EVOLUTION AND SIGNIFICANCE OF

INDIAN FINANCIAL SYSTEM BY A.K SIR

EVOLUTION OF INDIAN FINANCIAL SYSTEM
The Indian financial system has undergone significant transformations since
the country's independence in 1947. This evolution can be segmented into
several key phases marked by crucial milestones, reforms, and institutional
developments.

EARLY YEARS POST-INDEPENDENCE

In the initial years following independence, the focus was predominantly on

building a self-reliant economy. The government took control of the banking
sector, leading to the establishment of the Reserve Bank of India (RBI) in
1935, which was tasked with regulating the monetary system and providing
financial stability. In 1969, the Indian government nationalized 14 major
banks, a pivotal move that expanded banking access to the rural and
unbanked sections of society.

ECONOMIC REFORMS AND STRUCTURAL ADJUSTMENTS

The late 1980s and early 1990s marked a turning point for the Indian financial
system. In response to a balance of payments crisis in 1991, India adopted a
series of economic reforms aimed at liberalizing the economy. These reforms
included:

• Deregulation of Interest Rates: Allowing banks to set their interest

rates, leading to competitive financial products.
• Entry of Private Banks: Facilitating the entry of private and foreign
banks enhanced the competitive landscape of banking services.
• Stock Market Reforms: Strengthening the regulatory framework
through institutions like the Securities and Exchange Board of India
(SEBI) laid the groundwork for a more transparent and robust capital
market.
THE ROLE OF INSTITUTIONS

Institutional development has been crucial in shaping the financial landscape.

The RBI not only serves as the central bank but also plays a critical role in
monetary policy and monetary stability. Other noteworthy institutions
include:

• SEBI: Established to promote investor protection and regulate the stock

market, contributing to investor confidence and market integrity.
• Development Financial Institutions (DFIs): Such as the Industrial
Development Bank of India (IDBI) provided long-term finance for
industrial projects.

IMPACT OF LIBERALIZATION IN THE 1990S

The liberalization initiated in the 1990s radically transformed the Indian

financial system by opening it to global markets. This change brought several
advantages:

• Foreign Direct Investment (FDI): Enhanced inflow of capital into the

nation, boosting sectors such as IT, manufacturing, and infrastructure.
• Emergence of New Financial Instruments: Introduction of instruments
such as derivatives, mutual funds, and asset-backed securities
diversified investment opportunities for retail investors.
• Integration with Global Markets: Indian markets began to integrate
with international financial markets, leading to increased liquidity and
investment opportunities.

As a result, the Indian financial system has evolved into a complex, dynamic
environment that continues to foster economic growth and development
while adapting to global economic challenges.

COMPONENTS OF PRIMARY AND SECONDARY

MARKET
The Indian financial system comprises two fundamental markets: the primary
market and the secondary market. Each serves a distinct purpose,
incorporating various components to facilitate capital raising, investment,
and trading.
PRIMARY MARKET

The primary market is where new securities are issued, allowing companies to
raise capital directly from investors. This market is characterized by several
key components:

• Initial Public Offerings (IPOs): When a company offers its shares to the
public for the first time, it does so through an IPO. This process involves
careful regulatory compliance and the preparation of a prospectus,
guiding potential investors on the company's financial health.

• Rights Issues: Existing shareholders are given the right to purchase

additional shares at a predetermined price, often below the market rate.
This method allows companies to raise funds while giving current
investors a chance to maintain their ownership percentage.

• Bonus Issues: Companies may issue bonus shares to existing

shareholders for free, usually in proportion to their current holdings.
This is typically done from the company's reserves and serves as a way
to reward shareholders without affecting the company's cash flow.

SECONDARY MARKET

In contrast, the secondary market facilitates the trading of existing securities.

Here, the ownership of stocks and bonds changes hands, providing liquidity
and price discovery for investors. Key components of the secondary market
include:

• Stock Exchanges: These regulated platforms, such as the Bombay Stock

Exchange (BSE) and National Stock Exchange (NSE), provide a structured
environment for security trading. Stock exchanges facilitate price
formation by matching buy and sell orders from various market
participants.

• Over-the-Counter (OTC) Markets: Unlike stock exchanges, OTC markets

involve trading directly between two parties, often through dealer
networks. These markets cater to securities not listed on formal
exchanges, allowing for greater flexibility but with variable transparency.
 • Market Participants: Numerous players engage in the secondary
market, including:

◦ Retail Investors: Individuals trading shares for personal

investment.
◦ Institutional Investors: Entities like mutual funds and pension
funds that manage large portfolios.
◦ Brokerage Firms: Act as intermediaries facilitating transactions
between buyers and sellers.
◦ Market Makers: These participants provide liquidity by quoting buy
and sell prices, ensuring smoother transactions.

IMPORTANCE OF PRIMARY AND SECONDARY MARKETS

Both markets play critical roles in the financial ecosystem. The primary
market equips companies with essential capital for growth and expansion,
while the secondary market ensures liquidity, enabling investors to easily
enter or exit positions. Together, they support the overall health and efficiency
of the Indian financial system, fostering economic development.

SIGNIFICANCE OF CAPITAL MARKET

The capital market plays a vital role in the Indian economy, acting as a
conduit for raising funds, fostering economic growth, and providing
investment opportunities for individuals and institutions. By facilitating the
mobilization of savings, it not only supports businesses but also enhances
overall market stability.

ROLE IN FUNDRAISING FOR BUSINESSES

For companies, the capital market serves as a platform to raise necessary

capital for expansion and operational needs. Through mechanisms such as:

• Initial Public Offerings (IPOs): Companies can raise significant amounts

of capital by offering shares to the public for the first time. This influx of
funds enables firms to invest in new projects, research and
development, and asset acquisitions.
• Debt Instruments: Corporations often issue debentures or bonds to
secure long-term funding. These instruments attract different types of
investors seeking regular income through interest payments.
The ability to access a wide array of financial instruments allows businesses to
choose tailored funding solutions that align with their financial strategies.

INVESTMENT OPPORTUNITIES

The capital market not only provides companies access to funds but also
opens avenues for investors. It allows for:

• Diverse Investment Options: Investors can select from various financial

instruments, such as stocks, bonds, and mutual funds. This diversity
helps them build balanced portfolios and manage risk effectively.
• Potential for High Returns: Equity investments in the capital market can
yield substantial long-term returns, attracting both retail and
institutional investors looking to grow their wealth.
• Liquidity: The secondary market ensures adequate liquidity, enabling
investors to buy or sell their holdings with relative ease. This encourages
more participants to engage actively in the market, bolstering overall
economic dynamism.

ECONOMIC GROWTH AND DEVELOPMENT

A robust capital market significantly contributes to the economy's health. Key

factors include:

• Efficient Capital Allocation: By connecting savers and investors, the

capital market ensures that funds flow into sectors with the most
potential for growth, facilitating optimal resource use.
• Infrastructure Development: The capital market provides essential
funding for infrastructure projects, enhancing transportation,
communication, and other vital sectors, which in turn stimulates
economic activity.
• Corporate Governance: A transparent capital market promotes good
governance practices as companies become accountable to a wider
group of stakeholders, thereby fostering a healthier investment climate.
MARKET STABILITY

The capital market serves as a barometer for economic conditions. It can

signal investor sentiments and confidence levels, while also impacting
monetary policy decisions. Its significance is further underscored by:

• Risk Management: The availability of various investment products

enables investors to hedge against market risks, contributing to overall
financial stability.
• Regulatory Framework: Oversight bodies, such as the Securities and
Exchange Board of India (SEBI), help maintain order and transparency in
capital markets, boosting investor confidence and market integrity.

In summary, the capital market is integral to the Indian economy, supporting

businesses in fund-raising, providing investment opportunities, and
promoting market stability while acting as a catalyst for economic growth and
development.

BONUS ISSUES AND RIGHTS ISSUES

The concepts of bonus issues and rights issues are crucial mechanisms within
corporate finance that companies utilize to raise capital and reward
shareholders. Understanding these mechanisms is essential for finance
professionals and investors engaging with the Indian market.

BONUS ISSUES

A bonus issue, also known as a scrip issue or capitalization issue, occurs when
a company issues additional shares to its existing shareholders at no cost.
This is typically done by utilizing the company’s retained earnings or reserves.
Key characteristics and implications of bonus issues include:

• Proportional Allocation: Bonus shares are generally issued in proportion

to existing holdings (e.g., 1 bonus share for every 5 shares held). This
ensures that shareholders maintain their relative ownership percentage.
• No Cash Outflow: Unlike dividends, which reduce a company’s cash
reserves, bonus shares do not require a cash outflow. This is particularly
beneficial for companies looking to reward shareholders without
affecting liquidity.
• Market Perception: Issuing bonus shares may signal to the market that
a company is financially healthy and has retained earnings, thereby
potentially boosting investor confidence and share prices.
Example in India: TATA Steel recently issued bonus shares to its shareholders,
indicating robust financial performance while simultaneously enhancing
shareholder value.

RIGHTS ISSUES

In contrast, a rights issue enables companies to raise additional capital by

offering existing shareholders the opportunity to purchase additional shares
at a predetermined price, usually lower than the current market price. Key
aspects include:

• Ownership Preservation: Rights issues allow shareholders to maintain

their proportionate ownership in the company by purchasing additional
shares before they are offered to new investors.
• Investment Opportunity: Shareholders may exercise their rights if they
believe the company's future prospects are promising. However, if they
choose not to participate, their ownership percentage may dilute.
• Short-term Impact: While rights issues can provide necessary funding
for growth or debt repayment, they may exert downward pressure on
stock prices in the short term due to perceived dilution.

Example in India: Reliance Industries successfully completed a rights issue

that garnered large investor interest, significantly bolstering its capital base
for future expansion.

DISTINCTION BETWEEN BONUS AND RIGHTS ISSUES

Feature Bonus Issue Rights Issue

Cost to Shareholders must pay for new

No cost to acquire bonus shares
Shareholders shares

Reward shareholders from

Purpose Raise capital for expansion/debt
reserves

Shareholder
Maintains ownership structure Opportunity to prevent dilution
Impact

Cash inflow required from

Cash Outflow No cash outflow
shareholders
CURRENT PRACTICES IN INDIA

The practice of issuing bonus shares and rights issues remains prevalent in
India, reflecting companies’ strategies to enhance liquidity and shareholder
engagement. The Securities and Exchange Board of India (SEBI) oversees
these practices, ensuring fairness and transparency in the processes, which in
turn bolsters market integrity.

With a comprehensive understanding of bonus and rights issues, finance

professionals and investors can better navigate corporate finance and make
informed decisions related to their investments and corporate strategies in
the Indian financial market.

NEW ISSUE MARKET AND ITS FUNCTIONS

The New Issue Market (NIM), often referred to as the primary market, is a
crucial segment of the Indian financial system where new securities are
issued directly to investors. This market plays an essential role in capital
formation, providing companies with the necessary funds for growth and
expansion. Below, we delve into the functions and mechanisms of the New
Issue Market, highlighting its significance and the regulatory aspects that
govern its operations in India.

FUNCTIONS OF THE NEW ISSUE MARKET

The New Issue Market serves several important functions:

• Capital Raising: Companies utilize the NIM primarily to raise capital by

offering new shares or debt instruments to the public through various
means, such as:

◦ Initial Public Offerings (IPOs): When a company offers shares to

the public for the first time, effectively transitioning from private to
public ownership.
◦ Rights Issues: Existing shareholders are granted the right to
purchase additional shares, enabling companies to raise funds
while allowing current investors to maintain their ownership
percentage.

• Price Discovery: The NIM facilitates the process of price discovery for
new securities. Through the bidding system established during IPOs, the
 market determines the fair value of the shares based on investor
demand.

• Market Segmentation: The NIM is segmented into various sub-markets,

including equity, debt, and hybrid securities, allowing companies to
select the most appropriate type of security for their financing needs.

MECHANISM FOR INITIAL PUBLIC OFFERINGS (IPOS)

The IPO process is a structured mechanism through which companies tap

into the New Issue Market:

1. Preparation: Companies appoint underwriters and prepare a draft

prospectus that includes financial statements, business plans, and risk
factors. This document is essential for informing potential investors
about the offering.

2. Regulatory Approval: The draft prospectus is submitted to the Securities

and Exchange Board of India (SEBI) for approval. SEBI reviews the
document to ensure compliance with regulatory requirements,
safeguarding investor interests.

3. Marketing: Companies conduct roadshows to market their IPO,

engaging with potential investors to generate interest and gauge
demand.

4. Issuance: Upon receiving approval, shares are offered to the public. The
subscription period usually lasts for a few days, during which investors
place their orders.

5. Listing: Once subscribed and allocated, the shares are listed on stock
exchanges such as the Mumbai Stock Exchange or the National Stock
Exchange, marking the transition to the secondary market.

INVESTOR PARTICIPATION

Investor participation is fundamental to the New Issue Market, as it directly

influences the success of IPOs and rights issues. The following groups are
typically involved:

• Retail Investors: Individual investors seeking opportunities for capital

growth through stock ownership.
 • Institutional Investors: Entities like mutual funds, insurance companies,
and pension funds often participate significantly due to their larger
investment capacities.
• Qualified Institutional Buyers (QIBs): A subset of institutional investors
that includes banks, mutual funds, and foreign investors who meet
specific criteria defined by SEBI.

REGULATORY ASPECTS

The New Issue Market is largely governed by SEBI, which establishes

guidelines to ensure transparency and protect investor interests. Key
regulations include:

• Disclosure Requirements: Companies must provide detailed disclosures

in their prospectus, enabling investors to make informed decisions.

• Price Band Regulation: SEBI mandates a price band for IPOs, ensuring
that companies do not exploit investors by setting excessive prices.

• Stabilization Measures: SEBI can introduce measures like greenshoe

options in certain offerings, allowing companies to increase the number
of shares sold if demand exceeds expectations.

Through its structured framework, the New Issue Market not only facilitates
capital raising for companies but also fosters investor participation, crucial for
the growth of the Indian financial system.

COMPONENTS OF SECONDARY MARKET

The secondary market is an essential part of the Indian financial system,
providing a platform for the trading of existing securities. Understanding its
components—stock exchanges, market makers, brokers, trading methods,
and the regulatory framework—is key for finance professionals and investors.

STOCK EXCHANGES

Stock exchanges, such as the Bombay Stock Exchange (BSE) and the National
Stock Exchange (NSE), serve as regulated platforms where securities are
bought and sold. Their primary functions include:

• Price Discovery: Stock exchanges facilitate the determination of prices

through the interaction of supply and demand when traders execute
buy or sell orders.
 • Liquidity: They ensure that investors can quickly buy or sell securities,
thus enhancing market efficiency.
• Transparency: Exchanges operate under strict regulatory oversight,
providing a transparent environment for all market transactions.

MARKET MAKERS

Market makers are crucial participants in the secondary market who enhance
liquidity by continuously buying and selling securities. Their responsibilities
include:

• Bid-Ask Spread: They provide two-sided quotes, offering a buying price

(bid) and a selling price (ask), thereby ensuring that there's always a
market for securities.
• Providing Stability: By being ready to trade at all times, market makers
help stabilize prices, reducing volatility.

ROLE OF BROKERS

Brokers act as intermediaries between buyers and sellers in the secondary

market. Their primary functions include:

• Facilitating Transactions: Brokers execute trades on behalf of clients by

accessing the stock exchanges, ensuring that trades are completed
efficiently.
• Advisory Services: Many brokers provide research and analysis services
to clients, guiding them in making informed investment decisions.

TYPES OF ORDERS

In the secondary market, investors can place different types of orders, which
include:

• Market Orders: Executed immediately at the current market price,

allowing investors to buy or sell quickly.
• Limit Orders: Set at a specific price, these orders are executed only
when the market price matches the limit specified by the investor.
• Stop-Loss Orders: Used to limit potential losses, they are triggered when
the stock price reaches a specified level.
TRADING METHODS

The trading in the secondary market can be executed through different

methods:

• Continuous Trading: Most transactions occur on exchanges where

buyers and sellers are matched in real-time.
• Auction Systems: Some securities are traded through periodic auctions
where buyers submit bids, and securities are allocated based on the
highest offers.

REGULATORY FRAMEWORK

The secondary market in India is governed by a robust regulatory framework,

primarily overseen by the Securities and Exchange Board of India (SEBI). Key
regulations include:

• Market Conduct Rules: SEBI enforces rules to prevent market

manipulation and insider trading, promoting fairness and transparency.
• Reporting Requirements: Brokers and exchanges must report trading
activity to maintain accurate records for regulatory oversight.
• Investor Protection: SEBI implements measures to protect investors,
such as mandatory disclosures and complaint redressal mechanisms.

This structured environment of the secondary market not only facilitates

trading but also ensures that investor interests are safeguarded, contributing
to the overall health of the Indian financial system.