Introduction to Indian Financial System ()

The financial system of a country is an important tool for economic development of the country, as it helps in creation of wealth by linking savings with investments.
It facilitates the flow of funds form the households (savers) to business firms (investors) to aid in wealth creation and development of both the parties

1. Indian Financial System

2. Objectives Learn the concept of Indian financial system; Explain the key elements related to Indian financial system; Discuss the nature and functions of Indian financial system; Understand role of financial system and financial instruments; Understand components of Indian financial system.

3. Introduction to Indian Financial System The financial system of a country is an important tool for economic development of the country, as it helps in creation of wealth by linking savings with investments. It facilitates the flow of funds form the households (savers) to business firms (investors) to aid in wealth creation and development of both the parties. The financial system of a country is concerned with: Allocation and Mobilization of savings Provision of funds Facilitating the Financial Transactions Developing financial markets Provision of legal financial framework Provision of financial and advisory services According to Robinson, the primary function of a financial system is “to provide a link between savings and investment for creation of wealth and to permit portfolio adjustment in the composition of existing wealth”

4. Features of Financial System It plays a vital role in economic development of a country It encourages both savings and investment It links savers and investors It helps in capital formation It helps in allocation of risk It facilitates expansion of financial markets It aids in Financial Deepening and Broadening

5. Functions of Indian Financial System Regulation of currency: As a part of the financial system, central banks generally control the supply of a currency and interest rates, while currency traders control exchange rates. Banking functions (a) to assemble capital and make it effective; (b) to receive deposits and make collections; (c) to check out and transfer funds; (d) to discount or lend; (e) to exercise fiduciary or trust powers; (f) to issue circulating notes . Performance of agency services and custody of cash reserves: Different constituents of the financial system act as the agents for their clients . They buy and sell shares and bonds, receive and pay utility bills, premiums, dividends, rents and interest for their clients. Management of national reserves of international currency: Various parts of financial system help the economy in particular and polity in general to manage international reserve . Credit control: Financial system controls credit by serving the dual purpose of: (a) increasing sales revenue by extending credit to customers who are deemed a good credit risk (b) minimizing risk of loss from bad allocation

6. Functions of Indian Financial System … Ensure stability of the economy: Financial system performs the function of administering national, fiscal, and monetary policy to ensure the stability of the economy . Supply and deployment of funds for productive use: Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes. Maintaining liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets. Price determination: Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets. Information aggregation and coordination: Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrower s. Risk sharing: Financial markets allow a t ransfer of risk from those who undertake investments to those who provide funds for those investments. Improve efficiency: Financial markets reduce transaction costs and information costs . Ensure long term growth to itself: Long-term growth of financial markets is ensured through: ( a) Giving autonomy to Financial Institutions to become efficient under competition (b) Education of investors (c) Consolidation through mergers (d) Facilitating entry of new institutions to add depth the market (e) Minimizing regulatory measures and market segmentation .

7. Structure of Indian Financial System/Components of Indian Financial System

8. Financial System The financial system consists of the Central Bank (RBI), as the apex financial institution, other regulatory authorities, financial institutions, markets, instruments, a payment and settlement system, a legal framework and regulations . The financial system carries out the vital financial intermediation function of borrowing from surplus units and lending to deficit units. The legal framework and regulators are needed to monitor and regulate the financial system. The payment and settlement system is the mechanism through which transactions in the financial system are cleared and settled . 1. Regulatory Authorities 2. Financial Institutions 3. Financial Markets 4. Financial Instruments 5. Payment and Settlement Infrastructure.

9. Regulatory Authorities Reserve Bank of India (RBI) The regulation and supervision of banking institutions is mainly governed by the Companies Act, 1956, Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/1980, Bankers’ Books Evidence Act, Banking Secrecy Act and Negotiable Instruments Act, 1881. The regulation and supervision of finance companies is done by the Banking Regulation Act, 1949 which governs the financial sector. Individual Institutions are regulated by Acts like: 1. State Bank of India Act, 1954 2. The Industrial Development Bank (Transfer of Undertaking and Repeal) Act, 2003 3. The Industrial Finance Corporation (Transfer of Undertaking and Repeal) Act, 1993 4. National Bank for Agriculture and Rural Development Act 5. National Housing Bank Act 6. Deposit Insurance and Credit Guarantee Corporation Act.

10. Regulatory Authorities … Securities and Exchange Board of India (SEBI) The Securities and Exchange Board of India was made a statutory body on April 12, 1992 in accordance with the provisions of the Securities and Exchange Board of India Act, 1992 to protect the interests of investors in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto.

11. Regulatory Authorities … Insurance Regulatory and Development Authority (IRDA) Insurance Regulatory and Development Authority regulates and supervises the insurance industry-insurance companies and their agents and insurance brokers to protect the interests of the policyholders, to regulate, promote and ensure orderly growth of the insurance industry and for matters connected therewith or incidental thereto.

12. Financial Institutions The financial system consists of many financial institutions. While most of them are regulated by the Reserve Bank, there are some which it manages just indirectly. Institutions regulated by the Reserve Bank of India 1. Nationalised Commercial Banks 2. Specialised Banks 3. Registered Finance Companies 4. Registered Finance Leasing Establishments 5. Micro-finance Institutions. Institutions not regulated by the Reserve Bank of India Certain financial institutions are not regulated by the Reserve Bank of India. These include securities firms, investment banks and mutual funds which come under the purview of the SEBI, Insurance Companies and Insurance Brokers which are regulated by the IRDA, etc.

13. Financial Institutions Financial institutions are intermediaries of financial markets which facilitate financial transactions between individuals and financial customers . It simply refers to an organization (set-up for profit or not for profit) that collects money from individuals and invests that money in financial assets such as stocks, bonds, bank deposits, loans etc. There can be two types of financial institutions: Banking Institutions or Depository institutions – These are banks and credit unions that collect money from the public in return for interest on money deposits and use that money to advance loans to financial customers. Non- Banking Institutions or Non-Depository institutions – These are brokerage firms, insurance and mutual funds companies that cannot collect money deposits but can sell financial products to financial customers.

14. Financial Institutions … Financial Institutions may be classified into three categories Regulatory – It includes institutions like SEBI, RBI, IRDA etc. which regulate the financial markets and protect the interests of investors. Intermediaries – It includes commercial banks such as SBI, PNB etc. that provide short term loans and other financial services to individuals and corporate customers. Non – Intermediaries – It includes financial institutions like NABARD, IDBI etc. that provide long-term loans to corporate customers.

15. Financial Markets The Financial Market, which is the market for credit and capital, can be divided into the Money Market and the Capital Market. The Money Market is the market for short-term interest-bearing assets. Examples: 1. Treasury bills, 2. Commercial paper, 3. Certificates of deposits The major task of the Money Market is to facilitate the liquidity management in the economy. The Capital Market is the market for trading in medium-long-term assets. Examples: 1. Treasury bonds, 2. Private debt securities (bonds and debentures) 3. Equities (shares) The main purpose of the Capital Market is to facilitate the raising of long-term funds. The main issuers in the 1. Money Market are the Government, banks and private companies, while the main investors are banks, insurance companies and pension and provident funds. 2. Capital Market are the Government, banks and private companies, while the main investors are pension and provident funds and insurance companies.

16. Financial Markets … The Financial Market can also be classified according to instruments, such as – Debt market Equity market. The debt market is also known as the Fixed Income Securities Market and its segments are the Government Securities Market (Treasury bills and bonds) and the Private Debt Securities Market (commercial paper, private bonds and debentures).

17. Financial Markets … Another distinction can also be drawn between primary and secondary markets. The Primary Market is the market for new issues of shares and debt securities, The Secondary Market is the market in which existing securities are traded. The Reserve Bank of India through its conduct of monetary policy influences the different segments of the Financial Market in varying degrees. The Reserve Bank's policy interest rates have the greatest impact on a segment of the Money Market called the inter-bank call money market and a segment of the Fixed Income Securities Market, i.e. the Government Securities Market.

18. Financial Assets/Instruments Financial assets include cash deposits, checks, loans, accounts receivable, letter of credit, bank notes and all other financial instruments that provide a claim against a person/financial institution to pay either a specific amount on a certain future date or to pay the principal amount along with interest.

19. Financial Instruments Deposits Loans Treasury Bills and Bonds Repurchase Agreements Commercial Paper Corporate Bonds and Debentures Asset-backed Securities (Secured Debentures) Warrants Shares Financial Derivatives

20. Deposits Deposits are sums of money placed with a financial institution, for credit to a customer's account. There are three types of deposits — demand deposits, savings deposits and fixed or time deposits. Demand deposits are mainly used for transaction purposes and for the safekeeping of funds. Funds can be withdrawn on demand. Demand deposits do not earn interest. Savings deposits earn interest, which may be calculated on a daily, weekly, monthly or annual basis. Funds may be withdrawn from savings accounts at any time. Fixed or time deposits are funds placed at financial institutions for a specified period or term. Fixed/time deposits earn a higher rate of interest than savings deposits. Fixed/time deposits can be for short, medium or long term. Funds can only be withdrawn before the maturity date with prior notice and a penalty may be imposed

21. Loans A loan is a specified sum of money provided by a lender, usually a financial institution, to a borrower on condition that it is repaid, either in installments or all at once, on agreed dates and at an agreed rate of interest. In most cases, financial institutions require some form of security for loans.

22. Treasury Bills and Bonds Treasury bills are government securities that have a maturity period of up to one year . Treasury bills are issued by the central monetary authority (the RBI), on behalf of the Government of India. Treasury bills are issued in maturities of 91 days, 182 days and 364 days . Treasury bills are zero coupon securities and are sold at a discount to face valu e, which is paid at maturity. The difference between the purchase price and the face value is the interest income to the owner. Treasury bills are considered liquid assets as they can be easily sold in the secondary market and converted to cash. Treasury bonds are medium and long-term government securities and are issued in maturities ranging from 2 years to 20 years . Treasury bills and bonds are guaranteed by the Government and are the safest of all investments, as they are default risk free. Treasury bills and bonds are tradable securities which are sold by auction to Primary Dealers, who in turn market the securities to the public.

23. Repurchase Agreements Repurchase agreements (Repo) are arrangements involving transaction between two parties that agree to sell and repurchase the same security. Under repurchase agreement, the seller sells the specified securities to the buyer with an agreement to repurchase the same at a mutually decided future date and price. Such kind of transaction between parties approved by RBI and in securities (Treasury Bills, Central/State Govt. securities) as approved by RBI.

24. Commercial Paper Commercial Papers (CPs) are short-term, non- collateralised (unsecured) debt securities issued by private sector companies to raise funds for their own use, by banks and other financial intermediaries. CPs are generally issued by creditworthy (high-rated) institutions in large denominations and have additional bank guarantees of payment. CPs are usually sold at a discount, although some are interest bearing .

25. Corporate Bonds and Debentures Corporate bonds are medium or long-term securities of private sector companies which obligate the issuer to pay interest and redeem the principal at maturity. Corporate bonds that are not backed by a specific asset are called debentures . Debentures are medium or long term, interest-bearing bonds issued by private sector companies, banks and other financial institutions that are backed only by the general credit of the issuer. Debentures are usually issued by large, well-established institutions. The holders of debentures are considered creditors and are entitled to payment before shareholders in the event of the liquidation of the issuing company. Convertible Debentures are debentures issued with an option to debenture holders to convert them into shares after a fixed period . A convertible debenture is a type of debenture or commercial loan that gives the choice to the lender to take stock or shares in the company, as an alternative to taking the repayment of a loan. Convertible debentures are either partially or fully convertible. Non-convertible Debentures are debentures issued without conversion option. The total amount of the debenture will be redeemed by the issuing company at the end of the specific period.

26. Asset-backed Securities (Secured Debentures) Asset-backed Securities (ABS) are bonds collateralized (secured) by mortgages, loans, or other receivables . Typically, the issuing institution sells mortgages, loans, instalment credit, credit card or other receivables to a trust or a Special Purpose Vehicle (SPV) that in turn sells ABSs to the public. ABSs are interest- bearing instruments and are often enhanced through the use of guarantees or insurance .

27. Warrants Warrants can be described as a derivative security that gives the holder the right to purchase securities (usually equity) from the issuer at a specific price within a certain time frame. Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends. They can be used to enhance the yield of the bond, and make them more attractive to potential buyers. Warrants can also be used in private equity deals.

28. Shares Shares are securities representing a portion of the ownership of a company that are a claim on the company's earnings and assets. Shareholders are paid dividends which are a percentage of the profits of the company. Equity shares: Equity shares are shares which do not enjoy any preferential right in the matter of payment of dividend or repayment of capital. The equity shareholder gets dividend only after the payment of dividends to the preference shares. The rate of dividend depends upon the surplus profits. In case of winding up of a company, the equity share capital is refunded only after refunding the preference share capital. Equity shareholders have the right to take part in the management of the company . Preference shares: Preference shares are the shares which carry preferential rights over the equity shares . These rights are: 1 . Receiving dividends at a fixed rate, 2. Getting back the capital in case the company is wound-up . Investment in these shares are safe, and a preference shareholder also gets dividend regularly .

29. Financial Derivatives A financial derivative is a financial instrument that is linked to another specific financial instrument, indicator or commodity and through which specific financial risks (such as interest rate risk, foreign exchange risk, equity and commodity price risk) can in their own right, be traded in financial markets. The value of a financial derivative comes from the price of an underlying item such as an asset or index. Financial derivatives can be used for risk management, hedging (protecting) against financial losses on commercial transactions and financial instruments and arbitrage between markets and speculation. There are two distinct classes of financial derivatives — forwards and related instruments, and options . The most common forward instruments are forward contracts, futures contracts, Forward Rate Agreements (FRAs) and Interest Rate Swaps (IRS) . Financial derivatives are traded over-the-counter , in which case they are customized and can be purchased from financial institutions or are standardized products which are traded on organized exchanges.

30. Financial Services Financial Services are concerned with the design and delivery of financial instruments and advisory services to individuals and businesses within the area of banking and related institutions, personal financial planning, leasing, investment, assets, insurance etc . It involves provision of a wide variety of fund/asset based and non-fund based/advisory services and includes all kinds of institutions which provide intermediate financial assistance and facilitate financial transactions between individuals and corporate customers.

31. Functions of Financial System Linking Surplus and Deficit Spending Units – A financial system facilitates transfer of funds from Surplus Spending Units (SSUs) to deficit spending units (DSUs) by providing means and mechanism to link the two groups. The most important deficit spending units are businesses, local and state governments and sometimes foreigners. The financial system seeks to funnel funds from SSUs to DSUs in two basic ways: Direct Financing: In the direct financing route, DSUs issue financial claims on themselves and sell them for funds to SSUs. The SSUs hold the financial claims in their portfolios on interest bearing assets. The claims issued by the DSUs are called direct claims and are typically sold in financial markets. Indirect Financing: Another route to transfer funds from SSUs to DSUs is indirect financing. In indirect financing, financial intermediaries such as banks, insurance companies, pension funds, etc., are involved. Indirect financing has emerged to overcome the problems involved in direct financing.

32. Functions of Financial System 2. Providing Financial infrastructure & Payment System – A financial system provides for effective system of payment for personal, business and government transactions through array of financial instruments and intermediaries. Financial infrastructure refers to the different systems that provide for the execution of both large-value and small-value payments. Payment and settlement systems enable the transfer of money in the accounts of financial institutions to settle financial obligations between individuals and institutions.

33. Functions of Financial System 3. Managing Risks A well-developed, smooth-functioning financial system offers a wide variety of financial instruments that enable economic agents to pool, price and exchange risk. It provides adequate mechanism for risk-pooling and risk-sharing for both households and business firms. These mechanisms are built in hedging, diversification and insurance. While hedging is a technique to move from a risky asset to riskless assets, diversification provides for pooling and subdividing risks. Insurance enables the insured to retain the economic benefits of ownership while laying off the possible losses.

34. Functions of Financial System Price Information Besides facilitating transfer of funds from savers to investors, financial system provides necessary information that plays significant role in coordinating decentralised decision-making. Information about existing interest rates and securities not only enable individuals in making their saving and investment decisions but also aid the managers of business enterprises in deciding about choice of investment projects and funding thereof.

35. Importance of Indian Financial System It 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 protects the interests of investors and ensures smooth financial transactions through regulatory bodies such as RBI, SEBI etc. It helps economic development and raising the standard of living of people It helps to promote the development of weaker section of the society through rural development banks and co-operative societies It helps corporate customers to make better financial decisions by providing effective financial as well as advisory services It aids in Financial Deepening and Broadening