Financial Institutions & Markets Module 1 : Financial System in India

Financial Institutions & Markets Module 1 : Financial System in India

Syllabus Covered

● Introduction – Meaning of Financial System– Financial concepts -

Constituents of Financial System – Structure of Financial System – Role of
Financial system- Functions of Financial System
● Development of the Financial System in India. Financial Sector Reforms -
Financial System and Economic Development – Weakness of Indian financial
system.

1.1 Financial system

A financial system refers to a complex network of institutions, markets,

regulations, and intermediaries that facilitate the flow of funds and capital within
an economy. Its primary purpose is to efficiently allocate resources, connect
borrowers and lenders, and enable the functioning of the broader economy. The
financial system plays a crucial role in promoting economic growth and stability.

In the financial system, there are two primary groups of participants; Savers and
Users (borrowers or investors), and they are indeed interconnected to facilitate the
allocation of capital for productive purposes.

Savers are individuals, households, businesses, and institutions that have excess
funds or savings.They typically want to preserve and potentially grow their wealth
over time. To achieve this, they seek to invest their savings in ways that offer
returns on their capital. Savers channel their funds into various financial
instruments and institutions, including bank deposits, savings accounts, bonds,
stocks, and other investments.
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Users represent individuals, businesses, and governments that require funds to

finance various activities and investments.They may need capital for purposes such
as starting or expanding a business, buying a home, funding education, or
infrastructure development.Users access funds through loans, credit lines, equity
investments, or by issuing bonds or other financial instruments.

Financial system acts as an intermediary that connects savers and users of capital.
Complex network of institutions, markets, regulations, and intermediaries that
facilitate this connection is called the Financial System.

1.2 Constituents/ Features/ Structure / Components of Financial System

The financial system is a complex and interdependent network comprising various

key components. These components collectively form the foundation upon which
economic activity thrives, enabling the efficient allocation of capital, risk
management, and the facilitation of transactions. The components of the financial
system can be broadly categorized as follows

1. Financial Institutions
2. Financial Markets
3. Financial Products & Services
4. Financial Infrastructure
5. Regulatory Bodies

1.2.1 Financial Institutions

Financial institutions are organizations that provide various financial services and
intermediation between savers (those who have excess funds) and borrowers
(those who need funds). These services can include accepting deposits, lending
money, processing payments, investing money, offering insurance products, and
more. They play a crucial role in the allocation of capital within the economy as
they facilitate the flow of capital between savers and borrowers, and by providing
essential financial services to individuals and businesses.

The following are the major financial institutions in India

1. Commercial Banks

Commercial banks are the backbone of the financial system. They offer a wide
range of financial services, including accepting deposits, providing loans,
facilitating payments and transactions, and offering investment products.
Commercial banks play a vital role in the economy by channelling funds between
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savers and borrowers, helping to maintain financial stability, and supporting

economic growth. They can be classified into public sector banks, private sector
banks, foreign banks, regional rural banks, payments banks, and small finance
banks.

2. Investment Banks

Investment banks are financial institutions that specialise in providing a range of

financial services to corporations, governments, and other large organisations.
These services primarily revolve around raising capital, managing financial assets,
and facilitating complex financial transactions. Investment banks play a crucial
role in the financial markets by advising on mergers and acquisitions,
underwriting securities, providing financial advisory services, and engaging in
issuance of shares or debt instruments for corporations.

3. Savings and Credit Unions (Cooperative Banks and Self Help Groups)/

Savings and credit unions, known as cooperative banks and self-help groups
(SHGs) in India, are community-based financial institutions that provide financial
services to their members. Cooperative banks offer a variety of services similar to
commercial banks, but they focus on serving specific communities or groups.
SHGs, on the other hand, are not traditional financial institutions but play a vital
role by pooling savings and enabling access to credit, particularly for women in
rural and semi-urban areas.

4. Central Bank

The Reserve Bank of India (RBI) acts as the central bank of India. It plays a pivotal
role in the financial system by providing banking services to the government,
regulating and supervising other financial institutions, and acting as the lender of
last resort. Additionally, the RBI manages its own investment portfolio, holds
foreign exchange reserves, and conducts various financial transactions to maintain
the stability of the financial system.

5. NBFCs (Non-Banking Financial Companies)

Non-banking financial companies (NBFCs) are financial institutions that offer a

variety of financial services similar to banks, but they do not hold a full banking
license. NBFCs play a crucial role in filling gaps in traditional banking services by
extending credit and financial products to diverse customer segments,
contributing to financial inclusion and economic growth in India. There are
different categories of NBFCs regulated by the RBI based on their activities,
including investment and credit companies, core investment companies, factor
NBFCs, infrastructure debt funds, infrastructure finance companies, microfinance
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institutions, account aggregators, mortgage guarantee companies, non-operative

financial holding companies, peer-to-peer lending platforms, and asset
reconstruction companies.

6. Insurance Companies

Insurance companies are essential players in the financial system, offering various
insurance products to individuals and businesses. These products provide financial
protection against a wide range of risks, including life, health, property, and
liability. Insurance companies collect premiums from policyholders and invest
those funds to meet their obligations and generate returns. They are subject to
strict regulations by the Insurance Regulatory and Development Authority of India
(IRDAI).

7. Brokerage Firms

Brokerage firms act as intermediaries between buyers and sellers in financial

markets. They provide a platform and services for investors to trade securities
efficiently. Brokerage firms can be full-service, offering research, investment
advice, and portfolio management, or discount, focusing on low-cost execution of
trades with limited advisory services. Hybrid firms combine elements of both
models. Brokerage firms are regulated by the Securities and Exchange Board of
India (SEBI) to ensure fair and transparent trading practices.

8. Asset Management Companies (AMCs)

Asset management companies (AMCs) specialize in managing investment funds

for individuals and institutions. They offer a variety of investment products,
including mutual funds, exchange-traded funds (ETFs), alternative investment
funds (AIFs), and portfolio management services (PMS). AMCs employ fund
managers who make investment decisions based on the specific objectives and risk
tolerance of each fund. Investors pay fees to AMCs for managing their investments.

9. Pension Funds

Pension funds play a critical role in securing the financial future of retirees by
managing and investing contributions from individuals and employers. These
funds invest in a diversified portfolio of assets to provide retirement benefits,
which can be in the form of lump-sum payments, annuities, or a combination of
both. There are two main types of pension funds in India: the Employees' Provident
Fund Organization (EPFO) which manages the mandatory Employee Provident
Fund (EPF) scheme, and Pension Fund Managers (PFMs) who manage individual
accounts under the voluntary New Contributory Pension System (NPS).
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10.Development Financial Institutions (DFIs)

Development financial institutions (DFIs) are specialized financial institutions that

provide long-term financing for infrastructure and key manufacturing projects to
support economic development. DFIs differ from commercial banks by focusing on
long-term projects and often providing technical assistance in addition to financial
support. They raise funds by borrowing from governments and selling bonds to the
public. Some of the major operational DFIs in India include the Industrial Finance
Corporation of India (IFCI), Export-Import Bank of India (EXIM Bank), National
Bank for Agriculture and Rural Development (NABARD), National Housing Bank
(NHB), Small Industries Development Bank of India (SIDBI), and Indian
Infrastructure Finance Company Limited (IIFCL).

1.2.2 Financial Markets

Financial Markets include any marketplace (physical and digital) that provides
buyers and sellers the means to trade financial instruments, including bonds,
equities, the various international currencies, and derivatives. These markets
facilitate the efficient allocation of capital, enabling businesses to raise funds,
individuals to invest, and governments to finance their activities.

Financial markets can be classified based on various criteria, such as the stage at
which financial assets are bought and sold (primary or secondary), the maturity of
the instruments traded (short-term or long-term), the timing of delivery (cash or
futures), the types of assets traded (equity, debt, foreign exchange, or derivatives),
and the market structure (organized exchanges or over-the-counter markets)

Financial markets play a crucial role in the economy by providing liquidity, price
discovery, and risk management opportunities. They also contribute to economic
growth by channeling capital to productive investments.
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The advent of technology has dramatically transformed the landscape of financial

markets, making them more accessible, efficient, and global. In the past, financial
transactions were confined to physical trading floors and required intermediaries
such as brokers. However, with the rise of digital platforms and advancements in
technology, financial markets have become omnipresent, reaching the corners of
the world.

There are a few technological advancements that made the financial markets
omnipresent. Such prominent advancements are as follows.

1. Internet: The widespread adoption of the internet has provided a global

platform for financial transactions, enabling investors from anywhere in the
world to access markets and trade financial instruments.

2. Computers and Mobile Devices: The increasing affordability and power of

computers and mobile devices have made it easier for individuals and
businesses to participate in financial markets.

3. Financial Technology (FinTech): Innovations in FinTech have led to the

development of new financial products and services, such as online trading
platforms, mobile payments, and cryptocurrency exchanges.

4. E-KYC (Electronic Know Your Customer): The use of Aadhaar for e-KYC has
simplified the process of customer onboarding, making it easier for
individuals to open bank accounts and access financial services.

5. Digital Public Infrastructure (DPI): The development of DPI, such as UPI

(Unified Payments Interface), has enabled seamless and secure digital
payments, facilitating financial transactions and promoting financial
inclusion.

The digital revolution has fundamentally changed the way financial markets
operate. Technology has made it possible for individuals and businesses to
participate in global financial markets with unprecedented ease and convenience.
Financial markets have become "Everything Everywhere All at Once" reflecting
their interconnectedness, complexity, and the vast array of financial instruments
and activities they encompass.

1.2.3 Financial Products & Services

Financial products and services are the various offerings available in the financial
markets provided by the financial institutions. These products and services cater to
the diverse needs of individuals, businesses, and governments. These products and
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services play a crucial role in enabling economic activity, managing risk, and
achieving financial goals.

While financial products are typically tangible assets or contracts, such as stocks,
bonds, or insurance policies, financial services are often considered intangible.
Financial products can be owned by individuals, while services are typically
consumed rather than owned. Products provide direct value (e.g., a stock
represents ownership in a company), while services offer assistance or expertise.

1.2.3.1 Financial Products

Financial products can serve a wide range of purposes within the realm of finance
and they are mainly categorized into,

● Savings and Depositing products

● Borrowing products
● Payment products
● Investment products
● Speculative products
● Risk Management products

1. Savings and Depositing products

Savings and depositing products are financial instruments offered by banks and
other financial institutions that enable individuals and businesses to safely store
their funds and earn interest. These products provide a secure and convenient way
to accumulate wealth over time and serve as a foundation for financial planning.

● Savings Accounts: Basic accounts for everyday transactions and savings.

● Recurring Deposits (RDs): Fixed-term deposits with periodic contributions.
● Fixed Deposits (FDs): Lump sum deposits for a fixed period.
● Post Office Savings Schemes: Savings schemes offered by the Indian postal
service, including NSCs and KVP.
● Public Provident Fund (PPF): Government-backed long-term savings
scheme.
● Sukanya Samriddhi Yojana (SSY): Government-backed savings scheme for
girls.
● Senior Citizens Savings Scheme (SCSS): Savings scheme for senior citizens.
2. Borrowing products

Borrowing products are financial instruments offered by banks and other financial
institutions that enable individuals and businesses to access credit to finance
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various needs. These products provide a means to borrow funds for various
purposes, such as purchasing assets, managing cash flow, or consolidating debt.

● Personal Loans: Unsecured loans for various purposes, such as debt

consolidation, home renovations, or medical expenses.
● Home Loans: Secured loans for purchasing or constructing residential
property.
● Education Loans: Loans specifically designed to finance higher education
expenses.
● Business Loans: Loans provided to businesses for various needs, such as
working capital or expansion.
● Gold Loans: Secured loans using gold Jewelry or ornaments as collateral.
● Auto Loans: Secured loans for purchasing a vehicle.
● Loan Against Assets: Loans secured by various assets, such as property or
equity shares.
● Credit Cards: Revolving lines of credit that allow for purchases and deferred
payments.
● Overdraft Facility: A line of credit linked to a current account for short-term
cash flow management.

3. Payment products

Payment products refer to the tangible or electronic instruments or accounts used

to facilitate transactions. They are issued by financial institutions or payment
service providers and are linked to payment systems to enable the transfer of
funds.
● Cash: Physical currency used for transactions.
● Cheque: A written order instructing a bank to pay a specified amount.
● Demand Draft (DD):: A bank-issued instrument guaranteeing payment of a
specified amount.
● Debit Card: A payment card linked to a bank account, deducting funds
directly.
● Credit Card: A payment card that allows you to borrow funds and pay later.
● Prepaid Card: A card with a preloaded amount that can be used for
purchases.
● Digital Wallets: Mobile apps that store payment information and enable
quick transactions.
● Payment Apps: Third-party or bank-owned apps that facilitate payments.
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● Buy Now, Pay Later (BNPL): A short-term financing option for deferred
payments.

4. Investment products

Investment products provide individuals and institutions with various avenues to

allocate their funds with the objective of generating returns, building wealth, and
achieving financial goals.
● Equity Shares: Investing directly in shares of public companies.
● Government Bonds: Debt securities issued by the government, offering low
risk and guaranteed returns.
● Corporate Bonds: Debt securities issued by companies, offering higher
interest rates but with varying risk levels.
● Employee Provident Fund (EPF): A mandatory retirement savings scheme
for salaried employees.
● Unit Linked Insurance Plans (ULIPs): Combine investment with life
insurance coverage.
● T-Bills: Short-term debt securities issued by the government.
● Commercial Paper: Short-term debt securities issued by large corporations.
● Certificate of Deposit: Short-term deposits offered by banks.
● Call / Notice / Term Money: Short-term interbank lending arrangements.
● Repurchase Agreements: Short-term borrowing arrangements involving
securities.
● Digital Gold: Investing in gold electronically.
● Sovereign Gold Bonds: Government-issued bonds denominated in gold.
● Real Estate Investment Trusts (REITs): Trusts that invest in
income-producing real estate.
● Infrastructure Investment Trusts (InvITs): Trusts that invest in
infrastructure projects.
● Hedge Funds: Investment funds using complex strategies for returns.
● Venture Capital: Investing in early-stage companies with high growth
potential.
● Private Equity: Investing in private companies not listed on stock
exchanges.
● Mutual Funds: Pooled investment vehicles that invest in a diversified
portfolio.
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● Exchange-Traded Funds (ETFs): Index-tracking funds traded on stock

exchanges.
● National Pension Scheme (NPS): A voluntary retirement savings scheme
with various investment options.

5. Speculative / Hedging products1

Speculative products are financial instruments that involve a high degree of risk
and uncertainty in terms of potential returns. They are often characterized by
significant price volatility, making them suitable only for investors with a
high-risk tolerance and a thorough understanding of the associated risks.

● Forwards: Customized agreements to buy or sell an asset at a predetermined

price on a future date.
● Futures: Standardized agreements to buy or sell an asset at a predetermined
price on a future date.
● Options: Contracts that give the buyer the right, but not the obligation, to
buy or sell an asset at a predetermined price.
● Swaps: Agreements to exchange cash flows in the future, often used for
hedging.

6. Risk Management products2

Risk management products are financial instruments or services designed to help

individuals and organizations identify, assess, and mitigate potential risks that
could threaten their financial well-being or business continuity. These products
provide various mechanisms to protect against losses, minimize uncertainties, and
enhance overall financial stability.

● Life Insurance: Provides financial protection to beneficiaries upon the death

of the insured.
● Term Insurance: Provides coverage for a specific term, with benefits paid
out only if the insured dies during that term.

1
These are collectively called derivative instruments as they derive their value from an underlying asset.
They are also used as hedging instruments as it allows one to take a position in one asset to offset the risk of
an adverse price move in another asset. The use of these derivatives for speculation or hedging depends on
the objective of the person involved in these transactions.
2
Derivatives instruments which can be used for hedging are also considered as risk management products
as hedging is a part of risk management. Risk management is a broad term that encompasses the
identification, assessment, and prioritization of risks followed by coordinated and economical application of
resources to minimize, monitor, and control the probability or impact of unfortunate events or to maximize
the realization of opportunities. It is a proactive approach to dealing with uncertainty and potential losses.
Hedging is a specific risk management strategy that involves taking a position in one asset to offset the risk
of an adverse price move in another asset.
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● Health Insurance: Covers medical expenses incurred due to illness or injury.

● Property Insurance: Protects against damage or loss of property, such as
homes, vehicles, or businesses.
● Liability Insurance: Covers legal expenses and damages arising from claims
of negligence or wrongdoing.
● Travel Insurance: Provides coverage for medical expenses, lost baggage, trip
cancellation, and other travel-related risks.
● Auto Insurance: Covers damage to vehicles, injuries to others, and property
damage in case of an accident.
● Freight Insurance: Protects against losses or damage to goods during
transportation.

1.2.3.2 Financial Services

Beyond the structured financial products that institutions offer, there exists a
realm of financial services that are not neatly categorized into financial products
but are equally essential to the functioning of our financial world. Financial
institutions and professional service providers deliver a wide array of intangible
yet crucial services that underpin economic activities, risk management, and
financial well-being.

Here are some of the common financial services.

1. ATM (Automated Teller Machine): Self-service banking terminal for cash

withdrawals, deposits, and other transactions.
2. Locker Facility: Secure storage for valuables.
3. Currency Exchange: Converting one currency into another.
4. International Remittance: Transferring funds across borders.
5. Export Credit Guarantee: Protecting exporters against non-payment risks.
6. Trade Documentation: Assisting with international trade documentation.
7. Tax Planning: Minimizing tax liabilities through strategic planning.
8. Valuation: Determining the fair market value of assets.
9. M&A Consulting: Advising on mergers, acquisitions, and divestitures.
10. Due Diligence: Conducting thorough investigations before transactions.
11. Tax Filing: Preparing and submitting tax returns.
12. Underwriting: Evaluating and assuming risk in issuing securities.
13. Equity Research: Analyzing publicly traded companies.
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14. Financial Literacy Programs: Educating individuals on personal finance.

15. Auditing: Examining and evaluating financial statements.
16. Factoring: Selling accounts receivable to a factoring company for immediate
cash.
17. Credit Rating Services: Assessing the creditworthiness of individuals or
companies.
18. Loan Syndication: Multiple lenders collaborating to provide a large loan.
19. Risk Assessment Services: Identifying and analyzing potential risks.
20. Facilitating Trading in Exchanges: Providing access to stock exchanges.
21. Financial Advisory Services: Providing personalized financial planning and
investment advice.
22. Margin Trading: Borrowing funds from a broker to purchase securities.

1.2.4 Financial Infrastructure

Financial infrastructure comprises the technical and logistical systems that

support financial transactions and operations. The financial infrastructure is a
critical component of the financial system, providing the underlying foundation
that enables financial institutions to operate effectively and efficiently. It
encompasses a wide range of institutions, information systems, technologies,
rules, and standards that facilitate the flow of funds and financial transactions
within the economy. It plays a foundational role in facilitating secure, efficient,
and transparent financial transactions and services.

Financial Infrastructure is classified into

● Payment system
● Securities Clearing and Settlement Systems
● Credit Information Systems
● Collateral Registries
● Database systems

1. Payment Systems

Payment systems facilitate the transfer of funds between individuals, businesses,

and financial institutions. They are essential for conducting everyday transactions,
such as paying for goods and services, transferring money between accounts, and
making online payments.
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National Payments Corporation of India (NPCI): NPCI operates retail payment systems
like Unified Payments Interface (UPI) and National Electronic Funds Transfer (NEFT),
which have revolutionized digital payments in India.

Clearing Corporation of India Limited (CCIL): CCIL facilitates clearing and settlement of
interbank transactions, ensuring smooth and efficient transfer of funds between banks.

2. Securities Clearing and Settlement Systems

Securities clearing and settlement systems ensure the efficient and timely transfer
of ownership of securities, such as stocks and bonds, after a trade has been
executed. They play a crucial role in maintaining market stability and reducing
counterparty risk.

National Securities Depository Limited (NSDL): NSDL provides electronic depository and
settlement services for securities, enabling investors to hold and trade securities in a
secure and efficient manner.

Central Depository Services (India) Limited (CDSL): CDSL is another major depository
for securities, providing similar services to NSDL and contributing to the smooth
functioning of the securities market.

3. Credit Information Systems

Credit information systems collect, store, and disseminate credit information

about borrowers, enabling lenders to assess creditworthiness and make informed
lending decisions. They play a vital role in promoting responsible lending and
reducing credit risk.

Credit Information Bureau (India) Limited (CIBIL): CIBIL is the most prominent credit
bureau in India, providing credit scores and reports that are widely used by lenders to
evaluate borrowers' creditworthiness.

4. Collateral Registries

Collateral registries provide a centralized record of collateral pledged by

borrowers, reducing the risk of fraud and enhancing the ability of lenders to
recover their assets in case of default. They play a crucial role in secured lending
and risk mitigation.
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Central Registry of Securitisation Asset Reconstruction and Security Interest of India

(CERSAI): CERSAI maintains a centralized record of collaterals pledged for secured loans,
providing lenders with a reliable source of information to assess and manage their credit
exposure.

National Securities Depository Limited (NSDL): NSDL also operates a registry for
dematerialized securities as collateral, enabling lenders to track and verify the collateral
pledged by borrowers in the form of securities.

5. Database Systems

Database systems play a significant role in supporting financial infrastructure by

providing secure and reliable platforms for identity verification, document storage,
and data sharing. They have simplified the process of KYC (Know Your Customer)
verification, reduced paperwork, and enhanced the overall accessibility of financial
services.

Aadhaar: Aadhaar is a 12-digit unique identity number issued to every Indian resident.
It serves as a foundational identification tool that facilitates financial inclusion by
enabling individuals to open bank accounts, access government subsidies, and
participate in the formal financial system.

DigiLocker: DigiLocker is a digital platform for storing and sharing documents

electronically. It plays a crucial role in streamlining financial transactions by providing a
secure and convenient way to access and share documents such as identity proofs,
financial statements, and other relevant documents required for financial services.

1.2.5 Regulatory Bodies

Regulatory bodies are government agencies responsible for overseeing and

regulating the financial system. They play a crucial role in ensuring the integrity,
fairness, and stability of financial markets.

The 4 regulatory bodies in India are as follows,

● Reserve Bank of India (RBI): The central bank of India, responsible for
monetary policy, regulating banks and other financial institutions.
● Securities and Exchange Board of India (SEBI): Regulates the securities
market, including stocks, bonds, and derivatives.
● Insurance Regulatory and Development Authority of India (IRDAI):
Regulates the insurance sector.
● Pension Fund Regulatory and Development Authority (PFRDA): Regulates
the pension fund industry.
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Reserve Bank of India (RBI)

Founded: 1935
Focus Area: Central banking, Monetary policy, Financial regulation & supervision
Autonomy: Highly autonomous, governed by a central board led by the Governor
with limited interference from the government
Objectives:
● Maintain price stability (control inflation)
● Promote and develop the financial system
● Manage foreign exchange reserves
Scope:
● Issues currency and regulates money supply
● Sets benchmark interest rates and oversees commercial banks
● Manages foreign exchange reserves and influences exchange rates
● Supervises other financial institutions like NBFCs and payment systems
● Conducts research and provides economic guidance\

Securities and Exchange Board of India (SEBI)

Founded: 1992
Focus Area: Capital markets, Securities regulation, Investor protection
Autonomy: Moderately autonomous, operates under the Ministry of Finance but
has independent powers for decision-making and enforcement
Objectives:
● Protect investor interests
● Promote fair and efficient securities markets
● Regulate stock exchanges, mutual funds, and other market participants
● Prevent market manipulation and insider trading
Scope:
● Issues licenses and regulates stock exchanges, brokers, and other market
intermediaries
● Monitors trading activity and investigates market misconduct
● Sets disclosure requirements for listed companies and mutual funds
● Resolves investor disputes and educates investors
● Promotes financial literacy and awareness
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Insurance Regulatory and Development Authority (IRDAI)

Founded: 1999
Focus Area: Insurance sector regulation and development
Attached to: Ministry of Finance
Autonomy: Moderately autonomous, operates under the Ministry of Finance but
has independent powers for decision-making and enforcement
Objectives:
● Protect policyholders' interests
● Promote fair and efficient insurance market
● Ensure solvency and financial stability of insurance companies
● Regulate insurance products, pricing, and marketing practices
Scope:
● Issues licences and regulates insurance companies, distributors, and
intermediaries
● Approves insurance products and monitors pricing practices
● Investigates complaints and resolves disputes between policyholders and
insurers
● Promotes development of insurance products and services

Pension Funds Regulatory and Development Authority (PFRDA)

Founded: 2003
Focus Area: Pension sector, regulation and development
Autonomy: Moderately autonomous, operates under the Ministry of Finance but
has independent powers for decision-making and enforcement
Objectives:
● Promote and develop pension sector in India
● Protect interests of pension fund subscribers
● Ensure solvency and financial stability of pension funds
● Regulate pension schemes and pension fund managers
Scope:
● Promotes and oversees voluntary pension schemes like National Pension
System (NPS)
● Issues licences and regulates pension fund managers and service providers
● Sets investment guidelines and monitors performance of pension funds
● Resolves disputes between subscribers and pension fund managers
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Ministry of Finance and Ministry of Corporate Affairs

The Ministry of Finance and the Ministry of Corporate Affairs are the two
ministers of the central government which is related to financial regulation in
the country.

MoF charts the course for India's economic progress, formulating policies for
fiscal management, taxation, and financial sector development. It acts as the
umbrella ministry for key financial regulators like RBI, SEBI, PFRDA, and IRDAI,
appointing their heads, approving budgets, and providing broader policy
guidance. MoF represents India on international financial platforms, managing
foreign exchange reserves and facilitating global financial integration. It
manages the national budget, allocating resources to different sector

MCA oversees compliance with the Companies Act and other regulations,
promoting responsible corporate practices and investor protection. It acts as the
central registry for companies, overseeing their incorporation, mergers,
liquidations, and filing requirements. MCA investigates instances of financial
misdeeds, insider trading, and accounting irregularities, safeguarding investors
and ensuring market integrity. MCA encourages responsible corporate behavior
towards stakeholders and the environment, aligning business goals with societal
well-being.

MoF and MCA work in concert to create a robust and regulated financial
landscape in India. MoF sets the broader policy framework, while MCA focuses
on the micro-level conduct of corporations. MoF can consider corporate
governance issues while formulating financial policies, and MCA can adapt its
regulations to align with broader economic objectives. Both ministries
collaborate by sharing data and insights, strengthening overall financial market
supervision and identifying potential risks. They partner on joint initiatives like
promoting financial literacy, combating financial fraud, and developing
responsible investment practices.

1.3 Role of financial system in economic development

A well-functioning financial system is essential for economic development. It

plays a crucial role in mobilizing savings, allocating capital efficiently, and
facilitating risk management.

The role of the financial system is to facilitate the flow of funds from those who
have savings (surplus funds) to those who need to borrow (deficit funds) in order
to promote economic growth and development.

The financial system facilitates the allocation of capital to its most productive uses.
By assessing creditworthiness and pricing risks, financial institutions ensure that
funds are directed towards projects with the highest potential returns.
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The facilitation of the flow of funds helps to promote economic development in a

number of ways

Investment: Businesses need funds to invest in new equipment, expand

their operations, and create jobs. The financial system provides businesses
with access to the funds they need to invest and grow.

Consumption: Individuals and households need funds to purchase goods

and services. The financial system provides individuals and households with
access to funds through loans, credit cards, and other financial products.

Government spending: Governments need funds to finance public goods

and services, such as education, healthcare, and infrastructure. The
financial system provides governments with access to funds through the
issuance of bonds and other financial instruments.

The constituents of the financial system enables this flow of funds as financial
institutions acting as intermediaries, financial markets providing the platform,
financial services tailored to meet the needs of parties, financial infrastructure
enables the operational structure and regulatory bodies protect the users from
fraud and unfair practices.

Studies have shown a strong positive correlation between financial development

and economic growth. Countries with well-developed financial systems tend to
experience higher rates of economic growth, lower levels of poverty, and greater
financial stability.

Several countries have successfully developed their financial systems and reaped
the benefits of economic growth and stability. Examples include:

● Singapore: Singapore has a highly developed financial system that has

played a crucial role in its transformation into a global financial center and
its sustained economic growth.

● South Korea: South Korea's financial system has undergone significant

reforms since the 1980s, contributing to its rapid economic growth and
emergence as a developed nation.

● China: China's financial system has evolved rapidly in recent decades,

supporting its economic transformation into the world's second-largest
economy.
Financial Institutions & Markets Module 1 : Financial System in India

The financial system plays a pivotal role in fostering economic growth and
development by facilitating the efficient flow of funds. Beyond its core function of
enabling transactions, it also serves specific objectives that contribute to overall
prosperity. These objectives include intermediation, risk management, providing
liquidity, and promoting financial inclusion. By effectively fulfilling these roles,
the financial system ensures that capital is allocated to productive endeavors,
thereby driving economic expansion and enhancing the well-being of individuals
and businesses.

1.4 Objectives of the financial system

A well-functioning financial system is crucial for the economic health of a nation.

It serves as a platform for the efficient allocation and transfer of financial
resources, supporting growth, stability, and overall prosperity. The primary
objectives of a financial system are as follows.

1. Promoting Economic Growth

A robust financial system plays a vital role in stimulating economic growth

by mobilizing savings, providing credit, and facilitating investment. By
efficiently channeling resources to productive endeavors, it can foster
innovation, entrepreneurship, and job creation.

● Mobilizing Savings: Mutual funds and pension funds collect savings

from individuals and invest them in various asset classes, supporting
economic growth.
● Providing Credit: Microfinance institutions offer small loans to
individuals and businesses in underserved communities, enabling
them to start or expand their enterprises.
● Facilitating Investment: Stock exchanges provide a platform for the
trading of securities, allowing individuals and businesses to invest in
companies and raise capital for growth.

2. Maintaining Financial Stability

A stable financial system is essential for a healthy economy. It involves

ensuring that financial institutions are resilient, markets are efficient, and
risks are managed effectively. This helps to prevent financial crises and
maintain confidence in the economy.

● Supervising Financial Markets: Securities and Exchange Board of

India (SEBI) in India regulate stock exchanges and other financial
markets to prevent fraud and maintain market integrity.
Financial Institutions & Markets Module 1 : Financial System in India

● Managing Systemic Risk: Central banks, such as the Reserve Bank of

India (RBI), use monetary policy tools to manage systemic risk and
prevent financial crises.
● Resolving Financial Crises: Deposit Insurance Corporation (DICGC)
in India provides a framework for resolving failing financial
institutions to minimize their impact on the broader economy.

3. Fostering Efficiency

A well-functioning financial system operates efficiently, reducing

transaction costs and promoting competition. This benefits both individuals
and businesses by making it easier and more affordable to access financial
services.

● Reducing Transaction Costs: National Payments Corporation of

India (NPCI) initiatives like Unified Payments Interface (UPI) and
Immediate Payment Service (IMPS) facilitate electronic payments,
reducing the time and cost of transactions.
● Promoting Competition: Deregulation of financial markets can
increase competition among financial institutions, leading to lower
prices and better services for consumers.
● Improving Information Flows: Credit rating agencies provide
information on the creditworthiness of individuals and businesses,
facilitating lending decisions and reducing information asymmetry.

4. Nurturing Financial Inclusion

Ensuring that everyone has access to financial services is a key objective of a

modern financial system. Financial inclusion helps to reduce poverty,
empower individuals, and promote economic development, particularly in
underserved communities.

● Expanding Access to Financial Services: Pradhan Mantri Jan Dhan

Yojana (PMJDY) in India has been instrumental in expanding
financial inclusion, providing basic banking services to millions of
unbanked and underbanked individuals.
● Promoting Financial Literacy: Financial education programs offered
by governments, NGOs, and financial institutions help individuals
understand financial concepts and make informed decisions.
● Reducing Barriers to Financial Inclusion: Government initiatives to
reduce documentation requirements and provide identity proofs,
such as Aadhaar in India, can help to make financial services more
accessible to underserved populations.
Financial Institutions & Markets Module 1 : Financial System in India

5. Advocating Economic and Social Well-being

A financial system should ultimately contribute to the overall well-being of

a society. By supporting economic growth, stability, and inclusion, it can
help to improve living standards, reduce inequality, and enhance social
welfare.

● Supporting Social Programs: Financial institutions can partner with

governments and NGOs to provide financial services for social
programs, such as affordable housing, education, and healthcare.
● Promoting Sustainable Development: Green finance initiatives, such
as green bonds and sustainable investments, can support
environmentally friendly projects and contribute to sustainable
development.
● Reducing Inequality: Financial inclusion can help to reduce income
inequality by providing opportunities for individuals from all
backgrounds to participate in the economy and access financial
services.

In conclusion, the objectives of the financial system are interconnected and

essential for the overall well-being of an economy. By achieving these objectives,
the financial system can contribute to economic growth, stability, efficiency,
inclusion, and social welfare.

1.5 Functions of Financial System

The functions of the financial system are the specific tasks that it performs to
achieve its objectives of the financial system and thereby the ultimate goal of
facilitating capital flow between savers and users for economic growth and
development.

The key functions of a financial system are as follows

1. Producing information
2. Monitoring investments
3. Facilitating the trading, diversification, and management of risk
4. Mobilizing and pooling savings
5. Easing the exchange of goods and services
6. Price discovery
7. Providing Liquidity
Financial Institutions & Markets Module 1 : Financial System in India

1. Producing information

The financial system helps to produce information about possible investments and
how to allocate capital. This information is essential for both borrowers and
lenders.

For example, credit rating agencies provide information on the creditworthiness of borrowers,
which helps lenders to assess their risk. Financial analysts provide research reports on companies,
which helps investors to make informed investment decisions.

2. Monitoring investments

The financial system also helps to monitor investments and exert corporate
governance after providing finance. This helps to ensure that borrowers are using
the funds wisely and meeting their performance targets.

For example, venture capital firms monitor the companies they invest in to ensure that they are
on track to meet their goals. Shareholders can also attend shareholder meetings and vote on
corporate governance issues, such as the election of directors and the approval of executive
compensation.

3. Mobilizing and pooling savings

The financial system also helps to mobilise and pool savings. This means that it
helps to collect savings from individuals and businesses and make them available
to borrowers who need them to invest in new businesses, expand existing
businesses, or purchase assets.

For example, banks collect savings from depositors and lend them to borrowers. Mutual funds
and exchange-traded funds (ETFs) pool the savings of many investors and invest them in a
diversified portfolio of assets.

4. Facilitating trading, diversification, and risk management

The financial system also facilitates the trading, diversification, and management
of risk. This is important for both investors and businesses.

For example, stock exchanges provide a platform for investors to trade stocks, which allows them
to diversify their portfolios and manage their risk. Insurance companies offer a variety of
insurance products that help businesses and individuals to manage their financial risks.

5. Easing the exchange of goods and services

The financial system also helps to ease the exchange of goods and services. This is
important for both businesses and consumers.
Financial Institutions & Markets Module 1 : Financial System in India

For example, payment systems such as credit cards and debit cards make it easy for consumers to
purchase goods and services from merchants. Currency exchange services make it easy for
businesses and individuals to exchange currencies, which facilitates international trade and
investment.

6. Price discovery

The financial system helps to determine the prices of financial assets, such as
stocks, bonds, and commodities. This is important for both investors and
borrowers, as it allows them to make informed decisions about their investments
and borrowing.

For example, A stock exchange is a marketplace where buyers and sellers of stocks can trade. The
prices of stocks are determined by the supply and demand for the stocks. If there are more buyers
than sellers, the price of the stock will go up. If there are more sellers than buyers, the price of the
stock will go down.

7. Providing Liquidity

The financial system provides liquidity to the economy. This means that it makes it
easy for individuals and businesses to convert their financial assets into cash. This
is important for both investors and borrowers, as it allows them to meet their
financial obligations.

For example, A central bank can provide liquidity to the financial system by buying government
bonds from investors. This injects cash into the financial system and makes it easier for banks to
lend money and for businesses to invest.

The Financial System: A Highway Analogy

Features are the components of the financial system, like the roads, lanes, signs,
and bridges of a highway. They include financial institutions, instruments,
markets, and regulations.

The role of the financial system is like the highway's purpose: to connect and
facilitate. It connects savers and borrowers, enabling investment and growth.

Objectives are the goals, like a highway aiming for safety, efficiency,
accessibility, and revenue generation. The financial system seeks stability,
efficiency, inclusivity, economic growth, and revenue for itself and the
government.

Functions are the activities, like the highway's traffic flow, toll collection,
emergency services, and police patrolling. The financial system facilitates fund
transfers, capital raising, risk management, essential financial services, and
generates revenue through taxes and fees.
Financial Institutions & Markets Module 1 : Financial System in India

1.5 Development of Financial System in India

The Indian financial system has undergone a remarkable transformation over the
past few decades, evolving from a highly regulated and fragmented system to a
more dynamic and inclusive one. This evolution has been driven by a combination
of factors, including economic liberalization, technological advancements, and
demographic shifts.

1.5.1 Pre-Liberalization Era (Pre-1991)

Prior to the economic liberalization of 1991, the Indian financial system was
characterized by a high degree of government control, dominated by public sector
banks and government policies. The Reserve Bank of India (RBI), the country's
central bank, played a dominant role in regulating and overseeing financial
institutions. Interest rates were fixed by the government, and banks were directed
to lend to priority sectors such as agriculture and small-scale industries.

This highly regulated system had several shortcomings. It limited access to finance
for many individuals and businesses, particularly those in rural areas. It also stifled
innovation and competition in the financial sector. By the end of the 1980s, the
financial sector in India was virtually owned by the government with nationalized
banks and insurance companies and a single public sector mutual fund.

The key features of this period include

1. Government Dominance
● The government owned and controlled most of the major banks in India,
limiting private sector participation.
● The Reserve Bank of India (RBI) exercised strict control over interest rates,
credit allocation, and other aspects of the financial system.
● Financial transactions were often time-consuming and inefficient due to
bureaucratic procedures and red tape.
2. Regulated Interest Rates
● Fixed Interest Rates: The government set interest rates for loans and
deposits, limiting flexibility and discouraging savings.
● Negative Real Interest Rates: In many cases, inflation rates exceeded
interest rates, leading to negative real returns on savings.
Financial Institutions & Markets Module 1 : Financial System in India

3. Priority Sector Lending

● Government Mandates: Banks were required to allocate a portion of their
lending to priority sectors such as agriculture, small-scale industries, and
exports.
● Subsidized Interest Rates: Government subsidies were often provided to
encourage lending to these sectors, leading to financial burdens on banks.
4. Limited Competition
● Monopoly Power: Government-owned banks enjoyed a dominant position
in the market, limiting competition and innovation.
● Restricted Entry: New banks were rarely allowed to enter the market,
restricting the range of financial products and services available to
consumers.
5. Controlled Foreign Exchange
● Strict Regulations: The government tightly controlled foreign exchange
transactions, limiting the convertibility of the Indian rupee.
● Capital Controls: Foreign investment was heavily restricted, limiting the
inflow of capital into the country.
6. Inefficient Financial Markets
● Limited Depth and Liquidity: Financial markets, such as the stock market
and bond market, were relatively small and illiquid.
● Lack of Transparency: Information about financial products and markets
was limited, making it difficult for investors to make informed decisions.
7. Lack of Financial Inclusion
● Limited Access: A large portion of the population, especially in rural areas,
lacked access to formal financial services.
● Informal Credit Markets: Many individuals and businesses relied on
informal credit markets, which often charged exorbitant interest rates and
lacked proper regulation.

In summary, the pre-liberalization era of the Indian financial system was

characterized by government control, regulated interest rates, limited
competition, and restricted access to finance. These factors hindered economic
growth, innovation, and financial inclusion.
Financial Institutions & Markets Module 1 : Financial System in India

1.5.2 The Liberalization Era (1991-2009)

The liberalization era marked a significant turning point in the history of India's
financial system. Initiated in 1991, this period witnessed a series of reforms aimed
at opening up the economy, reducing government control, and increasing
competition.

Following are the key reforms and their impacts

Deregulation

● Interest Rate Liberalization: The government gradually moved away from

fixed interest rates, allowing banks to set their own rates based on market
conditions. This increased competition and led to more efficient allocation
of resources.
● Reduction of Entry Barriers: New private sector banks were allowed to enter
the market, increasing competition and offering consumers a wider range of
products and services.
● Relaxation of Licensing Requirements: Restrictions on foreign banks and
non-banking financial companies (NBFCs) were eased, facilitating their
entry into the Indian market.
Privatization
● Sale of Public Sector Banks: Some public sector banks were privatized,
leading to increased efficiency and improved corporate governance.
● Reduction of Government Control: Privatization reduced government
interference in the financial sector, allowing market forces to play a more
significant role.
Globalization
● Increased Foreign Investment: Foreign investors were allowed to invest in
Indian financial markets, providing much-needed capital and expertise.
● Integration with Global Markets: The Indian financial system became more
integrated with global markets, exposing it to international best practices
and trends.
Financial Sector Reforms
● Establishment of Regulatory Bodies: New regulatory bodies, such as the
Securities and Exchange Board of India (SEBI) and the Insurance Regulatory
and Development Authority of India (IRDAI), were established to oversee
specific sectors of the financial market.
Financial Institutions & Markets Module 1 : Financial System in India

● Strengthening of Regulatory Framework: Existing regulatory frameworks

were strengthened to ensure financial stability and protect consumer
interests.

Following are the key developments that happened during this phase.

● Growth of Private Sector Banks: Private sector banks gained market share
and played a more significant role in providing financial services to
individuals and businesses.
● Expansion of Financial Markets: The stock market, bond market, and
derivatives market witnessed significant growth, providing investors with a
wider range of investment opportunities.
● Increased Competition: Competition among financial institutions led to
lower interest rates, improved customer service, and the introduction of
innovative financial products.
● Enhanced Financial Inclusion: The liberalization reforms facilitated
financial inclusion by expanding access to financial services, particularly in
rural areas.
● Technological Advancements: The liberalization era paved the way for
technological advancements in the financial sector, such as the introduction
of ATMs, debit cards, and internet banking.

Despite the significant progress made during the liberalization era, the Indian
financial system also faced challenges, including;

● Non-Performing Assets: The liberalization period saw a rise in

non-performing assets (NPAs) in the banking sector, particularly in the
corporate lending segment.
● Financial Crises: The global financial crisis of 2008 had a significant impact
on the Indian financial system, highlighting the interconnectedness of
global markets.
● Regulatory Challenges: The rapid pace of financial liberalization and
deregulation created challenges for regulators in keeping up with the
changing landscape.

The liberalization era laid the foundation for the transformation of India's
financial system. While it faced challenges and setbacks, the reforms implemented
during this period have had a lasting impact on the country's economic
development.
Financial Institutions & Markets Module 1 : Financial System in India

1.5.3 The Digital Era (2009-Present)

Economic Liberalization coupled with the Technological advancement and

demographic shifts transformed the Indian financial system from a highly
regulated and fragmented system to a more dynamic and inclusive one. The digital
era of the Indian financial system has been characterized by rapid technological
advancements, increased financial inclusion, and a shift towards digital
transactions.

Following are the key developments that emerged during the digital era of the
Indian financial system.

Aadhaar and Digital Payments

● Aadhaar as a Foundation: The introduction of Aadhaar, a unique 12-digit
biometric identifier, provided a solid foundation for digital payments and
financial inclusion.
● Unified Payments Interface (UPI): UPI revolutionized digital payments in
India, enabling instant and secure transactions between bank accounts.
● Mobile Wallets: Mobile wallets like Paytm, PhonePe, and Google Pay gained
widespread popularity, offering convenient and contactless payment
options.
Fintech Innovation
● Rise of Fintech Startups: A wave of fintech startups emerged, offering
innovative financial products and services, such as peer-to-peer lending,
digital insurance, and wealth management.
● Digital Lending: Fintech companies pioneered digital lending models, using
data analytics to assess creditworthiness and provide loans to underserved
segments of the population.
● Digital Payments: Fintech startups developed new payment solutions,
including QR code payments, biometric authentication, and chatbots.
Financial Inclusion
● Expanded Access to Financial Services: Digital technologies made financial
services more accessible to previously unbanked and underbanked
populations, particularly in rural areas.
● Government Initiatives: Government initiatives like Pradhan Mantri Jan
Dhan Yojana (PMJDY) and Direct Benefit Transfer (DBT) leveraged digital
platforms to deliver financial services and subsidies to millions of people.
Financial Institutions & Markets Module 1 : Financial System in India

● Financial Literacy: Digital tools and platforms were used to promote

financial literacy and education, empowering individuals to make informed
financial decisions.
E-commerce and Digital Banking
● Growth of E-commerce: The rise of e-commerce platforms led to a surge in
digital payments and the adoption of online banking services.
● Digital Banking: Banks embraced digital transformation, offering online
and mobile banking services, allowing customers to manage their finances
conveniently.
● Digital Onboarding: Banks adopted digital onboarding processes, making it
easier for customers to open accounts and access financial services.

Despite the progress that has been made, the Indian financial system still faces a
number of challenges. These include:

● Financial Illiteracy: A significant proportion of the Indian population is still

financially illiterate, which makes them vulnerable to exploitation and
fraud.
● Cybersecurity Risks: The increasing digitization of financial services has
raised concerns about cybersecurity risks.
● Unbanked and Underbanked Population: Despite the progress in financial
inclusion, there is still a large unbanked and underbanked population in
India.
● Digital Divide: Despite significant progress, the digital divide persisted, with
some segments of the population still lacking access to digital devices and
internet connectivity.

Addressing these challenges will require continued efforts from the government,
financial institutions, and civil society organizations. However, the Indian
financial system has a strong foundation and is well-positioned to meet the
challenges and opportunities of the future.

The digital era has transformed the Indian financial system, making it more
inclusive, efficient, and customer-centric. As technology continues to evolve, the
future of the Indian financial system is likely to be characterized by further
innovation, digitalization, and a focus on customer experience.

The pre-liberalization era was characterized by government control, regulated

interest rates, and limited competition, hindering economic growth and financial
inclusion. The liberalization era marked a significant shift towards a more
market-oriented financial system, characterized by deregulation, privatization,
Financial Institutions & Markets Module 1 : Financial System in India

and increased competition, leading to greater efficiency and innovation.The digital

era witnessed a rapid transformation of the Indian financial system, driven by
technological advancements, increased financial inclusion, and the rise of digital
payments, fintech innovations, and e-commerce.

1.5.4 Timeline of important events in the development of India's financial

system

Year Event

1770 The Bank of Hindustan was established in Calcutta, becoming the first
bank in India.

1809 The Bank of Bengal is established in Calcutta.

1840 The Bank of Bombay is established in Bombay (now Mumbai).

1843 The Bank of Madras was established in Madras (now Chennai).

1875 The Bombay Stock Exchange, the first stock exchange in India, was
founded.

1882 Post Office Savings Bank of India came into existence.

1912 The Indian Co-operative Societies Act is passed, providing a legal

framework for the formation and operation of cooperative societies.

1921 The Bank of Bengal, Bank of Bombay and Bank of Madras merged to
create the Imperial Bank of India.

1935 The Reserve Bank of India (RBI) is established as the central bank of
India.

1948 IFCI Ltd., established as the Industrial Finance Corporation of India

(IFCI) was the first Development Financial Institution in the country,
setup to cater to the long-term finance needs of the industrial sector.

1949 The Reserve Bank of India is nationalised.

The Banking Regulation Act, 1949 passed in the legislature providing a

comprehensive framework for the regulation and supervision of
banking companies.

1955 The Imperial Bank of India was nationalised and renamed the State
Bank of India (SBI).

The Industrial Credit and Investment Corporation of India (ICICI) was

established as a joint venture between the World Bank, the Indian
government, and private sector banks and insurance companies.
Financial Institutions & Markets Module 1 : Financial System in India

1956 The Life Insurance Corporation of India (LIC) is established,

nationalizing the life insurance industry.

1963 The Reserve Bank of India (RBI) set up the Agricultural Refinance
Corporation (ARC) in 1963 to work as a refinancing agency in providing
medium-term and long-term agricultural credit

(In 1975, ARC was renamed as ARDC - Agriculture Refinance and

Development Corporation)

The Unit Trust of India (UTI) is established as a mutual fund company.

1964 Industrial Development Bank of India (IDBI), a development finance

institution, which provided financial services to the industrial sector
focusing on smaller and medium-sized enterprises (SMEs) was
established.

1969 Fourteen major private banks are nationalised, bringing the total
number of nationalised banks to 16.

1975 Regional Rural Banks (RRBs) were established with a view to

developing the rural economy.

1977 Housing Development Finance Corporation (HDFC) was established to

provide long-term finance for housing and housing-related activities.

1980 6 more banks were nationalised

1982 NABARD was established by transferring the agricultural credit

functions of the RBI and the refinancing functions of the former
Agricultural Refinance and Development Corporation (ARDC).

Export Import Bank - EXIM Bank was established realising the need
for a specialised export credit agency for India and the role of
international trade in India's economic development.

1988 National Housing Bank, was set up as the apex regulatory body for
overall regulation and licensing of housing finance companies in India.
NHB was established with a specific mandate to promote affordable
housing

Establishment of SEBI

1990 Small Industries Development Bank of India was set up as the apex
regulatory body for overall licensing and regulation of micro, small
and medium enterprise finance companies

1991 Economic liberalisation policies are introduced, leading to reforms in

the financial sector.

1993 Establishment of NSE

Financial Institutions & Markets Module 1 : Financial System in India

Reserve Bank of India (RBI) gave banking licences to 10 new private

sector banks

1999 Establishment of Insurance Regulatory and Development Authority of

India (IRDAI).

2009 The Introduction of Aadhar, a unique identification number.

National Pension System (NPS) which was introduced as a

defined-contribution (DC) pension plan with co-contribution for the
government employees extended to public

2012 Introduction of Rupay

2015 Digilocker is launched

2016 Introduction of UPI

Demonetisation of 500 & 1000 rupee notes pushing towards cashless

economy

Introduction of Small Finance Banks

The Insolvency and Bankruptcy Code passed against the backdrop of

mounting non-performing loans, with a view to establishing a
consolidated framework for insolvency resolution

2017 Introduction of Payments Banks

2021 National Asset Reconstruction Company Limited (NARCL) was

incorporated in July 2021 as a ‘bad bank’ to help dispose of the stressed
assets of the commercial banks.

2022 Introduction E-Rupee, India’s CBDC

● In 2005, IDBI was merged with its commercial division, IDBI Bank, forming
the present-day banking entity

● In 2002, ICICI was merged with its commercial division, ICICI Bank, forming
the present-day banking entity

● In 2023, HDFC was merged with its commercial division, HDFC Bank,
forming the present-day banking entity

Story of Indian financial sector over the period 1950–2015

IMF Working Paper on Indian Financial Sector: Structure, Trends and Turns…
Financial Institutions & Markets Module 1 : Financial System in India

1.5.5 Financial Sector Reforms: A Comprehensive Overview

Financial sector reforms encompass a wide range of measures aimed at improving

the efficiency, stability, and inclusiveness of a country's financial system. These
reforms can be broadly categorized into three main areas:

1. Deregulation: This involves reducing or eliminating government control

over financial institutions and markets. This can be done by removing
restrictions on entry and competition, allowing for greater flexibility in
pricing and product development, and reducing regulatory oversight.

2. Privatization: This involves transferring ownership of state-owned

financial institutions to private entities. This can lead to improved efficiency
and profitability, as private companies are often more motivated to
maximize profits.

3. Financial Inclusion: This involves expanding access to financial services to

all segments of the population, particularly those in underserved areas. This
can be achieved through a variety of measures, such as microfinance, mobile
banking, and simplified account opening procedures.

Objectives of Financial Sector Reforms

The primary objectives of financial sector reforms were to

1. Promote economic growth: By improving the efficiency and availability of

financial services, financial sector reforms can contribute to economic
growth by channeling capital to productive investments, supporting
entrepreneurship, and facilitating trade and investment.

2. Enhance financial stability: By strengthening the regulatory framework and

reducing risk exposure, financial sector reforms can help to prevent
financial crises and protect depositors' money.

3. Promote financial inclusion: By expanding access to financial services to all

segments of the population, financial sector reforms can help to reduce
poverty and promote economic equality.

Benefits of Financial Sector Reforms

Financial sector reforms have been associated with a number of benefits,

● Increased financial intermediation: Reforms can lead to a more efficient

allocation of capital, as financial institutions are better able to identify and
support profitable investments.
Financial Institutions & Markets Module 1 : Financial System in India

● Reduced cost of financial services: Competition among financial

institutions can drive down the cost of financial services, making them more
affordable for consumers and businesses.

● Increased financial literacy: Exposure to financial services can improve

financial literacy among individuals, enabling them to make more informed
financial decisions.

● Reduced poverty and inequality: Financial inclusion can help to reduce

poverty and inequality by providing individuals with access to credit,
savings, and insurance products.

● Promote economic development: A sound and stable financial system is

essential for economic development, as it provides the necessary
infrastructure for businesses to thrive and individuals to prosper.

Major Financial Sector Reforms in India

Committee/Act Changes Introduced

Recommended liberalization of interest rates,

Narasimham Committee
privatization of banks, and increased foreign investment in
Report (1991)
the financial sector.

Banking Regulation Act Amended to allow for the entry of new private sector banks
(1949) and reduce government control over the banking sector.

Insurance Regulatory and

Established the IRDA to regulate the insurance sector and
Development Authority
promote competition.
(IRDA) Act (1999)

Securities and Exchange

Established SEBI to regulate the securities market and
Board of India (SEBI) Act
protect investor interests.
(1992)

Pradhan Mantri Jan Dhan Launched to provide financial inclusion by offering basic
Yojana (PMJDY) (2014) banking services to the unbanked population.

National Financial Established to promote financial inclusion through various

Inclusion Mission (NFIM) initiatives, such as creating financial literacy centers and
(2011) providing financial services to underserved areas.

Unified Payments Launched to enable real-time peer-to-peer payments and

Interface (UPI) (2016) merchant transactions.
Financial Institutions & Markets Module 1 : Financial System in India

Financial Resolution and

Established a framework for resolving failing financial
Deposit Insurance (FRDI)
institutions and protecting depositors' interests.
Act (2017)

1.6 SWOT Analysis of Indian Financial System

The Indian financial system presents both opportunities and challenges. A

comprehensive SWOT analysis can help identify the strengths, weaknesses,
opportunities, and threats facing this vital sector.

Strengths

1. Large and Growing Market: India's vast population and rapidly expanding
economy provide a significant market for financial services. For instance,
the country's growing middle class is increasingly demanding a wider range
of financial products, from home loans and car loans to investment options
and insurance.
2. Diverse Financial Institutions: India has a diverse range of financial
institutions, including public sector banks, private sector banks, cooperative
banks, and non-banking financial companies (NBFCs). This diversity offers
consumers a wide range of options and helps to mitigate risks. For example,
public sector banks play a crucial role in providing financial services to rural
areas, while private sector banks often offer more competitive rates and
innovative products.
3. Technological Advancements: India has witnessed significant
advancements in financial technology (fintech). For example, the
widespread adoption of UPI (Unified Payments Interface) has revolutionized
digital payments, making transactions faster, more convenient, and more
secure.
4. Government Support: The Indian government has implemented various
initiatives to promote financial inclusion and strengthen the financial
system. For example, the Pradhan Mantri Jan Dhan Yojana (PMJDY) has
helped to bring millions of people into the formal financial system,
providing them with access to basic banking services.

Weaknesses

1. Non-Performing Assets (NPAs): High NPAs, particularly in public sector

banks, pose a significant challenge to the financial system's stability. For
example, the issue of NPAs in the agricultural sector has been a
long-standing problem, as farmers often struggle to repay their loans due to
factors such as crop failures and low prices.
Financial Institutions & Markets Module 1 : Financial System in India

2. Lack of Financial Literacy: A large section of the population, especially in

rural areas, lacks financial knowledge, hindering their effective
participation in the financial system. This can lead to financial exploitation
and poor decision-making.
3. Inadequate Credit Penetration: Despite significant progress in financial
inclusion, a significant portion of the Indian population remains unbanked
or underbanked. This lack of access to formal financial services limits the
ability of individuals and businesses to participate fully in the economy.
According to the World Bank's Global Findex 2021 report, 23% of Indian
adults are unbanked, while 56% lack access to formal credit.This lack of
access to formal financial services is exacerbated by the high reliance on
informal credit channels, such as moneylenders. This reliance on informal
credit often leads to higher interest rates and poorer repayment terms,
hindering financial stability and economic growth. According to a 2019
report by the Microfinance Institutions Network (MFIN), around 59 million
households in India rely on informal credit channels, such as moneylenders
and self-help groups (SHGs).
4. Infrastructure Finance Gap : India's ambitious infrastructure development
plans require substantial funding, but the financial system has struggled to
provide adequate financing for these projects. The traditional banking
model, with its focus on short-term lending, is not well-suited to the
long-term financing needs of infrastructure projects.
5. Regulatory Challenges: Complex regulatory frameworks and bureaucratic
procedures can hinder innovation and efficiency in the financial sector. For
example, the lengthy approval processes for new financial products can
discourage startups and other innovative players.

Opportunities
1. Rising Disposable Income: As the Indian economy grows, there is a rise in
disposable income, leading to increased demand for financial services. For
example, the growing middle class is increasingly interested in investment
options, insurance, and wealth management services.
2. Digital Transformation: The growing adoption of digital technologies
presents opportunities for innovative financial products and services. For
example, fintech startups are developing new solutions for payments,
lending, and insurance, offering more convenient and affordable options to
consumers.
3. Financial Inclusion: Expanding financial inclusion can contribute to
economic growth and poverty reduction. By providing access to financial
services to the unbanked and underbanked population, the government can
help to create more inclusive and equitable economic opportunities.
Financial Institutions & Markets Module 1 : Financial System in India

4. International Integration: Increasing economic integration with the global

economy offers opportunities for Indian financial institutions to expand
their operations. For example, Indian banks have been expanding their
presence in overseas markets, particularly in regions with strong economic
growth.

Threats

1. Cybersecurity Risks : The Indian financial system is increasingly vulnerable

to cyberattacks, which can lead to significant financial losses, damage to
reputation, and disruption of operations. Data breaches, ransomware
attacks, and phishing scams are among the most common threats.

2. Climate change : Climate change poses both physical and transition risks to
the Indian financial system. Extreme weather events, such as floods,
droughts, and cyclones, can damage infrastructure, disrupt economic
activity, and increase credit risks. Moreover, the shift towards a low-carbon
economy can lead to stranded assets and financial losses for companies and
financial institutions that are heavily invested in carbon-intensive
industries.

3. Financial Market Volatility : The Indian financial system is susceptible to

global economic shocks and domestic factors that can trigger market
volatility. Economic downturns, financial crises, or geopolitical events in
other parts of the world can lead to capital outflows, currency depreciation,
and asset price declines. Domestic factors, such as economic policy
uncertainties, political instability, or natural disasters, can also contribute
to market volatility. The global financial crisis of 2008-2009 had a
significant impact on Indian financial markets, highlighting the need for
robust risk management practices and regulatory oversight.

The Indian financial system is a dynamic and evolving sector with significant
potential for growth and development. By leveraging its strengths, addressing its
weaknesses, and capitalizing on emerging opportunities, India can build a resilient
and inclusive financial system that supports economic growth and improves the
lives of its citizens. However, it is essential to remain vigilant about the threats
facing the system, such as cybersecurity risks, climate change, and financial
market volatility, and take proactive measures to mitigate them.