The Indian Financial System

By:

Akarshak Yadav

Amit Desai

Hitesh Seth

Vivek Jain

Nandita Mishra

Prashant Priyadarshani
The Financial system:

It is the system that allows the transfer of money between savers and borrowers. It deals
with money and monetary assets with the intention of mobilizing the savings in the economy
towards the players who want to use it for investments.

In any country, the financial system consists of:

 Financial markets
 Financial intermediation
 Financial instruments/products

The Indian financial system can be broadly classified into the organised and non-organised
sectors.
The Organised Indian Financial System:
Evolution of the Financial System:
The Financial System & Economy – An Interrelation:
The Financial Market:

The financial market is the actual mechanism which allows the trade between people. As
with most things in the economy, it too is affected by the forces of demand and supply. It primary
function is that of a facilitator.

The capital markets provide liquidity. As an extra benefit, the transaction prices quoted in the capital
markets of an asset gives a good estimate of the actual value of that asset.

Role of the Capital Market:

1. Mobilization of Savings and acceleration of capital formation.

2. Promotion of Industrial growth.

3. Raising of long term capital.

4. Ready and continuous markets.

5. Proper channelization of funds.

6. Provision of a variety of services.

A Historical Perspective of the Indian Capital Market:

 Traditionally, the stock market had always been considered the right of a privileged few. It
utilized the extremely inefficient outcry method where the stock bids were physically made on the
exchange floor. These inefficiencies resulted in a massive loss of transparency with hidden costs
further dissuading newer players to trade.

With the absence of technology coupled with an already outdated banking system, the
capital markets remained archaic. No wonder the volumes trade remained lower than Rs. 300 crore
which is a pittance compared to today’s volumes. Also, the investors weren’t protected displayed by
an absence of a settlement guarantee mechanism which pushed the risks up even further.

Milestones in the Indian Capital Market:

 1994 -Equity Trading commences on NSE

 1995 -All Trading goes Electronic

 1996 - Depository comes in to existence

 1999 - FIIs Participation- Globalization

 2000 - over 80% trades in Demat form

 2001 - Major Stocks move to Rolling Settlements

 2003 - T+2 settlements in all stocks

 2003 - Demutualization of Exchanges

Reforms in the Indian Capital Markets:

 Screen bases trading introduced in the NSE

 Capital adequacy norms stipulated

 Dematerialization of shares. This eliminated the risks associated with fraudulent paper.

 Entry of foreign investors

 Rolling settlements replaced accounting settlements allowing trades to be accounted for the
next day instead of accumulated towards the end of the week.

 Interactions between banks and exchanges.

 Introduction of Derivatives – Stock Futures & Options

 Straight Through Processing (STP) introduced, allowing the entire trade process including
payments to be conducted electronically with the need for manual intervention.

The Indian Market structure (As on July 31, 2005)

 There are 23 Stock Exchanges in India

 There are over 10000 Electronic Terminals at over 400 locations all over India.

 9644 Listed Companies are traded by 9108 Stock Brokers and 14582 Sub brokers

 2 Depositories and 483 Depository Participants

 128 Merchant Bankers, 59 Underwriters

 34 Debenture Trustees, 96 Portfolio Managers

 83 Registrars & Transfer Agents, 59 Bankers to Issue

 4 Credit Rating Agencies

Overview of the Indian Capital Market:

The Indian Capital Market Instruments:

The Role of Stock Exchange:

1. Raising capital for investment opportunities

2. Redistribution of wealth

3. Facilitates the growth of companies

4. Although debatable, it acts as a barometer of the economy

Factors for the Growth of the Indian Capital Markets:

1. Establishment of development banks & industrial financial institutions.

2. Progressive legislative measures.

3. Increasing awareness of investment opportunities.

4. Growing public confidence.

5. Growth of the underwriting business.

6. Setting up of the regulator SEBI.

7. Proliferation of Mutual Funds.

8. Increase in the number of Credit Rating agencies.

Deficiencies of the Indian Capital Markets:

1. Lack of transparency.

2. Physical settlement.

3. Manipulative practices.

4. Insider trading.

The Money Market:

 The money market is the mechanism for the transfer of short term monetary and financial
assets that are a near substitute for money. Short term generally refers to a period less than one
year while the term near substitute refers to assets which are highly liquid, i.e they can be converted
into money quickly with minimum transaction costs.

The money market is a subsection of the fixed income market which specialized in short
term debt securities. It is a market for institutions and the Government to manage their short term
cash needs.

The Money Market Instruments:

Defects of the Money Markets:

1. Lack of integration.

2. Lack of a Rational Interest Rates structure.

3. Absence of an Organized Bill market.

4. Seasonal Stringency of funds and fluctuations in Interest rates

5. Inadequate banking facilities

Financial Regulators:
There are three chief finance regulators in the country. They are:

 Securities and Exchange Board of India (SEBI)

 The Reserve Bank of India (RBI)

 The Ministry of Finance

Securities and Exchange Board of India (SEBI):

The SEBI is a non-statutory body for regulating the securities market in India which was
established in 1988 and became autonomous in 1992. The primary function of SEBI is to regulate the
capital markets through checks on the security trades as well as keeping malpractices under control
through various rules and regulations.

SEBI also regulates the stockbrokers and the sub-brokers. It aims to enhance investor
knowledge on the market through education and also readily promotes research and investigation.

Reserve Bank of India (RBI):

The RBI is the apex monetary authority of the country having been established on April 1,
1935 under the RBI act of 1934.

Functions of RBI:

1. Monetary authority:

a. Formulation and Implementation of monetary policies.

b. Maintaining price stability and ensuring adequate flow of credit to the Productive
sectors.

2. Issuer of currency:

a. Issues and exchanges or destroys currency and coins.

b. Provide the public adequate quantity of supplies of currency notes and coins.

3. Regulator and supervisor of the financial system:

a. Prescribes broad parameters of banking operations

b. Maintain public confidence, protect depositors' interest and provide cost-effective

banking services.
 4. Authority On Foreign Exchange:

a. Manages the Foreign Exchange Management Act, 1999.

b. Facilitate external trade, payment, promote orderly development and maintenance of

foreign exchange market.

5. Developmental role:

a. Performs a wide range of promotional functions to support national objectives.

6. Related Functions:

a. Banker to the Government: performs merchant banking function for the central and the
state governments.

b. Maintains banking accounts of all scheduled banks.

Monetary measures of the RBI:

1. Bank Rate:

The Bank Rate was kept unchanged at 6.0 per cent.

2. Repo Rates:

The Repo rate is around 7 per cent and the Reverse repo rate is around 6.10 per cent.

3. Cash Reserve Ratio:

The Cash Reserve Ratio (CRR) of scheduled banks is currently at 5.0 per cent.

Reforms in the Indian Financial Sector:

The Pre-Reform period:

The period from the mid 1960’s to the early 90’s is referred to as the pre-reform period. This period
is characterised by:

 Administered interest rates

 Industrial licensing and controls

 Dominant public sector

 Limited competition

 High capital-output ratio

The banks and other financial institutions acted as basic deposit agencies. Price discovery
was prevented with the Government failing to provide investment opportunities and public services.
This resulted in a closed, highly regulated and segmented financial system.

The economic reforms introduced in 1991 changed the entire financial system. The
objectives of these reforms are as follows:

1. Reorientation of the economy

2. Macro-economic stability

3. To Increase competitive efficiency in the operations

4. To remove structural rigidities and inefficiencies

5. To attain a balance between the goals of financial stability & integrated & efficient markets

Recommendations:

1. Increase the level of disinvestment in state owned banks.

2. Lift restrictions on the foreign ownership of banks.

3. Encourage the development of the corporate-bond market.

4. Strengthen legal protections, thus encouraging extremely risk-averse investors.

5. Deregulate the insurance industry.

6. Encourage consumer ownership of Mutual fund products.

7. Introduce a gold deposit scheme

8. Separate the RBI’s regulatory and central bank responsibilities.

9. Phase out statutory priority lending and restrictions on asset allocation

10. Lift the remaining capital account controls

Conclusion:

Today, the Indian financial system is fairly integrated, stable and fundamentally sound.
However, there are a few weaknesses that still exist in the system which need to be addressed.
Further reforms to come in the system need to be more capital-centric in nature. Even though
foreign capital flows and foreign exchange reserves have increased, the absorption of this foreign
capital is low and needs to be corrected.