Financial System in India

MEANING OF FINANCIAL SYSTEM

Financial system means a set of complex and interlinked institutions, agents, practices, markets, transactions,
claims and liabilities dealing in money, credit and finance of an economy.

We may broadly define finance as all types of monetary resources consisting of debt and ownership funds of the
state, company or person. Hence, any system or institutional arrangement that deals with such monetary
resources may be regarded as a part of the financial system of an economy. It is a set of institutional arrangements
through which financial surplus in the economy is mobilized from surplus spending units and is channelized to
deficit spending units of the economy.
SIGNIFICANCE OF FINANCIAL SYSTEM

The financial system of an economy plays a very significant role in the growth process of that economy. It helps
in production, capital accumulation and economic growth of a country in the following ways:

(i) By encouraging savings or raising inducement to save

(ii) By mobilising savings

(iii) By allocating savings in proper use

COMPONENTS OF FINANCIAL SYSTEM

Financial system of an economy is a set of institutional arrangements through which financial surpluses in the
economy are mobilized from surplus spenders and are transferred to deficit spenders. By institutional
arrangements we mean all conditions and mechanisms involving production, distribution, exchange and holding
of financial assets of all kinds and the organization as well as the operation of all financial markets and
institutions. This description of the financial system of an economy clearly reveals that any financial system has
three main components.

They are as follows:

(i) Financial assets
(ii) Financial markets and
(iii) Financial institutions
FUNCTIONS OF FINANCIAL SYSTEM

The financial system of an economy performs some important functions.

They are as follows:
1. Supply of liquidity of money
2. Mobilisation of savings
3. Channelising savings into productive investment Financial System
4. Efficient functioning of payment mechanism
5. Transformation services.

There are again four types of transformation services.

They are as follows:
1. Liability-asset transformation function
2. Size transformation function
3. Risk transformation function
4. Maturity transformation function
Different Kinds of Finance

a. Rudimentary finance,
b. Direct finance and
c. Indirect finance.

Under Rudimentary finance, there is no financial asset other than money. Under this type of financial system,
saving, investment and rate of growth all are low. Again, in a financial transaction, if there is no financial
intermediary between the lender and the borrower, it is called Direct Finance. On the other hand, when there
are financial intermediaries between the lender and the borrower in a financial transaction, it is called Indirect
Finance. Direct finance is risky, uncertain and expensive. On the other hand, Indirect finance is less risky, flexible
and relatively cheap. Hence, most of the financial transactions are indirect finance.
Financial System and Economic Development

The financial system of a country can play a vital role in the process of economic development of that country. It
helps in economic development in the following ways:

 generating savings
 mobilizing savings
 allocating funds in a proper way
 financing industry
 financing agriculture and small scale industries
 developing money and capital markets of the country

Without a developed financial system, development process of a country is bound to be halted

Financial System and Economic Development
Basic Elements of a Well-functioning Financial System :

•  A strong legal and regulatory environment

•  Stable money

•  Sound public finances and public debt management

•  A central bank

•  Sound banking system

•  Information system

•  Well-functioning securities market

FINANCIAL SYSTEM DESIGNS

A financial system is a vertical arrangement of a well-integrated chain of financial markets and institutions that
provide financial intermediation. Different designs of financial systems are found in different countries. The
structure of the economy, its pattern of evolution, and political, technical, and cultural differences affect the
design (type) of financial system.

Two prominent polar designs can be identified among the variety that exists.
•  Bank-based
• Market-based

At one extreme is the bank-dominated system, such as in Germany, where a few large banks play a dominant
role and the stock market is not important. At the other extreme is the market-dominated financial system, as in
the US, where financial markets play an important role while the banking industry is much less concentrated.
The other major industrial countries fall in between these two extremes.
Market-based Financial System

Advantages
• Provides attractive terms to both investors and borrowers
• Facilitates diversification
• Allows risk-sharing
• Allows financing of new technologies

Drawbacks
• Prone to instability
• Exposure to market risk
• Free-rider problem
Bank-based Financial System

Advantages
• Close relationship with parties
• Provides tailor-made contracts
• Efficient intertemporal risk-sharing
• No free-rider problem

Drawbacks
• Retards innovation and growth
• Impedes competition
FDI and its types:

• Horizontal FDI
• Vertical FDI
• Conglomerate FDI
• Platform FDI

FDI routes:

• Automatic route
• Government approval route