Financial System in

India

Rajat Dixit
 Financial System

Savings Finance Investment

Economic Growth Capital Formation

● The financial system is possibly the most important institutional and
functional vehicle for economic transformation.
● Finance is a bridge between the present and the future and whether it be
the mobilisation of savings or their efficient, effective and equitable
allocation for investment, it is the success with which the financial system
performs its functions that sets the pace for the achievement of broader
national objectives.
● Van Horne defined the financial system as the purpose of financial markets
to allocate savings efficiently in an economy to ultimate users either for
investment in real assets or for consumption.
● Robinson defined the primary function of a Financial system is "to provide a
link between savings and investment for the creation of new wealth and to
permit portfolio adjustment in the composition of the existing wealth."
 Gold Smith’s Economic Units
Savings

Saving Surplus Units Saving- Deficit units Neutral units

Common
Man’s Business
Flow
Money man
Organization of Financial System in India

Financial Services Providers Users of Financial Services

● Central bank
● Household
● Banks
● Business
● Financial institutions
● Government
● Money and capital markets
● Informal financial enterprises.

Organized Unorganized
System System
 Organized Indian Financial System
● The organised financial system comprises of network of banks, other financial and
investment institutions and a range of financial instruments, which together function in
fairly developed capital and money markets.
● Short-term funds are mainly provided by the commercial and cooperative banking
structure.
● Almost 90% of such banking business is managed by Nationalized public sector Banks.
● In addition to commercial banks, there is the network of cooperative banks and land
development banks at state, district and block levels.
Sub-system of Organized Financial System

1. Banking system
2. Cooperative system
3. Development Banking system
a. Public sector
b. Private sector
4. Money markets
5. Financial companies/institutions.
 Unorganized Financial System
● The unorganised financial system comprises of relatively less controlled
moneylenders, indigenous bankers, lending pawn brokers, landlords, traders etc.
● This part of the financial system is not directly amenable to control by the
Reserve Bank of India (RBI).
● There are some financial companies, investment companies, chit funds etc.,
which are also not regulated by the RBI or the government in a systematic
manner.
● However, they are also governed by rules and regulations and are, therefore
within the orbit of the monetary authorities
 Financial System
● The economic development of any country depends upon the existence of a well
organised financial system.
● It is the financial system which supplies the necessary financial inputs for the
production of goods and services which in turn promote the well-being and standard of
living of the people of a country.
● Thus, the ‘financial system’ is a broader term which brings under its fold the financial
markets and the financial institutions which support the system.
● The major assets traded in the financial system are money and monetary assets.
● The responsibility of the financial system is to mobilise the savings in the form of
money and monetary assets and invest them to productive ventures.
● An efficient functioning of the financial system facilitates the free flow of funds to more
productive activities and thus promotes investment.
 Function of the Financial System
● Provision of liquidity
● Mobilisation of savings
● Size transformation function
● Maturity transformation function
● Risk transformation function
 Provision of Liquidity
● In financial language, the money and monetary assets are referred to as liquidity.
● The term liquidity refers to cash or money and other assets which can be converted
into cash readily without loss of value and time.
● All activities in a financial system are related to liquidity- either provision of liquidity or
trading in liquidity.
● RBI has been vested with the monopoly power of issuing coins and currency notes.
● Commercial banks can also create cash (deposit) in the form of ‘credit creation’ and
other financial institutions also deal in monetary assets.
● Over supply of money is also dangerous to the economy.
● Inflation can happen if the money supply grows faster than the economic output under
otherwise normal economic circumstances. Inflation, or the rate at which the average
price of goods or services increases over time, can also be affected by factors beyond
the money supply.
● RBI has to control the money supply and creation of credit by banks and regulate all
the financial institutions in the country in the best interest of the nation.
 Mobilisation of Saving
● Another important activity of the financial system is to mobilise savings and channelise
them into productive activities.
● The financial system should offer appropriate incentives to attract savings and make
them available for more productive ventures.
● The financial system facilitates the transformation of savings into investment and
consumption.
● The financial intermediaries have to play a dominant role in this activity
 Size Transformation Function
● The savings of millions of small investors are in the nature of a small unit of capital
which cannot find any fruitful avenue for investment unless it is transformed into a
perceptible size of credit unit.
● Banks and other financial intermediaries perform this size transformation function by
collecting deposits from a vast majority of small customers and giving them as loan of a
sizeable quantity.
● The size transformation function is considered to be one of the very important functions
of the financial system.
 Maturity Transformation Function
● The financial intermediaries accept deposits from public in different maturities
according to their liquidity preference and lend them to the borrowers in different
maturities according to their need and promote the economic activities of a country.
 Risk Transformation Function
● Most of the small investors are risk-averse with their small holding of savings.
● So, they hesitate to invest directly in stock market.
● On the other hand, the financial intermediaries collect the savings from individual
savers and distribute them over different investment units with their high knowledge
and expertise.
● Thus, the risks of individual investors get distributed.
● This risk transformation function promotes industrial development.
● Moreover, various risk mitigating tools are available in the financial system like
hedging(strategically using financial instruments or market strategies to offset the risk
of any adverse price movements), insurance etc.
 Important Financial Concepts
● Financial Assets
● Financial Intermediaries
● Financial Markets
● Financial Rates of Return
● Financial Instruments.
 Financial Assets
● In any financial transaction, there should be a creation or transfer of financial asset.
● Hence, the basic product of any financial system is the financial asset.
● A financial asset is one which is used for production or consumption or for further
creation of assets.
● For instance, A, buys equity shares and these shares are financial assets since they
earn income in future.
● There is a distinction between financial assets and physical assets.
● Unlike financial assets, physical assets are not useful for further production of goods or
for earning income.
● For example, X purchases land and buildings, or gold and silver. These are physical
assets since they cannot be used for further production.
● The objective of investment decides the nature of the asset.
● For instance, if a building is bought for residence purposes, it becomes a physical
asset. If the same is bought for renting, it becomes a financial asset.
Financial Assets
 Financial Intermediaries
● The term financial intermediary includes all kinds of organisations which intermediate
and facilitate financial transactions of both individuals and corporate customers.
● Thus, it refers to all kinds of financial institutions and investing institutions which
facilitate financial transactions in financial markets
● They may also be classified into two categories:
○ Capital market intermediaries.
○ Money market intermediaries.
Financial Intermediaries
 Financial Markets
● There is no specific place or location to indicate a financial market.
● Wherever a financial transaction takes place, it is deemed to have taken place in the
financial market.
● Hence, financial markets are pervasive in nature since, financial transactions are
themselves very pervasive throughout the economic system.
● For instance, issue of equity shares, granting of loan by term lending institutions,
deposit of money into a bank, purchase of debentures, sale of shares and so on.
● However, financial markets can be referred to as those centres and arrangements
which facilitate buying and selling of financial assets, claims and services.
● Sometimes, we do find the existence of a specific place or location for a financial
market as in the case of stock exchange.
Financial Markets
 Unorganized Markets
● In these markets, there are a number of moneylenders, indigenous bankers, traders,
etc., who lend money to the public.
● Indigenous bankers also collect deposits from the public.
● There are also private finance companies, chit funds, etc., whose activities are not
controlled by the RBI.
● RBI has taken steps to bring private finance companies and chit funds under its strict
control by issuing non-banking financial companies (Reserve Bank) Directions, 1998.
● RBI also has already taken some steps to bring the unorganised sector under the
organised fold, but they have not been successful.
● The regulations concerning their financial dealings are still inadequate and their
financial instruments have not been standardised.
 Organized Market
● In the organised markets, there are standardised rules and regulations governing their
financial dealings.
● There is also a high degree of institutionalisation and instrumentalisation.
● These markets are subject to strict supervision and control by the RBI or other
regulatory bodies.
● These organised markets can be further classified into two categories:
○ Capital Market
○ Money market.
 Capital Market
● The capital market is a market for financial assets which have a long or indefinite
maturity.
● Generally, it deals with long-term securities which have a maturity period of above one
year.
● Capital market may be further divided into three categories
○ Industrial securities market
○ Government securities market
○ Long-term loans market.
 Industrial Securities Market
● As the very name implies, it is a market for industrial securities namely:
○ Equity shares or ordinary shares
○ Preference shares, and
○ Debentures or bonds.
● It is a market where industrial concerns raise their capital or debt by issuing appropriate
instruments.
● It can be further subdivided into two categories:
○ Primary market or New issue market.
○ Secondary market or Stock exchange.
 Primary Market
● Primary market is a market for new issues or new financial claims and also called New
Issue Market.
● The primary market deals with those securities which are issued to the public for the
first time.
● In the primary market, borrowers exchange new financial securities for long-term funds.
Thus, primary market facilitates capital formation.
● There are three ways by which a company may raise capital in a primary market.
○ Public issue: raising capital by new companies is through sale of securities to
the public
○ Rights issue: When an existing company wants to raise additional capital,
securities are first offered to the existing shareholders on a pre-emptive basis
○ Private placement: way of selling securities privately to a small group of
investors.
 Secondary Market
● Secondary market is a market for secondary sale of securities and also known as the
aftermarket.
● In other words, securities which have already passed through the new issue market are
traded in this market.
● Generally, such securities are quoted in the Stock Exchange and it provides a
continuous and regular market for buying and selling of securities.
● This market consists of all stock exchanges recognised by the Government of India.
● The stock exchanges in India are regulated under the Securities Contracts (Regulation)
Act, 1956.
● The Bombay Stock Exchange is the principal stock exchange in India which sets the
tone of the other stock markets.
● Secondary market has further two components
● Spot Market: Where securities are traded for immediate delivery and payment.
● Futures Market : Where the securities are traded for future delivery and payment.
 Government Securities Market
● It is otherwise called Gilt-edged securities market.
● It is a market where Government Securities are traded.
● In India, there are many kinds of Government securities like short-term and long-term.
● Long-term securities are traded in this market while short-term securities are traded in
the money market.
● Securities issued by the Central Government, State Governments, Semi-government
authorities like City Corporations, Port Trusts, etc. Improvement Trusts, State Electricity
Boards, All India and State level financial institutions and public sector enterprises are
dealt in this market.
● Forms of Government Securities:
○ Stock certificates or inscribed stock
○ Promissory notes
○ Bearer bonds which can be discounted
● Government Securities are sold through the Public Debt Office of the RBI while
Treasury Bills (short-term securities) are sold through auctions.
 Long-Term Loans Market
● Development banks and commercial banks play a significant role in this market by
supplying long-term loans to corporate customers.
● Long-term loans market may further be classified into these categories:
○ Term loans market
○ Mortgages market
○ Financial guarantees market.
 Term Loans Market
● In India, many industrial financing institutions have been created by the Government
both at the national and regional levels to supply long-term and medium-term loans to
corporate customers directly as well as indirectly.
● These development banks dominate the industrial finance in India.
● Institutions like IRBI (Industrial Investment Bank of India), IFCI (Industrial Finance
Corporation of India) and other state financial corporations come under this category.
● These institutions meet the growing and varied long-term financial requirements of
industries by supplying long-term loans.
● They also help in identifying investment opportunities, encourage new entrepreneurs
and support modernisation efforts.
 Mortgages Market
● The mortgages market refers to those centres which supply mortgage loan mainly to
individual customers.
● A mortgage loan is a loan against the security of immovable property like real estate.
● The transfer of interest in a specific immovable property to secure a loan is called
mortgage.
● This mortgage may be equitable mortgage (mere deposit of title deeds to properties
as security) or legal mortgage (title in the property is legally transferred to the lender
by the borrower).
● Again, it may be a first charge (the mortgager transfers his interest in the specific
property to the mortgagee as security) or second charge (property in question is
already mortgaged once to another creditor).
● The mortgagee can also further transfer his interest in the mortgaged property to
another. In such a case, it is called a sub-mortgage.
● The mortgage market may have primary market as well as secondary market.
● The primary market consists of original extension of credit and secondary market has
sales and resales of existing mortgages at prevailing prices.
● In India, residential mortgages are the most common ones.
● The Housing and Urban Development Corporation (HUDCO) and the LIC play a
dominant role in financing residential projects.
● Besides, the Land Development Banks provide cheap mortgage loans for the
development of lands, purchase of equipment, etc.
● These development banks raise finance through the sale of debentures which are
treated as trustee securities.
 Financial Guarantee Market
● A guarantee Market is a centre where finance is provided against the guarantee of a
reputed person in the financial circle.
● Guarantee is a contract to discharge the liability of a third party in case of his default.
● Guarantee acts as a security from the creditor’s point of view.
● In case the borrower fails to repay the loan, the liability falls on the shoulders of the
guarantor.
● Hence, the guarantor must be known to both the borrower and the lender and he must
have the means to discharge his liability.
Instruments in Capital Market
1. Pure Instruments: Equity shares, preference shares, debentures and bonds which are
issued with the basic characteristics without mixing the features of other instruments
are called pure instrument.
2. Hybrid Instruments: Instruments which are created by combining the features of
equity, preference, bond are called as hybrid instruments. Example:
○ Convertible preference shares
○ Non-convertible debentures with equity warrant
○ Partly convertible debentures
○ Secured premium notes
3. Derivative Instrument: A derivative instrument is a financial instrument which derives
its value from the value of some other financial instrument or variable. Example:
○ Futures and Options belong to the categories of derivatives.
 Importance of Capital Market
● The capital market serves as an important source for the productive use of the
economy’s savings. It mobilises the savings of the people for further investment and
thus, avoids their wastage in unproductive uses.
● It provides incentives to saving and facilitates capital formation by offering suitable
rates of interest as the price of capital.
● It provides an avenue for investors, particularly the household sector to invest in
financial assets which are more productive than physical assets.
● It facilitates increase in production and productivity in the economy and thus, enhances
the economic welfare of the society. Thus, it facilitates ‘the movement of stream of
command over capital to the point of highest yield’ towards those who can apply them
productively and profitably to enhance the national income in the aggregate.
● The operations of different institutions in the capital market induce economic growth.
They give quantitative and qualitative directions to the flow of funds and bring about
rational allocation of scarce resources.
● A healthy capital market consisting of expert intermediaries promotes stability in values
of securities representing capital funds.
● It serves as an important source for technological upgradation in the industrial sector by
utilising the funds invested by the public.
● Absence of capital market acts as a deterrent factor to capital formation and economic
growth. Resources would remain idle if finances are not funneled through the capital
market.
 Money Market
● Money market is a market for dealing with financial assets and securities which have a
maturity period of up to one year.
● In other words, it is a market for purely short-term funds.
● The money market may be subdivided into four categories
○ Call money market
○ Commercial bills market
○ Treasury bills market
○ Short-term loan market.
 Call Money Market
● The call money market is a market for extremely short period loans say one day to
fourteen days.
● This market is highly liquid.
● The loans are repayable on demand at the option of either the lender or the borrower.
● In India, call money markets are associated with the presence of stock exchanges and
hence, they are located in major industrial towns like Mumbai, Kolkata, Chennai, Delhi,
Ahmedabad, etc.
● The special feature of this market is that the interest rate varies from day-to-day and
even from hour-to-hour and centre-to-centre.
● It is very sensitive to changes in demand and supply of call loans.
 Commercial Bills Market
● It is a market for bills of exchange arising out of genuine trade transactions.
● In the case of credit sale, the seller may draw a bill of exchange on the buyer.
● The buyer accepts such a bill, promising to pay at a later date the amount specified in
the bill.
● The seller need not wait until the due date of the bill.
● Instead, he can get immediate payment by discounting the bill.
● In India, the bill market is underdeveloped.
● The RBI has taken many steps to develop a sound bill market.
● The RBI has enlarged the list of participants in the bill market.
● The Discount and Finance House of India was set-up in 1988 to promote secondary
market in bills. In spite of all these, the growth of the bill market is slow in India.
● There are no specialised agencies for discounting bills.
● The commercial banks play a significant role in this market.
 Treasury Bills Market
● It is a market for treasury bills which have ‘short-term’ maturity.
● A treasury bill is a promissory note or a finance bill issued by the Government.
● It is highly liquid because its repayment is guaranteed by the Government.
● It is an important instrument for short-term borrowing of the Government.
● There are two types of treasury bills:
○ Ordinary or Regular treasury bills
○ ad hoc treasury bills (ad hocs).
● Ordinary treasury bills are issued to the public, banks and other financial institutions
with a view to raising resources for the Central Government to meet its short-term
financial needs.
● Ad hoc treasury bills are issued in favour of the RBI only.
● They are not sold through tender or auction.
● They can be purchased by the RBI only.
 Short-term Loan Market
● It is a market where short-term loans are given to corporate customers for meeting their
working capital requirements.
● Commercial banks play a significant role in this market.
● Commercial banks provide short-term loans in the form of cash credit and overdraft.
● Overdraft facility is mainly given to business people, whereas cash credit is given to
industrialists.
● An overdraft facility is a credit agreement made with a bank that allows an account
holder to use or withdraw more money than what they have in their account up to the
approved limit.
● Overdraft is purely a temporary accommodation and it is given in the current account
itself.
● But, cash credit is for a period of one year and it is sanctioned in a separate account.
 Financial Instruments
● A financial instrument is any contract that gives rise to a financial asset of one entity
and a financial liability or equity instrument of another entity.
● These instruments refer to those documents which represent financial claims on
assets.
● Simply, a financial instrument is a monetary contract between parties
● Examples: Cheques, Bill of Exchange, Promissory Note, Treasury Bill, Government
Bond, Deposit Receipt, Share, Debenture, etc.
● A financial instrument may be evidence of ownership of part of something, as in stocks
and shares. Bonds, which are contractual rights to receive cash, are financial
instruments.
● Financial Instrument Classified under two categories:
○ Cash Instruments
○ Derivative Instruments
 Instruments v. Securities
● Financial instruments are tradable assets of any kind.
● Financial Security is a type of Financial Instrument which can be traded at a stock
exchange.
● The term "security" is a fungible, negotiable financial instrument that holds some type
of monetary value. It represents an ownership position in a publicly-traded
corporation-via stock- a creditor relationship with a governmental body or a corporation-
represented by owning that entity's bond- or rights to ownership as represented by an
option.
● Financial instrument is a broader term.
● It refers to those traded in money markets, capital markets, FX markets, spot market,
and derivatives.
● Commonly, Cash Instruments are called Securities.
 Cash Instruments
● Cash Instruments are tradable and derive their value from financial markets.
● The values of cash instruments are directly influenced and determined by the markets.
● These can be securities that are easily transferable.
● Cash instruments may also be deposits and loans agreed upon by borrowers and
lenders.
● Cash Instruments can be further classified into two categories:
○ Equity instruments
○ Debt instruments.
 Equity Instruments
● Equity Instruments (Equity Security) refer to instruments which represent ownership of
the asset.
● An equity security represents ownership interest held by shareholders in an entity (a
company, partnership or trust), realized in the form of shares of capital stock, which
includes shares of both common and preferred stock.
● Holders of equity securities are typically not entitled to regular payments.
● Although equity securities often do pay out dividends, but they are able to profit from
capital gains when they sell the securities (assuming they've increased in value,
naturally).
● Equity securities do entitle the holder to some control of the company on a pro rata
basis, via voting rights. In the case of bankruptcy, they share only in residual interest
after all obligations have been paid out to creditors.
 Types of Equity Instruments

● Common Shares: Common (ordinary) shares represent partial ownership of the

company and provide their holders claims to future streams of income, paid out of
company profits and commonly referred to as dividends.
● Preferred shares is a financial instrument, which represents an equity interest in a firm
and which usually does not allow for voting rights of its owners. Typically the investor
into it is only entitled to receive a fixed contractual amount of dividends and this make
this instrument similar to debt. Preferred shares can also be non-cumulative,
redeemable, convertible, participating etc.
● Private Equity: When companies are organized as partnerships and private limited
companies, their shares are not traded publicly. The form of equity investments, which
is made through private placements, is called private equity. The most important
sources of private equity investments come from venture capital funds, private equity
funds and in the form of leveraged buyouts.
● ADRs, GDRs: Investors may invest into foreign shares by purchasing shares directly,
purchasing American Depository Receipts (ADRs), Global Depository Receipts
(GDRs).
● Exchange traded funds (ETFs) are passive funds, that track specific index. Thus
investor can invest into a specific index, representing a country’s (e.g. foreign) stock
market.
 Debt Instruments
● A debt security represents money that is borrowed and must be repaid, with terms that
stipulates the size of the loan, interest rate, and maturity or renewal date.
● Debt securities, which include government and corporate bonds, certificates of deposit
and collateralized securities, generally entitle their holder to the regular payment of
interest and repayment of principal (regardless of the issuer's performance), along with
any other stipulated contractual rights (which do not include voting rights).
● They are typically issued for a fixed term, at the end of which they can be redeemed by
the issuer.
● Debt securities can be secured (backed by collateral) or unsecured, and, if unsecured,
may be contractually prioritized over other unsecured, subordinated debt in the case of
a bankruptcy.
 Hybrid Instruments
● Hybrid Instrument or Hybrid securities, as the name suggests, combine some of the
characteristics of both debt and equity securities.
● Examples of hybrid securities include equity warrants (options issued by the company
itself that give shareholders the right to purchase stock within a certain timeframe and
at a specific price), convertible bonds (bonds that can be converted into shares of
common stock in the issuing company) and preference shares (company stocks whose
payments of interest, dividends or other returns of capital can be prioritized over those
of other stockholders).
 Types of Hybrid Instruments
● Convertible Bonds: Companies issue them to encourage investors with the
opportunities of higher return. The holders of this type of hybrid instruments are
authorized to convert each bond for some shares of common stock when the stock
increase in value. Convertible bonds also brings profits to the company because
issuance is more quicker and the new capital does not affect the firm's earnings. Also
the owners pay less interest on this types of convertibles.
● Convertible Preferred Shares - it is another types of hybrid security. Similar to the
above discussed they retain a lower risk profile but also have a possibility of higher
return when they are changed to common stock for capital growth.
● Mezzanine Financing - is a form a financing which that functions by using two other
methods. It is an agreement in which funds are granted in a traditional loan. However
the lender may take over the property if the loan is not paid full and on time. Lender
who provides this kind of hybrid instrument usually search for company who has a
possibility to grow, if equipped with proper additional capital.
 Derivative Instruments
● Investments based on some underlying assets are known as derivatives.
● In general derivatives contracts promise to deliver underlying products at some time in
the future or give the right to buy or sell them in the future.
● The value and characteristics of derivative instruments are based on the various
components, such as Type of assets, interest rates etc.
● An equity options contract, for example, is a derivative because it derives its value from
the underlying stock. The option gives the right, but not the obligation, to buy or sell the
stock at a specified price and by a certain date. As the price of the stock rises and falls,
so too does the value of the option although not necessarily by the same percentage.
● There can be over-the-counter (OTC) derivatives or exchange-traded derivatives.
● OTC is a market or process whereby securities, that are not listed on formal exchanges
are priced and traded.
 Types of Derivative Instruments
● Forward Contract: A forward contract gives the holder the obligation to buy or sell a
certain underlying instrument at a certain date in the future at a specified price.
● Futures Contract: Futures contracts are forward contracts traded on organized
exchanges. A futures contract is a legally binding commitment to buy or sell a standard
quantity at a price determined in the present (the futures price) on a specified future
date.
● Swaps: A swap is an agreement whereby two parties (called counterparties) agree to
exchange periodic payments. The cash amount of the payments exchanged is based
on some predetermined principal amount.
● Options: An option is a contract in which the option seller grants the option buyer the
right to enter into a transaction with the seller to either buy or sell an underlying asset at
a specified price on or before a specified date.