THE INDIAN

FINANCIAL SYSTEM
Intermediaries, Institutions and Instruments

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Together we call it as:

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The Indian Financial System
• A financial system plays a vital role in the economic growth of a country. It
intermediates between the flow of funds belonging to those who save a part of their
income and those who invest in productive assets. It mobilizes and usefully allocates
scarce resources of a country. A financial system is a complex, well-integrated set of
sub-systems of financial institutions, markets, instruments, and services which
facilitates the transfer and allocation of funds, efficiently and effectively.

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• Financial System are of crucial importance to capital formation. The process of
capital formation involves three interrelated activities:
• Saving: the ability by which claims to resources are set aside and become available
for other purpose.
• Finance: the ability by which claims to resources are either assembled from those
released by domestic savings , obtained from abroad etc.
• Investment: the activity by which resources are actually committed to production.

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• The Indian financial system can also be broadly classified into the formal (organized) financial
system and the informal (unorganized) financial system. The formal financial system comes under
the purview of the Ministry of Finance (MoF), the Reserve Bank of India (RBI), the Securities and
Exchange Board of India (SEBI), and other regulatory bodies.

**The informal financial system consists of:

• Individual moneylenders such as neighbours, relatives, landlords, traders, and storeowners.

• Groups of persons operating as ‘funds’ or ‘associations.’ These groups function under a system of
their own rules and use names such as ‘fixed fund,’ ‘association,’ and ‘ saving club.’

• Partnership firms consisting of local brokers, pawnbrokers, and non-bank financial intermediaries
such as finance, investment, and chit-fund companies.

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 The Indian Financial System

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• So, Indian Financial System is a complex, well-integrated set of sub-systems of:
 Financial Institutions,
 Financial Markets,
 Financial Instruments, and
 Financial Services.
Fund Based: Leasing, Hire Purchase, Factoring etc.
Fee Based: Merchant Banking, Credit Rating, Mergers etc.
which facilitates the transfer and allocation of funds, efficiently and effectively.

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Financial Institutions
This segment is divided into two types of Institutions:
• Regulators
• Intermediaries

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REGULATORS

Regulatory Institutions are statutory bodies assigned with the job of monitoring and
controlling different segments of the Indian Financial System (IFS). These Institutions have
been given adequate powers through the vehicle of their respective Acts to enable them to
supervise the segments assigned to them. It is the job of the regulator to ensure that the players
in the segment work within recognized business parameters, maintain sufficient level of
disclosure and transparency of operations and do not act against the national interests. At
present, there are two regulators directly connected to IFS:

Reserve Bank of India

Security and Exchange Board of India

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• INTERMEDIARIES

Intermediary Financial Institutions are essentially of two types:

• Banking
• Non Banking

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• A distinguishing characteristic of banking Financial Institutions lies in the fact that, unlike
other institutions, they participate in the economy’s payments mechanism, i.e., they provide
transaction services, their deposit liabilities constitute a major part of the national money
supply, and they can, as a whole, create deposits or credit, which is money. Banks, subject to
legal reserve requirements, can advance credit by creating claims against themselves. Financial
Institutions, on the other hand, can lend only out of resources put at their disposal by the
savers. Indian Financial System boasts of well developed banking Financial Institutions each
designated to carry out a specific developmental task. Most FIs, however, work on commercial
lines with an eye on the development of the sectors assigned to them.
• Financial institutions have been the primary source of long term lending for large projects.
Conventionally, they raised their resources in the form of bonds subscribed by RBI, Public
Sector Enterprises, Banks and others. With the drying up of concessional Long Term
Operations (LTO) funds from the Reserve Bank in the early 1990s, Financial Institutions have
increasingly raised resources at the short end of the deposit market.

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Banking Intermediaries
• The Banking Segment in India functions under the umbrella of Reserve Bank of
India, the regulatory central bank. This segment broadly consists of:
• Commercial Banks
• Co-Operative Banks

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Non-Banking Financial Institutions
• Non-banking Financial Institutions carry out financing activities but their resources are not
directly obtained from the savers as debt. Instead, these Institutions mobilize the public
savings for rendering other financial services including investment. All such Institutions are
financial intermediaries and when they lend, they are known as Non-Banking Financial
Intermediaries (NBFIs) or Investment Institutions.

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• UNIT TRUST OF INDIA
• LIFE INSURANCE CORPORATION (LIC)
• GENERAL INSURANCE CORPORATION (GIC)
• Apart from these NBFIs, another part of Indian financial system consists of a large number of
privately owned, decentralised, and relatively small-sized financial intermediaries.
• Post 1996, Reserve Bank of India has set in place additional regulatory and supervisory
measure that demand more financial discipline and transparency of decision making on the
part of NBFCs. NBFCs regulations are being reviewed by the RBI from time to time keeping
in view the emerging situations.

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 • Financial institutions can also be classified as term-finance institutions such as the
Industrial Development Bank of India (IDBI), the Industrial Credit and Investment
Corporation of India (ICICI), the Industrial Financial Corporation of India (IFCI), the Small
Industries Development Bank of India (SIDBI), and the Industrial Investment Bank of India
(IIBI). Financial institutions can be specialized finance institutions like the Export Import
Bank of India (EXIM), the Tourism Finance Corporation of India (TFCI), ICICI Venture,
the Infrastructure Development Finance Company (IDFC), and sectoral financial
institutions such as the National Bank for Agricultural and Rural Development (NABARD)
and the National Housing Bank (NHB).
• Investment institutions in the business of mutual funds Unit Trust of India (UTI), public
sector and private sector mutual funds and insurance activity of Life Insurance Corporation
(LIC), General Insurance Corporation (GIC) and its subsidiaries are classified as financial
institutions. There are state-level financial institutions such as the State Financial
Corporations (SFCs) and State Industrial Development Corporations (SIDCs) which are
owned and managed by the State governments. In the post-reforms era, the role and nature
of activity of these financial institutions have undergone a tremendous change. Banks have
now undertaken non-bank activities and financial institutions have taken up banking
functions. Most of the financial institutions now resort to financial markets for raising
funds.

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 Financial Markets
Financial markets are a mechanism enabling participants to deal in financial claims. The markets also

provide a facility in which their demands and requirements interact to set a price for such claims.

• 1) Capital Market – Market where business enterprises or government entities raise fund for long term

using the weapon of securities or debts. It includes the Stock market (equities) and Bond Market (debt) for

fund raising.

• 2) Commodity Market – Commodity is a good for which there is a demand by the people thus commodity

market is the market where such goods are traded.

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• 3) Money Market – Deals with the assets involved in short-term borrowing and lending

with original maturities ranging from a period of one year or even lesser time frames.

• 4) Derivative Market – The derivative market is the financial market meant for derivatives.

The financial instruments like the futures contracts or options, which are derived from other

forms of assets, are traded in these markets.

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• 5) Insurance Market – Deals with the trading of insurance policies.

• 6) Futures Market – A vertical in financial market where people can trade standardized futures

contracts which is a contract to buy specific number of quantities of a commodity or financial

instrument at a specified price with the delivery of the commodity or financial instrument set at

a specified time in the future.

• 7) Foreign Exchange Market – Also known as Forex is a global, worldwide decentralized

financial market meant only for the trading of currencies.

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 Financial Instruments
Financial Instruments/Securities may be primary or secondary securities.
• Primary securities are also termed as direct securities as they are directly issued by the
ultimate borrowers of funds to the ultimate savers. Examples of primary or direct
securities include equity shares and debentures. Secondary securities are also referred
to as indirect securities, as they are issued by the financial intermediaries to the ultimate
savers. Bank deposits, mutual fund units, and insurance policies are secondary
securities.
• Financial instruments differ in terms of marketability, liquidity, reversibility, type of
options, return, risk, and transaction costs. Financial instruments help financial markets
and financial intermediaries to perform the important role of channelizing funds from
lenders to borrowers. Availability of different varieties of financial instruments helps
financial intermediaries to improve their own risk management.

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Financial services
• These are those that help with borrowing and funding, lending and investing,
buying and selling securities, making and enabling payments and settlements, and
managing risk exposures in financial markets. The major categories of financial
services are funds intermediation, payments mechanism, provision of liquidity, risk
management, and financial engineering. Funds intermediating services link the saver
and borrower which, in turn, leads to capital formation. These services refer to the
process of designing, developing, and implementing innovative solutions for unique
needs in funding, investing, and risk management

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• Following is a very brief description of the services
1. Banking Services – Includes all the operations provided by the banks including to the
simple deposit and withdrawal of money to the issue of loans, credit cards etc.
2. Foreign Exchange services – this includes the currency exchange, foreign exchange
banking or the wire transfer
3. Investment Services – It generally includes the asset management, hedge fund
management and the custody services
4. Insurance Services – It deals with the selling of insurance policies, brokerages,
insurance underwriting or the reinsurance
Some of the other services include the advisory services, venture capital, angel
investment etc.

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5. Portfolio Management

This segment includes a highly specialized and customized range of solutions that
enables clients to reach their financial goals through portfolio managers who analyze
and optimize investments for clients across a wide range of assets (debt, equity,
insurance, real estate, etc.). These services are broadly targeted at HNIs and are
discretionary (investment only at the discretion of fund manager with no client
intervention) and non-discretionary (decisions made with client intervention).

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Functions of IFS
• It bridges the gap between savings and investment through efficient mobilization
and allocation of surplus funds.
• It helps a business in capital formation.
• It helps in minimizing risk and allocating risk efficiently.
• It facilitates financial transactions through provision of various financial
instruments.
• It facilitates trading of financial assets/Instruments by developing and regulating
financial markets.

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Importance of IFS
• It accelerates the rate and volume of savings through provisions of various financial
instruments and efficient mobilization of savings.
• It aids in increasing the national output of the country by providing funds to
corporate customers to expand their perspective business.
• It protects the interests of investors and ensures smooth financial transactions
through regulatory bodies such as RBI, SEBI, etc.
• It helps economic development and raising standard of living of people.
• It helps to promote the development of weaker section of the society through rural
development banks and cooperative societies.

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• It helps corporate customers to make better financial decisions by providing effective
financial as well as advisory services.
• It aids in financial deepening and broadening:
Financial Deepening: It refers to the increase in financial assets as a percentage of GDP.
Financial Broadening: It refers to the increasing number of participants in the financial
system.

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