Unit I: Introduction to the Financial System
1. Meaning of the Financial System
The financial system refers to the network of financial institutions, markets, instruments,
and services that facilitate the flow of funds between savers and borrowers. It acts as the
backbone of an economy by ensuring that financial resources are allocated efficiently. A
well-functioning financial system promotes economic stability, investment, and growth.
Real-life Example:
Consider how a startup like Zomato raised funds through different components of the
financial system—initially through venture capitalists and later through an IPO in the stock
market. This showcases the role of financial markets and institutions in supporting business
growth.
2. Structure of the Financial System
The Indian financial system consists of four major components:
1. Financial Institutions – Banks, Non-Banking Financial Companies (NBFCs), Insurance
companies, etc.
2. Financial Markets – Capital Market (Stock Market), Money Market, and Derivatives
Market.
3. Financial Instruments – Stocks, Bonds, Treasury Bills, Mutual Funds, etc.
4. Financial Services – Investment Banking, Insurance, Asset Management, etc.
These components work together to mobilize savings and channel them into productive
investments.
Real-life Example:
The Securities and Exchange Board of India (SEBI) regulates financial markets in India,
ensuring transparency and investor protection. The RBI, as the central bank, controls
monetary policy to maintain financial stability.
3. Functions of the Financial System
The financial system performs several key functions, including:
1. Mobilization of Savings: Encourages savings by providing various investment
avenues like banks, mutual funds, and bonds.
2. Facilitating Investments: Channels funds from savers to businesses, enabling
economic growth.
3. Credit Creation: Banks lend money to individuals and businesses, helping in
economic expansion.
4. Liquidity Management: Ensures that cash and credit are available for economic
activities.
5. Risk Management: Provides insurance and derivatives to hedge against financial
risks.
6. Price Determination: Financial markets help in determining asset prices based on
demand and supply.
Real-life Example:
The home loan sector in India has helped millions of people buy houses by mobilizing
savings into productive use. Institutions like HDFC, SBI, and LIC Housing Finance play a
crucial role in this.
4. Components of the Financial System
1. Money Market – Deals with short-term funds (e.g., Treasury Bills, Commercial
Papers).
2. Capital Market – Deals with long-term funds (e.g., Equity Shares, Bonds).
3. Foreign Exchange Market – Facilitates currency trading and international
transactions.
4. Credit Market – Provides loans and credit facilities to businesses and individuals.
Real-life Example:
When Reliance Industries needed capital, it issued bonds in the capital market and raised
money from investors worldwide.
5. Role of the Financial System in Economic Development
A strong financial system is essential for economic growth. Its role includes:
1. Encouraging Savings and Investment: It provides various instruments for people to
invest their money.
2. Efficient Resource Allocation: Directs funds toward productive sectors like
infrastructure, healthcare, and technology.
3. Employment Generation: A robust banking and financial sector creates job
opportunities.
4. Inflation and Monetary Control: The RBI regulates money supply to control inflation.
5. Foreign Investment and Globalization: A well-regulated system attracts FDI (Foreign
Direct Investment).
Real-life Example:
India’s Startup India initiative was supported by financial institutions, venture capitalists,
and government funding to encourage entrepreneurship.
6. Reforms in India’s Financial Sector
Financial sector reforms have played a crucial role in liberalizing and modernizing India’s
economy. Major reforms include:
1. Banking Sector Reforms:
o Nationalization of Banks (1969 & 1980)
o Introduction of private banks (HDFC, ICICI, Axis Bank)
o RBI’s prudential norms for Non-Performing Assets (NPAs)
2. Capital Market Reforms:
o SEBI establishment (1992) to regulate stock markets
o Online trading and dematerialization of shares
o Introduction of IPOs (Zomato, Paytm)
3. Insurance Sector Reforms:
o Privatization of LIC and entry of private insurers
o Foreign investment allowed in insurance companies
4. NBFC Reforms:
o Strengthening regulations for NBFCs to avoid crises like IL&FS.
Real-life Example:
Post-1991 reforms led to the rise of private banks like ICICI Bank and HDFC Bank, improving
banking efficiency.
7. Recent Fiscal Policies in India
Fiscal policy refers to government measures involving taxation, spending, and borrowing.
Recent policies include:
1. Union Budget Announcements: Increased focus on infrastructure, digital economy,
and MSME support.
2. Corporate Tax Reduction: Lower corporate tax to boost business investments.
3. GST Implementation: Simplified indirect taxation and improved tax compliance.
4. Atmanirbhar Bharat (Self-Reliant India): Incentives for domestic manufacturing and
startups.
5. Disinvestment and Privatization: Sale of government stakes in companies like Air
India to boost fiscal health.
Real-life Example:
The reduction in corporate tax in 2019 from 30% to 22% encouraged companies like Tata
and Infosys to reinvest more in the economy.
