with the standardised procedure.
ii. Over-the-Counter Market: An OTC is characterised by a decentralised organisation,
having customised procedures

Components of Financial Market:

Based on market levels

i. Primary market: A primary market is a market for new issues or new financial
claims. Therefore, it is also called new issue market. The primary market deals with
those securities which are issued to the public for the first time.
ii. Secondary market: A market for secondary sale of securities. In other words,
securities which have already passed through the new issue market are traded in this
market. Generally, such securities are quoted in the stock exchange and it provides a
continuous and regular market for buying and selling of securities.

Simply put, primary market is the market where the newly started company issued shares to
the public for the first time through IPO (initial public offering). Secondary market is the
market where the second hand securities are sold (security Commodity Markets).

Based on security types

 i. Money market: Money market is a market for dealing with the financial assets and
securities which have a maturity period of up to one year. In other words, it's a market
for purely short-term funds.
ii. Capital market: A capital market is a market for financial assets which have a long
or indefinite maturity. Generally, it deals with long-term securities which have a
maturity period of above one year. The capital market may be further divided into (a)
industrial securities market (b) Govt. securities market and (c) long-term loans market.
 Equity markets: A market where ownership of securities are issued and
subscribed is known as equity market. An example of a secondary equity
market for shares is the New York (NYSE) stock exchange.
 Debt market: The market where funds are borrowed and lent is known as debt
market. Arrangements are made in such a way that the borrowers agree to pay
the lender the original amount of the loan plus some specified amount of
interest.
iii. Derivative markets: A market where financial instruments are derived and traded
based on an underlying asset such as commodities or stocks.
iv. Financial service market: A market that comprises participants such as commercial
banks that provide various financial services like ATM. Credit cards. Credit rating,
stock broking etc. is known as financial service market. Individuals and firms use
financial services markets, to purchase services that enhance the workings of debt and
equity markets.
v. Depository markets: A depository market consists of depository institutions (such as
banks) that accept deposits from individuals and firms and uses these funds to
participate in the debt market, by giving loans or purchasing other debt instruments
such as treasury bills.
vi. Non-depository market: Non-depository market carry out various functions in
financial markets ranging from financial intermediary to selling, insurance etc. The
various constituencies in non-depositary markets are mutual funds, insurance
companies, pension funds, brokerage firms etc.

Various types of Financial Instruments:

Financial instruments may be divided into two types: cash instruments and derivative
instruments.

Cash Instruments

 The values of cash instruments are directly influenced and determined by the markets.
These can be securities that are easily transferable.
 Cash instruments may also be deposits and loans agreed upon by borrowers
and lenders.

Derivative Instruments

 The value and characteristics of derivative instruments are based on the vehicle’s
underlying components, such as assets, interest rates, or indices.
 An equity options contract, for example, is a derivative because it derives its value
from the underlying stock. The option gives the right, but not the obligation, to buy or
sell the stock at a specified price and by a certain date. As the price of the stock rises
 and falls, so too does the value of the option although not necessarily by the same
percentage.
 There can be over-the-counter (OTC) derivatives or exchange-traded derivatives.
OTC is a market or process whereby securities–that are not listed on formal
exchanges–are priced and traded.

Financial instruments may also be divided according to an asset class, which depends on
whether they are debt-based or equity-based.

Debt-Based Financial Instruments

Short-term debt-based financial instruments last for one year or less. Securities of this kind
come in the form of T-bills and commercial paper. Cash of this kind can be deposits and
certificates of deposit (CDs).

Exchange-traded derivatives under short-term, debt-based financial instruments can be short-

term interest rate futures. OTC derivatives are forward rate agreements.

Long-term debt-based financial instruments last for more than a year. Under securities, these
are bonds. Cash equivalents are loans. Exchange-traded derivatives are bond futures and
options on bond futures. OTC derivatives are interest rate swaps, interest rate caps and floors,
interest rate options, and exotic derivatives.

Equity-Based Financial Instruments

Securities under equity-based financial instruments are stocks. Exchange-traded derivatives

in this category include stock options and equity futures. The OTC derivatives are stock
options and exotic derivatives.

Multiplicity of Financial Instruments:

The expansion in size and number of financial institutions has consequently led to a
considerable increase in the financial instruments also. New instruments have been
introduced in the form of innovative schemes of LIC, UTI, Banks, Post Office Savings Bank
Accounts, Shares and debentures of different varieties, Public Sector Bonds, National
Savings Scheme, National Savings Certificates, Provident Funds, Relief Bonds, Indira Vikas
Patra, etc. Thus, different types of instruments are available in the financial system so as to
meet the diversified requirements of varied investors and thereby making the system more
healthy and vibrant.

Legislative Support

The Indian financial system has been well supported by suitable legislative measures taken
by the government then and there for its proper growth and smooth functioning. Though there
are many enactments, some of them are very important. The Indian Companies Act was
passed in 1956 with a view to regulating the functioning of companies from birth to death. It
mainly aims at giving more protection to investors since there is a diversity of ownership and
management in companies. It was a follow-up to the Capital Issues Control Act passed in
1947. Again, in 1956, the Securities Contracts (Regulation) Act was passed to prevent
undesirable transactions in securities. It mainly regulates the business of trading in the stock
exchanges. This Act permitted only recognised stock exchanges to function.

To ensure the proper functioning of the economic system and to prevent concentration of
economic power in the hands of a few, the Monopolies and Restrictive Trade Practices Act
was passed in 1970. In 1973, the Foreign Exchange Regulations Act was enacted to regulate
the foreign exchange dealings and to control Indian investments abroad and vice versa.

The Capital Issues Control Act was replaced by setting up of the Securities Exchange Board
of India. Its main objective is to protect the interest of investors by suitably regulating the
dealings in the stock market and money market so as to achieve efficient and fair trading in
these markets. When the government adopted the New Economic Policy, many of these Acts
were amended so as to remove many unwanted controls. Banks and financial institutions
have been permitted to become members of the stock market in India. They have been
permitted to float mutual funds, undertake leasing business, carry-out factoring services, etc.
Besides the above, the Indian Contract Act, The Negotiable Instruments Act, The Law of
Limitation Act, The Banking Regulations Act, The Stamp Act, etc., deserve a special mention.
When the financial system grows, the necessity of regulating it also grows side-by-side by
means of bringing suitable legislations. These legislative measures have reorganised the
Indian financing system to a greater extent and have restored confidence in the minds of the
investing public as well.

However, to avoid overlap in certain key areas between SEBI and other bodies such as
Company Law Board, RBI, etc., it is necessary to classify the respective jurisdictions. At
present, the jurisdiction is divided between the RBI (money, market, repos, debt market) and
SEBI. It would be advisable to consolidate the securities laws into one comprehensive
legislation on the lines of the British Financial Services and Market Act, 2000.

Financial Sector Legislative Reforms Commission (FSLRC)

The Central Government has very recently constituted the Financial Sector Legislative
Reforms Commission (FSLRC) under the chairmanship of former Justice B.N. Srikrishna to
rewrite and harmonise the various financial sector legislations, rules and regulations. There
are over 60 Acts and multiple rules and regulations and many of them have become archaic.
Moreover, large number of amendments made in these Acts over time have increased the
ambiguity and complexity of the system.

Weakness of Indian Financial System:

After the introduction of planning, rapid industrialisation has taken place. It has in turn led to
the growth of the corporate sector and the government sector. In order to meet the growing
requirements of the government and the industries, many innovative financial instruments
have been introduced. Besides, there has been a mushroom growth of financial intermediaries
to meet the ever growing financial requirements of different types of customers. Hence, the
Indian financial system is more developed and integrated today than what it was 50 years ago.
Yet, it suffers from some weaknesses as listed below:

(i) Lack of Coordination between Different Financial Institutions

There are a large number of financial intermediaries. Most of the vital 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.

(ii) 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, the entire 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.
(iii) 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. For industries abroad, institutional finance has been a result of
institutionalisation of personal savings through media like banks, LIC, pension and provident
funds, unit trusts and so on. But they play a less significant role in Indian financial system, as
far as industrial financing is concerned. However, in recent times attempts are being made to
raise funds from the public through the issue of bonds, units, debentures and so on. It will go
a long way in forging a link between the normal channels of savings and the distributing
mechanism.

(iv) 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 don’t
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.

(v) Imprudent Financial Practice

The dominance of development banks has developed imprudent financial practice among
corporate customers. The development banks provide most of the funds in the form of term
loans. So, there is a preponderance of debt in the financial structure of corporate enterprises.
This predominance of debt capital has made the capital structure of the borrowing concerns
uneven and lopsided. To make matters worse, when corporate enterprises face any financial
crisis, these financial institutions permit a greater use of debt than is warranted. It is against
the traditional concept of a sound capital structure.

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.