Financial System

Financial system refers to a system which enables the transfer of money

between investors and borrowers. A financial system could be defined at
an international, regional or organization level. The term “system” in
“Financial System” indicates a group of complex and closely linked
institutions, agents, procedures, markets, transactions, claims and
liabilities within an economy.
A financial system is a network of financial institutions, financial
markets, financial instruments and financial services to facilitate the
transfer of funds. The system consists of savers, intermediaries,
instruments and the ultimate user of funds.

According to Van Horne, It is the system to allocate savings efficiently

in an economy to ultimate users either for investment in real assets or for
consumption.
Prasanna Chandra defines it as, financial system consists of a variety
of institutions, markets and instruments related in a systematic manner
and provide the principal means by which savings are transformed into
investments.
Money, credit, and finance are used as medium of exchange in financial
systems. They serve as a medium of known value for
which goods and services can be exchanged as an alternative
to bartering. A modern financial system may include banks (both public
and private sector), financial markets, financial instruments,
and financial services. Financial systems allow funds to be allocated,
invested, or moved between economic sectors. They enable individuals
and companies to share the associated risks.
In simple term, financial system consist of institutional units and
markets that interact, typically in a complex manner, for the purpose of
mobilizing funds for investment, and providing facilities, including
payment system, for financing of various economic activities.
Features of Financial System
1. Financial system encourages both savings and investment.
2. It links savers and investors.
3. It helps in capital formation.
4. It helps in allocation of risk.
5. It facilitates expansion of financial markets.
6. It aids in Financial Deepening and Broadening.
7. It plays a vital role in economic development of a country.

Functions of Financial System

1. Mobilization of Savings: An important function of a financial
system is to mobilize savings and channelize them into productive
activities. A financial system helps in obtaining funds from the savers or
surplus units such as household individuals, business firms, public sector
units, central government, and state governments.
Mobilization of savings takes place when savers move into financial
assets, whether currency, bank deposits, post office savings deposits, life
insurance policies, bills, bonds, equity shares, etc.

2. Allocation of Funds: Another important function of a financial

system is to arrange smooth, efficient, and socially equitable allocation
of credit. Money-lenders and indigenous bankers have been providing
finance to their borrowers since long. But their finance suffers from
several defects. With modern financial development, new financial
institutions, assets and markets have come to be organized, which are
playing an increasingly important role in the provision of credit.

3. Development of Trade: The financial system helps in the

promotion of both domestic and foreign trade. The financial institutions
finance traders and the financial market helps in discounting financial
instruments such as bills. Foreign trade is promoted due to pre-shipment
and post-shipment finance by commercial banks.
The best part of the financial system is that the sellers or the buyers do
not meet each other and the documents are negotiated through the bank.
In this manner, the financial system not only helps the traders but also
various financial institutions.

4. Settlement of Commercial Transactions: The financial system

facilitates settlement of commercial transactions & financial claims
arising out of sale & purchase of goods & services. For this money is
used as an instrument which is legally recognized. Therefore values of
all transactions including sale & purchase of goods and services are
expressed in terms of money only. Over a period of time, the financial
system has evolved other instruments like cheques, demand drafts, credit
card etc. for settlement of economic transactions. These instruments are
recognized by law as a substitute for money.

5. Liquidity: In a financial system, liquidity means the ability to

convert into cash. The financial market provides investors the
opportunity to liquidate their investments, which are in instruments such
as shares, debentures and bonds. The price of these instruments is
determined daily according to the operations of the market force of
demand and supply.

6. Risk Protection: Financial markets provide protection against life,

health- and income-related risks. These risks can be covered through the
sale of life insurance, health insurance and property insurance and
various derivative instruments.

7. Overall Economic Development: India is a mixed economy.

The Government intervenes in the financial system to influence macro-
economic variables like interest rate or inflation. Thus, credits can be
made available to corporate at a cheaper rate. This leads to economic
development of the nation.
Components / Constituents / Structure of
Financial System
Financial structure refers to shape, components and their order in the
financial system. The Indian financial system comprises financial
institutions, financial markets, financial instruments and financial
services that are continuously monitored by various regulatory
authorities, namely, the Reserve Bank of India, Securities and Exchange
Board of India and Insurance Regulatory and Development Authority.

The basic components/structure of Indian Financial System is divided

into four components which are-

1. Financial Institutions
2. Financial Instruments
3. Financial Markets
4. Financial Services

1. Financial Institutions
Financial institutions are the intermediaries who facilitate smooth
functioning of the financial system by making investors and borrowers
meet. They mobilize savings of the surplus units and allocate them in
productive activities promising a better rate of return.

Financial institutions act as financial intermediaries because they act as

middlemen between savers and borrowers. On the basis of the nature of
activities, financial institutions may be classified as:

a. Regulatory and Promotional Institutions

b. Banking Institutions
c. Non-banking Institutions
Regulatory and Promotional Institutions
Financial institutions, financial markets, financial instruments and
financial services are all regulated by regulators like Ministry of
Finance, the Company Law Board, RBI, SEBI, IRDA, Dept. of
Economic Affairs, Department of Company Affairs etc.

The two major Regulatory and Promotional Institutions in India are

Reserve Bank of India (RBI) and Securities Exchange Board of India
(SEBI). Both RBI and SEBI administer, legislate, supervise, monitor,
control and discipline the entire financial system. RBI is the apex of all
financial institutions in India. The chief regulator of financial institutions
in our country is the Reserve bank of India.

Banking Institutions
These institutions mobilize the savings of people. They provide a
mechanism for the smooth exchange of goods and services .There are
three basic categories of banking institutions are

a. Commercial Banks
b. Cooperative Banks
c. Developmental Banks

a. Commercial Banks
Commercial bank is an institution that accepts deposit, makes loans and
offer related financial services. These institutions run to make profit.

Commercial banks provide administrations services such as making

business advances, offering fundamental investment schemes,
encouraging saving deposits, fixed deposits, Issuing bank drafts and
bank cheques, giving overdraft facilities, bond investment schemes, cash
management, mortgage loans, debit cards, credit cards, etc.

Commercial banking can be further divided into four parts as follows:

 i. Public Sector banks
ii. Private Sector banks
iii. Foreign Banks
iv.Regional Rural Banks

i. Public Sector Banks: Public Sector Banks (PSBs) are banks where in
the majority stake (i.e. more than 50%) is held by Government of India
e.g. State Bank of India, Punjab National Bank, Bank of Baroda etc..
Firstly, the conversion of the then existing Imperial Bank of India into
the State Bank of India in 1955, followed by the taking over of the seven
state associated banks as its subsidiary banks; secondly, the
nationalization of 14 major commercial banks on 19 July 1969 and
lastly, the nationalization of 6 more commercial banks on 15 April 1980.

Thus, 27 banks constitute the Public sector in Indian Commercial

Banking before 2020. Presently (as of July 2020), after the recent
mergers of government banks, there are only a total of 12 nationalized
(public sector) banks in India.

ii. Private Sector Banks: These banks are registered as companies with
limited liability. In 1994, the Reserve Bank of India issued a policy of
liberalization to license limited number of private banks, which resulted
in new generation tech-savvy banks .At present, there are 21 Private
Banks in India (as on 2022). These banks include leading banks, namely,
Axis Bank, ICICI Bank, HDFC Bank, ING Vysya Bank, etc.

iii. Foreign Banks: These banks are registered and have their
headquarters in a foreign country but operate their branches in India.
Some of the foreign banks operating in India are Hong Kong and
Shanghai Banking Corporation (HSBC), Citibank, American Express
Bank, Standard Chartered Bank, and Bank of Tokyo Ltd., etc. At
present, there are 46 total foreign banks in India as per the RBI (As on
2022).
iv. Regional Rural Banks: Regional Rural Banks (RRBs) were first
established in October 2, 1975 and are playing a pivotal role in the
economic development of rural India .The main objective of RRB is to
develop rural economy. Their borrowers include small and marginal
farmers, agricultural laborers, artisans, etc.
There were five commercial banks, viz. Punjab National Bank, State
Bank of India, Syndicate Bank, United Bank of India, and United
Commercial Bank, which sponsored the regional rural banks.

Regional Rural Banks are regulated by National Bank for Agriculture

and Rural Development (NABARD). The RRBs were owned by three
entities with their respective shares as follows:

i. Central Government 50%

ii. State Government 15%
iii.Sponsor Bank 35%

b. Cooperative Banks
A co-operative bank is a small-sized, financial entity, where its
members are the owners and customers of the Bank. They are
regulated by the Reserve Bank of India (RBI) and are registered
under the States Cooperative Societies Act.

C. Developmental Banks
Development banks are specialized institutions that provide
medium and long-term credit lending facilities. Their main objective
is to serve the public interest instead of earning profits. They
provide financial assistance to both public as well as private sector
institutions. Example- IFCI, IDBI, SDBs, etc

Non-banking Institutions
Non-banking financial institutions (NBFIs) also mobilize financial
resources directly or indirectly from people. They lend funds but do not
create credit. Companies such as LIC, GIC, UTI, Development Financial
Institutions, Organization of Pension and Provident Funds fall into this
category.

Non-banking financial institutions can be categorized as investment

companies, housing companies, leasing companies, hire purchase
companies, specialized financial institutions (EXIM Bank, etc.),
investment institutions, state level institutions, etc., the regulations
governing these institutions are relatively lighter as compared to those of
banks. Secondly, they are not subject to certain regulatory prescriptions
applicable to banks.

Some of the NBFIs are as below :

1. Tourism Finance Corporation of India Ltd. (TFCI )

2. General Insurance Corporation (GIC)
3. Life Insurance Corporation (LIC)
4. Export-Import Bank of India (EXIM)
5. National Bank for Agriculture and Rural Development (NABARD)
6. National Housing Bank (NHB)

2. Financial Instruments
Financial instruments are the financial assets, securities and claims.
They may be viewed as financial assets and financial liabilities.
Financial assets represent claims for the payment of a sum of money
sometime in the future (repayment of principal) and/or a periodic
payment in the form of interest or dividend. Financial liabilities are the
counterparts of financial assets.

A financial instrument is any contract that gives rise to both a financial

asset of one entity and a financial liability or equity instrument of
another entity. Financial assets and liabilities arise from the basic
process of financing. Some of the financial instruments are tradable/
transferable and some are non tradable/non-transferable. Financial assets
like deposits with banks, companies and post offices, insurance policies,
NSCs, provident funds and pension funds are not tradable. Securities
like equity shares and debentures, or government securities and bonds
are tradable. Hence they are transferable. Financial instruments can also
be classified as -

i. Primary or Direct Instruments

ii. Secondary or Indirect Instruments

Primary or Direct Instruments

Primary instruments or direct securities are issued directly by borrowers
to lenders. Equity shares, preference shares and debentures are primary
securities. Equity shares are ownership securities and risk capital.

The owners of such securities are residual claimants on income and

assets and participate in the management of the company. The holders of
such securities have preference rights over equity shareholders with
regard to both a fixed dividend and return of capital.

Secondary or Indirect Instruments

Indirect securities are not directly issued by borrowers to lenders. These
securities are issued via a financial intermediary to an ultimate lender.
This are-

i. Mutual Funds
ii. Security Receipts
iii.Securitized Debt Instruments
iv.Derivatives Instruments

Mutual Funds
Mutual funds are simply a means of combining or pooling the funds of a
large group of investors. The buy and sell decisions for the resulting
pool are then made by a fund manager, who is compensated for the
service provided.

Since mutual funds provide indirect access to financial markets for

individual investors, they are a form of financial intermediary. Mutual
funds issue units to investors, which represent an equitable right in the
assets of the mutual fund.

Security Receipts
Security Receipts are bonds issued by Asset Reconstruction Companies
to banks when they buy bad loans from them. Normally, when these
companies buy bad assets from banks, they do not pay cash up front.
The bonds (SR) are issued up to a maximum period of seven years.

Securitized Debt Instruments

Securitization is a financial process that involves issuing securities that
are backed by a number of assets, most commonly debt. The assets are
transformed into securities, and the process is called securitization. As of
2010, the most common form of securitized debt is mortgage backed
securities, but attempts are being made to securitize other debts, such as
credit cards and student loans.

Securitized debt instruments are created when the original holder (e.g. a
bank) sells its debt obligation to a third party, called a Special Purpose
Vehicle (SPV). The SPV pays the original lender the balance of the debt
sold, which gives it greater liquidity.

Derivatives Instruments
Derivatives are instruments whose value is derived from the value of
one/more basic variables called the underlying asset. In simpler form,
derivatives are financial security such as an option or future whose value
is derived in part from the value and characteristics of another an
underlying asset. The primary objectives of any investor are to bring an
element of certainty to returns and minimize risks. Example- Options,
Futures, Forwards, etc

3. Financial Markets

Financial markets are another part or component of financial system.

Efficient financial markets are essential for speedy economic
development. The vibrant financial market enhances the efficiency of
capital formation. It facilitates the flow of savings into investment.

Financial markets are the backbone of the economy. This is because they
provide monetary support for the growth of the economy. Financial
markets are the centers or arrangements that provide facilities for buying
and selling of financial claims and services.

These are the markets in which money as well as monetary claims is

traded in. A financial market is a broad term describing any marketplace
where buyers and sellers participate in the trade of assets such as
equities, bonds, bills, currencies and derivatives.

The financial market has two main components, namely are:

 Money Market
 Capital Market

Money Market
This is a market for borrowing and lending of short-term funds. It deals
in funds and financial instruments that have a maturity period of one day
to one year. It is a mechanism through which short-term funds are
loaned or borrowed and through which a large part of the financial
transactions of a particular country or of the world is carried out.

This market is dominated mostly by government, banks, and financial

institutions. The most important feature of the money market instrument
is its liquidity. The following are instruments that are traded in the
money market:

 Call and Notice Money Market is short term finance repayable on

demand, with a maturity period of one day to fifteen days, used for
inter-bank transactions. Call money is a method by which banks
borrow from each other to be able to maintain the credit is high.
 Treasury Bill is a promissory note issued by the RBI to meet the
short-term requirement of funds. Treasury bills are highly liquid
instruments that mean, at any time the holder of treasury bills can
transfer of or get it discounted from RBI. These bills are normally
issued at a price less than their face value and redeemed at face value.
 Certificate of Deposits (CDs) are unsecured, negotiable, short-term
instruments in bearer form, issued by commercial banks and
development financial institutions. They can be issued to individuals,
corporations, and companies during periods of tight liquidity when the
deposit growth of banks is slow but the demand for credit is high.
They help to mobilize a large amount of money for short periods..
 Commercial Papers (CPs) Commercial Papers are unsecured money
market instruments issued in the form of promissory notes or in demat
form. These were introduced in January 1990. Commercial Papers can
be issued by a listed company that has a working capital of not less
than INR 5 crore.

Capital Market
Capital market may be defined as a market dealing in medium and long-
term funds. It is an institutional arrangement for borrowing medium and
long-term funds and which provides facilities for marketing and trading
of securities.

So it constitutes all long-term borrowings from banks and financial

institutions, borrowings from foreign markets and raising of capital by
issue various securities such as shares debentures, bonds, etc. The
market where securities are traded known as Securities market. It
consists of two main different segments namely primary and secondary
market.

i. Primary Market
ii. Secondary Market
 i. Primary Market: This is a market for new issues or new
financial claims. Hence, it is also called a New Issue Market.
The primary market deals with those securities that are issued to
the public for the first time. In the primary market, borrowers
exchange new financial securities for long-term funds. There are
different ways by which a company may raise capital in a
primary market: (i) Public issue, (ii) Right issue and (iii) Private
placement.
ii. Secondary Market: The market in which securities are traded
after they are initially offered in the primary market is known as
secondary market. The secondary market is also known as the
stock market or stock exchange. It is a market for the purchase
and sale of existing securities. It helps existing investors to
disinvest and fresh investors to enter the market. It also provides
liquidity and marketability to existing securities. This market
consists of all stock exchanges recognized by the Government.

Foreign Exchange Market

The market in which participants are able to buy, sell, exchange and
speculate on currencies is the foreign exchange market. Foreign
exchange markets are made up of banks, commercial companies, central
banks, investment management firms, hedge funds, and retail forex
brokers and investors.

4. Financial Services

Financial services may be defined as the products and services offered

by financial institutions for the facilitation of various financial
transactions and other related activities. The development of a
sophisticated and matured financial system in the country, especially
after the early 1990s, led to the emergence of a new sector.
This new sector is known as the financial services sector. Its objective is
to intermediate and facilitate financial transactions of individuals and
institutional investors. There are different types of financial services
provided in financial markets. This financial service industry can be
classified into two broad categories are:

a. Fee-based Financial Services

b. Fund based Financial services

Fee-based Financial Services

These services are provided by financial institutions/NBFCs to earn
income by way of fee, dividend, commission, discount and brokerage.
The major fee-based financial services are as:

i. Issue Management and Merchant Banking

ii. Corporate Advisory Services
iii. Portfolio Management Services
iv.Asset securitization
v. Credit rating
vi.Other services such as draft, remittance, etc

Fund based financial services

In fund-based services, the financial service firm raises funds through
equity, debt and deposits and invests the same in securities or lends this
out to those who are in need of capital. The major fund-based services
are:

i. Loan Facility
ii. Leasing and Hire Purchase
iii.Venture Capital
iv.Factoring and Forfeiting

The financial services can also be called ‘financial intermediation’. It is

the process by which funds are mobilized from a large number of savers
and make them available to all those who are in need of it.
Importance/Role/Significance of Financial
System
Financial system plays a key role in providing funds for economic
activities. There are many advantages to having sound and healthy
financial system in a country. Some of the importance is as follows:

1. Provide Funds: Financial system facilitates in providing funds for

investment and industrial activities. Such funds help in overall
development of economic activities in the country.

2. Infrastructural Facilities: Financial system also offer basic

infrastructural facilities needed for the development and promotion
of lucrative ventures. Infrastructural facilities involve the
development of industrial estates, tech-parks, roads and water etc.

3. Promotional Activities: Promotional activities are undertaken by

various financial institutions in the financial system to mobilize the
funds, reduce the risk of selling financial securities, arrangement of
working and long term capital of the business. Underwriting
service is one of the best promotional activities of financial
institution.

4. Development of Backward Areas: Apart from the financial

activities, financial institutions also take some social
responsibilities of developing the backward areas free of cost by
offering credit facilities, free education, employment creation,
awareness, etc.

5. Helps in Planned Development: Financial system helps in

initiating all planned developments in the view of economic growth
 of the state. All planned developments are coordinated with the
government plan and social welfare. (Arunodoi Scheme, Subsidy)

6. Accelerating Industrialization: Since the financial institutions are

established to earn profit and safeguard the interests of their
members, they accelerate industrialization to contribute to
industrial growth. They support industries by granting finance,
project development and consultancy.

7. Employment Generation: Channelizing the funds for investment,

building of infrastructural facilities, and the acceleration of
industries generate employment both direct and indirect, to the
educated and qualified people of the nation.

8. Attracting Foreign Capital: Financial system promotes

capital market. A dynamic capital market is capable of attracting
funds both from domestic and abroad. With more capital,
investment will expand and this will speed up the economic
development of a country.

9. Economic Integration: Financial systems of different

countries are capable of promoting economic integration. This
means that in all those countries, there will be common economic
policies, such as common investment, trade, commerce,
commercial law, employment legislation, old age pension, transport
co-ordination, etc. We have a standing example of European
Common Market which has gone to the extent of creating a
common currency, representing several countries in Western
Europe.

10. Political Stability: The political conditions in all the

countries with a developed financial system will be stable. Unstable
political environment will not only affect their financial system but
also their economic development.
 11.Bringing Uniform Interest Rates: The financial
system is capable of bringing an uniform interest rate throughout
the country by which there will be balanced movement of funds
between centres which will ensure availability of capital for all
kinds of industries.

12. Fiscal Discipline and Control of Economy: It is

through the financial system, that the government can create a
congenial business atmosphere so that neither too much of inflation
nor depression is experienced. The industries should be given
suitable protection through the financial system so that their credit
requirements will be met even during the difficult period. The
government on its part can raise adequate resources to meet its
financial commitments so that economic development is not
hampered. The government can also regulate the financial system
through suitable legislation so that unwanted or speculative
transactions could be avoided. The growth of black money could
also be minimized.

Financial System and Economic

Development
The development of any country depends on the economic growth the
country achieves over a period of time. Economic growth deals about
investment and production and also the extent of Gross Domestic
Product in a country. Only when this grows, the people will experience
growth in the form of improved standard of living, namely economic
development.

The following are the roles of financial system in the economic

development of a country.
1. Savings-investment Relationship
To attain economic development, a country needs more investment and
production. This can happen only when there is a facility for savings.
As, such savings are channelized to productive resources in the form of
investment. Here, the role of financial institutions is important, since
they induce the public to save by offering attractive interest rates. These
savings are channelized by lending to various business concerns which
are involved in production and distribution.

2. Growth of Capital Market

Any business requires two types of capital namely, fixed capital and
working capital. Fixed capital is used for investment in fixed assets, like
plant and machinery. While working capital is used for the day-to-day
running of business. It is also used for purchase of raw materials and
converting them into finished products.

 Fixed capital is raised through capital market by the issue of

debentures and shares. Public and other financial institutions invest
in them in order to get a good return with minimized risks.
 For working capital, we have money market, where short-term
loans could be raised by the businessmen through the issue of
various credit instruments such as bills, promissory notes, etc.
Foreign exchange market enables exporters and importers to receive and
raise funds for settling transactions. It also enables banks to borrow from
and lend to different types of customers in various foreign currencies.
The market also provides opportunities for the banks to invest their short
term idle funds to earn profits. Even governments are benefited as they
can meet their foreign exchange requirements through this market.

3. Government Securities Market

Financial system enables the state and central governments to raise both
short-term and long-term funds through the issue of bills and bonds
which carry attractive rates of interest along with tax concessions. The
budgetary gap is filled only with the help of government securities
market. Thus, the capital market, money market along with foreign
exchange market and government securities market enable businessmen,
industrialists as well as governments to meet their credit requirements.
In this way, the development of the economy is ensured by the financial
system.

4. Development of Infrastructure and Growth

Economic development of any country depends on the infrastructure
facility available in the country. In the absence of key industries like
coal, power and oil, development of other industries will be hampered. It
is here that the financial services play a crucial role by providing funds
for the growth of infrastructure industries. Private sector will find it
difficult to raise the huge capital needed for setting up infrastructure
industries. For a long time, infrastructure industries were started only by
the government in India. But now, with the policy of economic
liberalization, more private sector industries have come forward to start
infrastructure industry. The Development Banks and the Merchant banks
help in raising capital for these industries.

5. Development of Trade, Industry and

Agriculture
The financial system helps in the promotion of both domestic and
foreign trade. The financial institutions finance traders and the financial
market helps in discounting financial instruments such as bills. Foreign
trade is promoted due to per-shipment and post-shipment finance by
commercial banks. They also issue Letter of Credit in favor of the
importer. Thus, the precious foreign exchange is earned by the country
because of the presence of financial system. The best part of the
financial system is that the seller or the buyer does not meet each other
and the documents are negotiated through the bank. In this manner, the
financial system not only helps the traders but also various financial
institutions. Some of the capital goods are sold through hire purchase
and installment system, both in the domestic and foreign trade. As a
result of all these, the growth of the country is speeded up.
6. Growth of Employment
The presence of financial system will generate more employment
opportunities in the country. The money market which is a part of
financial system provides working capital to the businessmen and
manufacturers due to which production increases, resulting in generating
more employment opportunities. With competition picking up in various
sectors, the service sector such as sales, marketing, advertisement, etc.,
also pick up, leading to more employment opportunities. Various
financial services such as leasing, factoring, merchant banking, etc., will
also generate more employment. The growth of trade in the country also
induces employment opportunities. Financing by Venture
capital provides additional opportunities for techno-based industries and
employment.

7. Provision of Venture Capital

There are various reasons for lack of growth of venture capital
companies in India. The economic development of a country will be
rapid when more ventures are promoted which require modern
technology and venture capital. Venture capital cannot be provided by
individual companies as it involves more risks. It is only through
financial system, more financial institutions will contribute a part of
their investable funds for the promotion of new ventures. Thus, financial
system enables the creation of venture capital.

8. Ensures Balanced Growth of Industries

Economic development requires a balanced growth which means growth
in all the sectors simultaneously. Primary sector, secondary sector and
tertiary sector require adequate funds for their growth. The financial
system in the country will be geared up by the authorities in such a way
that the available funds will be distributed to all the sectors in such a
manner, that there will be a balanced growth in industries, agriculture
and service sectors.
9. Fiscal Discipline and Control of Economy
It is through the financial system, that the government can create a
congenial business atmosphere so that neither too much of inflation nor
depression is experienced. The industries should be given suitable
protection through the financial system so that their credit requirements
will be met even during the difficult period. The government on its part
can raise adequate resources to meet its financial commitments so that
economic development is not hampered. The government can also
regulate the financial system through suitable legislation so that
unwanted or speculative transactions could be avoided. The growth of
black money could also be minimized.

10. Balanced Regional Development/Developing

Backward Areas
Through the financial system, backward areas could be developed by
providing various concessions or sops. This ensures a balanced
development throughout the country and this will mitigate political or
any other kind of disturbances in the country. It will also check
migration of rural population towards towns and cities.

11. Attracting Foreign Capital

Financial system promotes capital market. A dynamic capital market is
capable of attracting funds both from domestic and abroad. With more
capital, investment will expand and this will speed up the economic
development of a country.

12. Economic Integration

Financial systems of different countries are capable of promoting
economic integration. This means that in all those countries, there will
be common economic policies, such as common investment, trade,
commerce, commercial law, employment legislation, old age pension,
transport co-ordination, etc. We have a standing example of European
Common Market which has gone to the extent of creating a common
currency, representing several countries in Western Europe.
13. Political Stability
The political conditions in all the countries with a developed financial
system will be stable. Unstable political environment will not only affect
their financial system but also their economic development.

14. Bringing Uniform Interest Rates

The financial system is capable of bringing an uniform interest rate
throughout the country by which there will be balanced movement of
funds between centres which will ensure availability of capital for all
kinds of industries.

History of Reforms and Developments in the

Financial System

The Indian Government had appointed the committee in 1985 for

the review of the Indian Monetary System. Various measures such as
operating in short term money market instruments to enhance the
liquidity were adopted. The operations were commenced by the Reserve
Bank of India, Public Financial Institutions, and various other financial
institutions. In the early 1990s, the Government introduced major
reforms in the money market as mentioned below:
 Interest Rate Deregulation.
 Liquidity Adjustment Facility- a monetary policy that
allows banks to borrow money through repurchase
agreements
 Money Market Mutual Fund (MMMFs)
 Electronic Transactions
 Formation of CCIL (Clearing Corporation of India
Limited-2001) to provide clearing and settlement for
 transactions in govt securities, foreign exchange and
money markets in the country by acting as central
counterparty regulated by RBI.
 Development and Encouragement of New Market Instruments
such as Commercial Papers, Certificates of Deposits, Treasury
Bills, and many others.
Reforms were needed since there was excessive micro-regulation and
structural that created a barrier in financial innovation and further
enhanced the operational and transactional costs. There was an
inappropriate level of prudential regulation in the financial system. The
underdeveloped debt and money markets and obsolete technological and
institutional structures reduced the efficiency of the capital markets and
the financial system. Thus, the Government of India had to introduce the
reformation process of the financial system to increase the efficiency
and effectiveness of the different elements of the financial sector. The
major developments of the financial sector introduced by the Indian
Government were:

 Creating effective, efficient, and profit-making financial entities,

 Imparting functional and operational independence to the financial
institutions,
 Developing the banking sector as per the international standards,
 Allowing foreign direct investment in the private sector in a
controlled manner,
 Encouraging financial stability during the domestic and
international crisis,
 Market determination of interest rates enables the price discovery
process that facilitates the allocation of resources efficiently.

Narasimham Committee:
The Government of India formed the Narasimham Committee in August
1991, which made various recommendations for changes in the banking
sector and capital market. The suggestions were:

 Asset Quality
  Strengthening the Banking sector
 Structural issues
 Technological up-gradation
 Systems and methods in Banks

Reforms were undertaken in Banking Sector:

A major area of the banking sector is controlled by Public Sector Banks.
The Reserve Bank of India (RBI) has provided licenses to private sector
banks, being part of the liberalization process. The RBI has introduced
prudential norms for all the banks. However, it has also deregulated the
determination of interest rates for deposit and lending purposes. The
developments in the banking sector were:

 Strengthening of banks’ capital base by providing debt, borrowing

from the public through equity issues, and recapitalization.
 Introduction of prudential norms,
 Regulation of income recognition, provision for bad and doubtful
debts, declaration of non-performing assets, assets classification,
recognition of investments as per the market value,
 Licensing of private sector banks and restrictions on the opening of
the branches,
 Implementing KYC norms,
 Ensuring of Credibility of customers before the issuance of loans,
 Improvement in Audit norms for Banking Sector,
 The digitalization of Credit, Deposit, and Payment systems,

Other operation reforms to revolutionize the credit policy of banks:

 Removal of in-depth regulations for Maximum Permissible Bank
Finance.
 Substantial relaxation of Consortium Regulations
 Shifting of credit delivery to providing of loans from the cash
credit system.

Permission to different entities in the financial sector:

The Government also allowed the involvement of Public Sector
Enterprises, Private Companies, and Non-Banking Finance Companies
(NBFCs) with a strong base in the banking sector. The permission to
these entities led to an increment in the competition among the banking
sector, which in turn contributed to the enhancement of the quality of
services provided to the end-user. The inclusion of new segments in the
banking sector has increased the participation of the common man in the
banking services. The recent developments in the financial
system imparted the liberty to the banks to increase and decrease the
authorized capital without the restriction on the overall limit. The
reforms provided the banks with higher flexibility in conducting their
funds raising operations.

Reformation of Capital Market:

The financial market which operates for the flow of debt and equity
capital is termed as capital market. It channelizes the investments made
by financial institutions and individual investors by providing the
investors with numerous investing options such as financial instruments
such as debt bonds, shares, debentures, and many others, which are
technically termed as financial securities. The capital market is a
decentralized structure whose performance is based on the various
aspects that affect the Indian economy. The capital market is divided
into three important parts such as bond market, stock market, and money
market.

The capital market has facilitated the trading of financial debts by

issuance of shares and units. The capital market deals in Government
securities (which are considered safe for investment but with limited
returns) and equity and debt issued by other public and private limited
entities.

The Bombay Stock Exchange and National Stock Exchange have

witnessed the performance in capital markets for over several years. The
establishment of SEBI (Securities and Exchange Board of India) in 1988
got the legal status by the enactment of the SEBI Act, 1992. SEBI has
highly regulated capital market activities. The main objective of SEBI is
to secure the interest of investors in the securities market and provide
assurance for all the matters which are incidental and connected to the
securities market. The important functions of SEBI are given as under:

 To regulate the conduct of stock and other securities market

 To promote the formation of self-regulatory organizations
 To prevent fraudulent and unfair trade practices in the capital
market
 To encourage awareness among investors and provide education to
intermediaries for safe conducting of market activities.
 To restrict insider trading activities.
 To control the major acquisition of securities and companies’
takeover.
SEBI has assisted in conducting of trading of securities in a protected
manner.

Developments in Payment Systems

Pre-paid instruments are payment instruments that

facilitate purchase of goods and services against the
value stored on these instruments. The value stored on
such instruments represents the value paid for by the
holders by cash, by debit to a bank account, or by credit
card. The pre-paid payment instruments can be issued in
the form of smart cards, magnetic stripe cards, internet
accounts, internet wallets, mobile accounts, mobile
wallets, paper vouchers, etc.

The use of pre-paid payment instruments for cross border

transactions has not been permitted, except for the
payment instruments approved under Foreign Exchange
Management Act,1999 (FEMA).
Reserve Bank brought out a set of operating guidelines
on mobile banking for banks in October 2008, according
to which only banks which are licensed and supervised in
India and have a physical presence in India are permitted
to offer mobile banking after obtaining necessary
permission from Reserve Bank

ATMs / Point of Sale (POS) Terminals / Online

Transactions

As on Feb, 2014, there are over 1,50,008 ATMs (76836

onsite and 73172 offsite) in India. Savings Bank
customers can withdraw cash from any bank terminal up
to 5 times in a month without being charged for the same
(refer RBI circulars for latest changes).

Reserve Bank has mandated re-crediting of failed

transactions within 7 working day and mandated
compensation for delays beyond the stipulated period.

As on Feb, 2014, there are over 10 lakh POS terminals in

the country, which enable customers to make payments
for purchases of goods and services by means of
credit/debit cards.

To facilitate customer convenience the Bank has also

permitted cash withdrawal using debit cards issued by
the banks at PoS terminals.

Further, to reduce the risks arising out of the use of

credit/debit cards over internet/Interactive Voice
Response (technically referred to as Card Not Present
(CNP) transactions), Reserve Bank mandated that all CNP
transactions should be additionally authenticated based
on information not available on the card and an online
alert should be sent to the cardholders for such
transactions.

Formation of National Payments Corporation of

India

The Reserve Bank encouraged the setting up of National

Payments Corporation of India (NPCI) to act as an
umbrella organization for operating various Retail
Payment Systems (RPS) in India. NPCI became functional
in early 2009. NPCI has taken over National Financial
Switch (NFS) from Institute for Development and
Research in Banking Technology (IDRBT).
Oversight of the payment and settlement systems is a
central bank function whereby the objectives of safety
and efficiency are promoted by monitoring existing and
planned systems, assessing them against these
objectives and, where necessary, inducing change. By
overseeing payment and settlement systems, central
banks help to maintain systemic stability and reduce
systemic risk, and to maintain public confidence in
payment and settlement systems.

New announcement for Bank Consolidation

The RBI has given announcement for merging those banks whose NPA
is considerably high. The SBI merger with its 5 associate banks (Bikaner
& Jaipur, Hyderabad, Mysore, Patiala, and Travancore) and Bharatiya
Mahila Bank in 2017 is the latest instance of PSU bank merger in India.
This merger helped SBI to gain a spot among top 50 banks globally.

Master Directions
Introduction of master direction by RBI on regulatory matters from
January 2016

Conclusion:
Thus, the financial system is the backbone of the Indian economy. Even
after the undertaking of numerous reforms, there is still a lot of scope for
improvement in the financial sector. The recent developments in the
financial system have encouraged the common man to enhance their
involvement in the financial system. However, after the reforms of 1991,
the financial sector has proceeded on the path of development, which
strengthened the Indian economy.

Recent Developments that Redefined the

Indian Financial Sector

The Indian financial landscape is increasingly becoming innovation and tech-

driven, with India Stack, artificial intelligence (AI), embedded finance, and
robotics playing an instrumental role in its transformation. Conventional
lenders have been reevaluating their role and collaborating with fintechs to
offer bespoke loans, savings, insurance, and other credit products.

1. IndiaStack: The Foundation for Financial Revolution

The roots of digital transformation can be traced to the launch of Aadhaar, a
unique, unified identification system which now forms a part of IndiaStack.
Aadhaar, along with the launch of Jan Dhan Yojana in 2014, accelerated
financial inclusion by massively improving bank account enrollments and
offering overdraft facilities.
Additionally, the government and RBI pulled no pit stops while
advancing financial literacy through several educational initiatives and
campaigns launched over the years. IndiaStack, which is a decentralized
public utility, has enabled several financial sector players, including fintechs,
to offer paperless and cashless service solutions to India’s biggest payment
and data-management challenges. On using its sets of open APIs, lenders have
managed to lower loan costs, making credit accessible and affordable.

2. Digital Payments for Cashless Economy

With an 87% fintech adoption rate, there is no doubt that consumers have
taken to digital payments as fish takes to water. They have also been
integrating other digital solutions, such as online-only insurance, digital
wallets, and investment tech, into their lifestyles. Of course, a significant
portion of this growth can be traced to the pandemic days when going
cashless was the safest option.
Not to be left behind, even MSMEs have jumped on the digital payments
bandwagon. For instance, in FY22 alone, 74 billion UPI payments worth Rs.
125.94 trillion were processed, making it the most popular person-to-
merchant (P2M) payment method.
This growth is expected to sustain for a while, with lenders looking to further
link UPI to credit cards and integrate it into the global payments system (10+
countries today accept UPI). In fact, RBI aims to raise digital payment
transactions 3x by 2025, per its “Payment Vision 2025” report.

3. Digital Banking and Neobanks (Online base)

Digital banking has taken off with customer onboarding transitioning from
physical papers to online processing. Supplemented with AI/ML-driven
algorithms, several large incumbent banks have been striving for
digitalization, thus lowering processing and interest costs, while ensuring
superior customer engagements.
This trend also explains the soaring popularity of neobanks, i.e., digital-only
banks. For the uninitiated, neobanks are financial companies that behave like
banks but have no physical branches. With smartphone penetration, cheap
data rates, and consumers’ preferences for digital solutions, neobanks have
soared in popularity. Best of all, they offer personalized financial solutions,
fueling their growth further.
According to Inc42, neo-banking is forecasted to expand by 281%, accounting
for nearly 9% of India’s fintech market. This is despite the introduction of
stringent digital lending guidelines by RBI. In fact, another Inc42 report states
that these guidelines will spur the growth of niche regtech startups in the
financial sector.
4. The BNPL Trend in Consumer Lending
Buy Now Pay Later (BNPL) is a novel consumer lending product where banks
extend credit to their consumers by spacing out interest-bearing installments
over a short period. While concerns have been raised about financially
illiterate people taking on BNPL loans without understanding the financial
arrangements, this product continues to grow.
Indeed, according to GlobalData, the BNPL market is expected to grow
at 32.5% CAGR between 2022-2026, totaling Rs. 1.1 trillion by 2026. This
growth is driven mainly by the growing inclination toward shopping online.

5. The Rise of Embedded Finance

Embedded finance is the practice of integrating financial services by digital-
first, non-financial firms. As a result, consumers can directly pay on the
platform, discounting the need for the involvement of third-party payment
providers. Cab payments and e-commerce payments are some examples.

6. Blockchain, CBDC, and e-RUPI

Unless you’ve been living under a rock, blockchain took the world by storm
during COVID-19, including the financial landscape. Many central banks,
including RBI, have mulled over expanding their use cases by building a
central bank digital currency (CBDC) over the blockchain.
While a completely digital money product is still in piloting, RBI has
introduced an e-RUPI, which is a contactless and secure method of availing of
benefits by redeeming the government voucher. However, it is likely to
expand further into the retail payments space over the next 2-3 years.

7. Evolving Regulatory Landscape: Open Banking and AA

In addition to issuing digital lending guidelines, RBI has introduced an
Account Aggregator (AA) framework for an equitable regulatory ecosystem. It
has given a fillip to open banking by empowering individuals to share their
financial data with lenders on a consent basis to avail of easy credit options.
Furthermore, with India set to accede to The UN’s Responsible Digital
Payments principles, the financial sector is set to become more secure.

8. Engineering Finance
Some lenders, like Protium, have adopted engineering finance, a refreshing
approach to finance where they use their proprietary lending models for
evaluating a borrower’s creditworthiness. Engineering finance is a cohesive
collaboration between tech, data science and analytics and risk. This helps
ascertain the customer’s requirements through data analytics, build best-in-
class risk models and create innovative products using cutting-edge
technology.
As a result, business loans are no longer dependent on CIBIL scores. Instead,
lenders now utilize their own credit scoring models, including cash-flow-
based lending, to sanction tailored and affordable loan products.

Conclusion
Financial sector players have been capitalizing on technology to generate
value and transform India’s financial ecosystem. While the trends of AI/ML-
driven digital banking, digital rupee, engineering finance bode well for
borrowers, they have also raised some security and data privacy issues. The
government should continue to enhance financial literacy to enable the
masses to gain from this momentous financial transformation.

Overview of Indian Financial System

The financial system of a country is an important tool for economic
development of the country as it helps in the creation of wealth by
linking savings with investments. It facilitates the flow of funds from the
households (savers) to business firms (investors) to aid in wealth
creation and development of both the parties. The institutional
arrangements include all condition and mechanism governing the
production, distribution, exchange and holding of financial assets or
instruments of all kinds. There are four main constituents of the financial
system as follows:
1. Financial Services
2. Financial Assets/Instruments
 3. Financial Markets
4. Financial Institutions/Intermediaries

Financial Services
Financial Services are concerned with the design and delivery of
financial instruments, advisory services to individuals and businesses
within the area of banking and related institutions, personal financial
planning, leasing, investment, assets, insurance etc. These services
includes
o 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.
o Foreign Exchange services: Includes the currency exchange,
foreign exchange banking or the wire transfer.
o Investment Services: It generally includes the asset management,
hedge fund management and the custody services.
o Insurance Services: It deals with the selling of insurance policies,
brokerages, insurance underwriting or the reinsurance.
o Some of the other services include the advisory services, venture
capital, angel investment etc.

Financial Instruments/Assets
Financial Instruments can be defined as a market for short-term money
and financial assets that is a substitute for money. The term short-term
means generally a period of one year substitutes for money is used to
denote any financial asset which can be quickly converted into money.
Some of the important instruments are as follows:
o Call /Notice-Money: Call/Notice money is the money borrowed
on demand for a very short period. When money is lent for a day it
is known as Call Money. Intervening holidays and Sunday are
excluded for this purpose. Thus money borrowed on a day and
repaid on the next working day is Call Money. When the money is
borrowed or lent for more than a day up to 14 days it is called
 Notice Money. No collateral security is required to cover these
transactions.
o Term Money: Deposits with maturity period beyond 14 days is
referred as the term money. The entry restrictions are the same as
that of Call/Notice Money, the specified entities not allowed to
lend beyond 14 days.
o Treasury Bills: Treasury Bills are short-term (up to one year)
borrowing instruments of the union government. It’s a promise by
the Government to pay the stated sum after the expiry of the stated
period from the date of issue (less than one year). They are issued
at a discount off the face value and on maturit, the face value is
paid to the holder.
o Certificate of Deposits: Certificates of Deposits is a money market
instrument issued in dematerialized form or as a Promissory Note
for funds deposited at a bank, other eligible financial institution for
a specified period.
o Commercial Paper: CP is a note in evidence of the debt obligation
of the issuer. On issuing commercial paper the debt is transformed
into an instrument. CP is an unsecured promissory note privately
placed with investors at a discount rate of face value determined by
market forces.

Financial Markets
The financial markets are classified into two groups:
Capital Market:
A capital market is an organized market which provides long-term
finance for business. Capital Market also refers to the facilities and
institutional arrangements for borrowing and lending long-term funds.
Capital Market is divided into three groups:
o Corporate Securities Market: Corporate securities are equity and
preference shares, debentures and bonds of companies. The
corporate security market is a very sensitive and active market. It
can be divided into two groups: primary and secondary.
o Government Securities Market: In this market government
securities are bought and sold. The securities are issued in the form
 of bonds and credit notes. The buyers of such securities are Banks,
Insurance Companies, Provident funds, RBI and Individuals.
o Long-Term Loans Market: Banks and Financial institutions that
provide long-term loans to firms for modernization, expansion and
diversification of business. Long-Term Loan Market can be divided
into Term Loans Market, Mortgages Market and Financial
Guarantees Market.

Money Market
Money Market is the market for short-term funds. The money market is
divided into two types: Unorganized and Organized Money Market.
o Unorganized Market: It consists of Money lenders, Indigenous
Bankers, Chit Funds, etc.
o Organized Money Market: It consists of Treasury Bills,
Commercial Paper, Certificate Of Deposit, Call Money Market and
Commercial Bill Market. Organized Markets work as per the rules
and regulations of RBI. RBI controls the Organized Financial
Market in India.

Financial Intermediaries/Institutions
A financial intermediary is an institution which connects the deficit and
surplus money. The best example of an intermediary is a bank which
transforms the bank deposits to bank loans. The role of the financial
intermediary is to distribute funds from people who have extra inflow of
money to those who don’t have enough money to fulfil the needs.
Functions of Financial Intermediary are as follows:
o Maturity transformation: Deals with the conversion of short-term
liabilities to long term assets.
o Risk transformation: Conversion of risky investments into
relatively risk free ones.
o Convenience denomination: It is a way of matching small
deposits with large loans and large deposits with small loans.

Conclusion
Indian Financial System accelerates the rate and volume of savings
through provision 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
respective business. It helps economic development and raising the
standard of living of people and promotes the development of weaker
section of the society through rural development banks and co-operative
societies. These are the important facts about Indian Financial system.

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