78

DEVELOPMENT OF FINANCIAL SYSTEM IN INDIA – AN OVERVIEW

3.1: Introduction

The economic history of the world has demonstrated that various economic

crises can impact the economic systems and expose them to high risks. In order to

prevail over the future crisis, it becomes important to understand the evolution and

development of financial system. The present chapter gives a comprehensive

overview of the role and development of financial system in general and India in

specific. An economy without a financial system would have implied two things;

First, without a financial system, the economy would be subject to all the

inefficiencies of a barter system. Second, without a financial system, the economy

would probably have a relatively low level of investment and would tend to

misallocate whatever investment it had. There is no doubt that, finance is the linchpin

of economy and a financial system plays a key role in the smooth and efficient

functioning of the economy.

A financial system implies a set of complex and closely connected or

intermixed institutions, agents, practices, markets, claims, and so on in an economy.1

A financial system helps to mobilise the financial surpluses of an economy and

transfer them to areas of financial deficit. Economic growth and development of any

country depends upon a well-knit financial system. Financial system as in Chart-3.(i)

helps in the flow of funds from surplus spending units to deficit spending units. It

channels funds from "Lender-Savers" (suppliers of funds) to "Borrower-Spenders"

(seekers of funds).

Chart-3.(i): Flow of Funds through Financial System

Source: Mishkin and Eakins (2009) Financial Markets and Institutions

1 Khan M Y (2014), Indian Financial System, Eighth Edition, McGraw Hill Education (India) Private Limited, New Delhi, p.1

Flow of Funds (Savings)

Seekers of funds

(mainly business

firms and

government)

Suppliers of Funds

(mainly households) Flow of Financial Services

Income and Financial Claims

79

Financial system functions as an intermediary between savers and investors. It

facilitates the flow of funds in the economy. It is concerned about money, credit and

finance. These three parts are closely interrelated with each other and depend on each

other.

Financial System aims at establishing and providing a regular, smooth,

efficient and cost effective linkage between depositors and investors. A well-

developed financial system allows for the transfer of resources from surplus spending

units to deficit spending units and thus plays a crucial role in the functioning of the

economy. Therefore, financial system is generally defined as the one engaged in the

creation of different types of assets that creditors wish to hold, and financial liabilities

that debtors are willing to incur. Thus, the variations in the size and composition of

assets and liabilities of financial institutions, and the type of financial services offered

alter the portfolios of other sectors as well as decisions on savings and investments.

According to Van Horne, "financial system allocates savings efficiently in an

economy to ultimate users, either for investment in real assets or for consumption".2

According to Prasanna Chandra, "financial system consists of a variety of institutions,

markets and instruments related in a systematic manner and provides the principal

means by which savings are transformed into instruments3.

Thus, a financial system comprises of financial institutions, financial markets,

financial instruments and financial services and a large regulatory body - a Central

Bank, which oversees and supervises the operations of these intermediaries.

Financial system as a sector in the economy utilizes productive resources to facilitate

capital formation through the provision of a wide-range of financial instruments to

meet the different requirements of borrowers and lenders. The financial system

mobilizes and intermediates savings, and ensures that resources are allocated

efficiently to productive sectors.4

2 Van Horne James C (2002), Financial Management and Policy, 12th Edition, Pearson Education, India, Chapter. 1.

3 Chandra Prasanna (2001) Financial Management, Tata McGraw Hill, New Delhi, p.22

4 Ang B James (2008), "A Survey of Recent Developments in the Literature of Finance and Growth", Journal of Economic

Surveys, Vol. 22, No. 3, pp. 536-576.

80

According to Levine, in arising to ameliorate transaction and information

costs, financial systems serve one primary function, they facilitate the allocation of

resources across space and time, in an uncertain environment, thereby performing five

important functions:5

i) Facilitate trading, hedging, diversifying and pooling of risk

ii) Allocation of resources

iii) Monitor managers and exert corporate control

iv) Mobilise savings and

v) Facilitate the exchange of goods and services.

The financial system in the Indian economy also performs the above

mentioned functions and helps in the allocation of funds by channelizing it from

savers and lending it to the borrowers.

Savings are done by households, businesses, and government. The Central

Statistical Organisation (CSO) classifies the savers in India as the household sector,

domestic private corporate sector, and the public sector.

The household sector is defined to comprise individuals, non-government,

non-corporate entities in agriculture, trade and industry, and non-profit making

organisations like trusts, charitable and religious institutions. The public sector

comprises central and state governments, departmental and non-departmental

undertakings, the RBI etc.

The domestic private corporate sector comprises non-government, public and

private limited companies (whether financial or non-financial) and cooperative

institutions. The household sector is the dominant saver, followed by the domestic

private corporate sector. The contribution of the public sector to total net domestic

savings is relatively small.

5 Levine Ross (1997), "Financial Development and Economic Growth: Views and Agenda", Journal of Economic Literature,

June, 3592, pp.688-726.

81

Table- 3.1: Estimates of Gross Domestic Savings of India

1990-1991 to 2011-12 (` crore)

Year Household Sector Private Corporate

Sector Public Sector Total

1990-91 1,08,603 15,164 10,641 1,34,408

1991-92 1,05,632 20,304 17,594 1,43,530

1992-93 1,27,943 19,968 16,709 1,64,621

1993-94 1,51,454 29,866 11,674 1,92,994

1994-95 1,87,142 35,260 24,266 2,46,668

1995-96 1,98,585 59,153 31,527 2,89,265

1996-97 2,24,653 62,540 31,194 3,18,387

1997-98 2,84,127 66,080 29,583 3,79,790

1998-99 3,52,114 69,191 -3,146 4,18,159

1999-00 4,38,851 87,234 -9,238 5,16,847

2000-01 4,63,750 81,062 -29,266 5,15,545

2001-02 5,45,288 76,906 -36,820 5,85,374

2002-03 5,64,161 99,217 -7,148 6,56,230

2003-04 6,57,587 1,29,816 36,372 8,23,775

2004-05 7,63,785 2,12,519 74,499 10,50,703

2005-06 8,68,988 2,77,208 88,955 12,35,151

2006-07 9,94,396 3,38,584 1,52,929 14,85,909

2007-08 11,18,347 4,69,023 2,48,962 18,36,332

2008-09 13,30,873 4,17,467 54,280 18,02,620

2009-10 16,30,799 5,,40,955 10,585 21,82,338

2010-11 18,00,174 6,20,300 2,01,268 26,21,742

2011-12 20,54,737 6,58,428 1,11,295 28,24,459

Source: Government of India, Economic Survey 2014-15, Volume II, Ministry of Finance, Department

of Economic Affairs, February 2015, Oxford University Press, pp. A12-A13.

Both the public sector and the private corporate sector are net deficit spenders

who draw upon the savings of the household sector (the dominant saver in the

economy) to finance their spending. The households sector also borrows from other

sectors, which include mainly banks, cooperatives, term-lending institutions, and the

government.

82

The Table-3.1 presents the estimates of Gross Domestic Savings (GDS) in the

Indian economy over the years. The GDS which was `. 1,34,408 crores in 1990-91

witnessed a significant increase after the liberalisation of the economy as a whole and

the financial sector in particular. The GDS increased four-fold, i.e, `. 5,15,545 cores

in 2000-01. This was mainly because of the overcoming of the financial repressionist

policies and deregulating of interest rates and financial institutions. It has been

witnessing an increasing trend since then and was `. 28,24,459 crores in 2011-12 But

total GDS suffered a set-back in the backdrop of the global financial crisis which the

Indian economy witnessed during 2007-08 (from `. 18,36,332 to `. 18,02,620). The

household sector has been the main contributor to the GDS (`. 20, 54,737 crores in

2011-12), the next largest contribution comes from the private corporate sector

(`. 6,58,428).

The public sector comprising of the central and state governments,

departmental and non-departmental undertakings, and the RBI has been least

contributor to the total GDS. In 1998-2001, its contribution was negative to the total

GDS. Therefore, the public sector as said earlier, while defining the financial system,

has always been at the receiving end (seeking funds) rather than the giving end

(supplying funds). The trends in the Gross Domestic Savings have been shown by

using a line Graph-3.A. It shows that the role of the private corporate sector and the

public sector in contributing to the total GDS has been showing a mixed trend,

whereas, the household sector has kept up the tag of being the major contributor to

Gross Domestic Savings in India.

Graph-3.A: Trends in Estimates of Gross Domestic Savings of India

Source: Table-3.1

-500,000

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

Household Sector

83

3.2: Functions of Financial System

The principal function of financial intermediaries is to purchase primary

securities from ultimate borrowers and to issue indirect debt for the portfolios of

ultimate lenders. Although primary securities are their principal asset, financial

intermediaries also hold the indirect debt of other intermediaries and own tangible

assets as well.6

However, the financial system of a country performs certain valuable

functions for the economic growth of that country. The main functions of a financial

system may be briefly discussed as below:

1. Saving Function: An important function of a financial system is to mobilize

savings and channelize them into productive activities. It is through financial

system, savings are transformed into investments.

2. Liquidity Function: The most important function of a financial system is to

provide money and monetary assets for the production of goods and services.

Monetary assets are those assets which can be converted into cash or money

easily without loss of value. All activities in a financial system are related to

liquidity-either provision of liquidity or trading in liquidity.

3. Payment Function: The financial system offers a very convenient mode of

payment for goods and services. The cheque system and credit card system are

the easiest methods of payment in the economy. The cost and time of

transactions is considerably reduced.

4. Risk Function: The financial markets provide protection against life, health and

income risks. These guarantees are accomplished through the sale of life, health

insurance and property insurance policies.

5. Information Function: A financial system makes available price-related

information. This is a valuable help to those who need to take economic and

financial decisions. Financial markets disseminate information for enabling

participants to develop an informed opinion about investment, disinvestment,

reinvestment or holding a particular asset.

6 Gurley J G and E S Shaw (1960), Money in a Theory of Finance, The Brookings Institutions, Washington D.C., p.94.

84

6. Transfer Function: A financial system provides a mechanism for the transfer

of the resources across geographic boundaries.

7. Reformatory Functions: A financial system undertakes the functions of

developing, introducing innovative financial assets/instruments services and

practices and restructuring the existing assets, services etc, to cater to the

emerging needs of borrowers and investors (financial engineering and re-

engineering).

8. Other Functions: It assists in the selection of projects to be financed and also

reviews performance of such projects periodically. It also promotes the process

of capital formation by bringing together the supply of savings and the demand

for investible funds.

3.3: Financial System and Economic Growth

The process of economic development requires as one of its accompanying

structural changes in the economy, the development of a capital market which will

provide an adequate and properly distributed supply of finance to the entrepreneurs

setting up new industrial plants or thinking of expanding or modernising the already

established one. 7 While finance itself produces no output, but it enables the

entrepreneurs to gain control over real resources which enable them to engage in

industry by producing and distributing industrial products. At an early stage of

development, the would-be entrepreneurs normally find their own financial resources

inadequate and resort to external sources. Such finances are made available by the

financial intermediaries.

The adequate capital formation is sin-qua-non for speedy economic

development. The process of capital formation involves three distinct, although inter-

related activities.8

a) Savings, the ability by which claims to resources are set aside and so become

available for other purposes.

b) Finance, the activity by which claims to resources are either assembled from

those released by domestic savings or obtained from abroad or specially

created as bank deposits or notes and then placed in the hands of investors.

c) Investment, the activity by which resources are committed to production.

7 Sethuraman T V (1970), Institutional Finance and Economic Development in India, Vikas Publications, New Delhi.

8 Op.cit, Khan M Y, p.4.

85

The volume of capital formation depends upon the intensity and efficiency

with which these activities are carried on. Financial system helps to promote these

activities.

In the process of capital formation, financial system helps not only in effective

mobilisation of savings from a large number of scattered masses and canalisation of

these savings into the most desirable and productive forms of investment but also

affect the growth of real savings through their numerical spread over sections of

population approached, accessibility, popularity, nature and extent of facilities offered

and the rate of interest paid on deposits. The financial system, thus, helps to promote

the process of capital formation by bringing together the supply of savings and

demand for investible funds.9

In a modern economy, which is characterised by money exchange, the bulk of

the investors are business firms, while the prime savers are the households. Business

firms desiring funds for investment can and do borrow some of what they need

directly from savers by selling to them stocks and bonds, but many savers are

unwilling to lend their money directly to business in exchange for these types of

financial claims. In such a situation, some intermediary is needed to bring the deficit

and surplus units together. Indeed, this is the prime role of financial system.

Financial system not only helps in mobilisation and collection of scattered

savings from different sections of population, but they also help to increase the overall

level of savings and investment and allocate more efficiently scarce savings among

most desirable and productive investments in accordance with the national priorities.

There is another important angle to the role of financial system in economic

development, particularly of banks, which has been popularised by distinguished

economists like Schumpeter, Kalecki and Keynes. To Schumpeter, bank credit plays

a critical role in stimulating economic development. According to him, "created

credit" enables an entrepreneur to proceed with his innovation in anticipation of

savings. He wrote, "the banker, therefore, is not so much primarily a middleman in

the commodity 'purchasing power', as a producer of this commodity". 10 Newly

9 Joshi M S (1965), Financial Intermediaries in India, P.C. Manaktala and Sons Pvt. Ltd., Bombay, p. 29.

10 Schumpeter, J A (1949), The Theory of Economic Development, Harvard University Press, p. 74

86

created purchasing power by banks placed in the hands of the entrepreneur enables

him to secure command over physical resources and thus push through his investment

projects. Once the investment results in increased production, the initial credit

inflation disappears and the equivalence between money and commodities streams is

restored. Both Kalecki and Keynes regarded the availability of finance as a key factor

in ensuring independence of investment from savings. Schumpeter had vehemently

emphasised the crucial role of credit institutions in the financing of innovations and

thus facilitating economic development.

Besides performing the financial functions, financial system also provides

entrepreneurial assistance to the loanee concerns/ individual entrepreneurs/ projects,

and the system also act as an agency for securing foreign technical advice, and raising

funds from the capital markets of advanced countries. The intermediaries also

facilitate the expansion of markets through distributive techniques and undertake

other promotional jobs of an essential nature, such as, marketing and investment

research surveys, techno-economic feasibility and cost-benefit studies of different

growth sectors or a region, particularly the backward regions of the country so as to

identify the potential for economic growth.

Adequate financial resources are vital for increasing the pace of

industrialisation and, therefore, the existence of suitable agencies to mobilise and

develop resources that are internally available becomes necessary. It is at this stage,

that financial system comes into the picture. While financial system is not only an

engine of growth, it also acts as a growth inducing factor in desirable directions.

In a rudimentary economy, where there are no financial systems, there are

restraints on savings, on capital accumulation and on efficient allocation of savings to

investment. These factors act as an impediment to the growth of output and income.

This is true of developing countries where financial system is generally immature and,

therefore, acts as an obstacle to economic growth. In a developed financial system,

the efficient operation of specialised financial institutions can raise savings and

investment above the level that would have occurred had there been no such

institutions. In addition, by bringing about a better allocation of investment, the

productivity of capital is improved and this promotes the 'real' economic growth of

country.

87

In developing countries, availability of finance is one of the important

bottlenecks in the process of rapid economic development. Since personal savings are

meagre due to lower per capita income in these countries, the chances of increasing

the rate of savings appear to be poor. However, much can be done by putting greater

emphasis on institutionalisation of savings.11 Therefore, one of the most pressing

needs of the developing countries is to promote financial integrity, establish effective

and cheap protection for rights of creditors and create financial institutions through

which the savings of the community can be increased and effectively channelled into

the hands of investors. Further, in the developing countries, institutional arrangements

for the mobilisation and channelling of financial resources must be continuously

expanded and adopted to the growing and varied needs of the economy. But

whatever said, the important role of a financial system in any economy can be best

understood with the help of Chart-3.(ii).

Chart -3.(ii): Financial System and Economic Growth

and

Primary Securities Primary

Securities

Note: + (Surplus) Where Y = Income

- (Deficit) C = Consumption

I = Planned Investment

Source: Bharati V. Pathak (2012), The Indian Financial System: Markets, Institutions and Services, p.16.

11 Memorandum of IBRD to the Report of U.N. on , Methods of Financing Economic Development in Underdeveloped

Countries, 1949, New York.

Financial Intermediaries (+/-)

(Banks and Financial Institutions

Ultimate Lenders (+)

Ultimate Borrowers (-)

Financial Markets

Financial System

Surplus-spending Economic

Units Y>(C+I)

Householder Sector

Rest of the World

Capital Formation

Deficit-spending

Economic Units Y<(C+I)

Government

Corporate'

Economic Growth

Secondary Securities Primary Securities

88

Chart-3.(ii) very clearly shows the role of an efficient financial system in

achieving economic growth. For the surplus spending units i.e., household sector, and

rest of the world, income (Y) is greater than the combination of consumption and

planned investment, hence they become the ultimate lenders in the economy. The

deficit spending units like the government and corporate experience a function of Y<

(C+I), that is income is less than the sum of consumption and planned investment and

eventually they are the ultimate borrowers. The job of efficiently linking these

economic units is done in a systemic and organised manner by the financial system.

Besides linking savings and investment, the financial system helps in accelerating the

rate of savings and investment by offering diversified financial services and

instruments. This promotes a larger production of goods and services in the economy,

leading to economic growth.

3.4: Evolution of Financial System in India

In the 1950s and 1960s, Gurley and Shaw (195512, 196013) and Goldsmith

(1969)14 discussed the stages in the evolution of financial systems. According to

them, there is a link between per capita income and the development of a financial

system. At low levels of development, most investment is self-financed and financial

intermediaries do not exist, as the costs of financial intermediation are relatively high

compared to benefits. As countries develop and per capita income increases, bilateral

borrowing and lending take place, leading to the birth of financial intermediaries. The

number of financial intermediaries grows with further increases in per capita income.

Among the financial intermediaries, banks tend to become larger and prominent in

financial investment. As countries expand economically, non-bank financial

intermediaries and stock markets grow in size and tend to become more active and

efficient compared to banks. There is a general tendency for a financial system to

become more market-oriented as countries become richer.

The evolution of the Indian financial system from somewhat of a constricted

and an undersized one to a more open, deregulated and market oriented one and its

interface with the growth process is due to the turning points in its history. The

12 Gurley John G and Edward Stone Shaw (1955), "Financial Aspects of Economic Development", The American Economic

Review, Volume XLV, No. 4, September, (pp 515-538).

13 Gurley John G and Edward Stone Shaw (1960), Money in a Theory of Finance, Washington D.C., Brookings Institution.

14 Goldsmith W Raymond (1969), Financial Structure and Development, Yale University Press, Princeton N.J, p.7.

89

evolution of financial system in India owes much to its locational advantage providing

geopolitical and commercial avenues. During the colonial days too, it served as an

entrepot for regions and for the flourishment of trade. The process of financial

development in independent India hinged effectively on the development of

commercial banking, with the impetus given to industrialisation based on the

initiatives provided in the five year plans. Financing of emerging trade and industrial

activities during the 'fifties' and the 'sixties' reflected the dominance of banking as the

critical source. The First Five Year Plan Document15 emphasised that as part of price

policy, both financial and physical controls were necessary. It also recognised the

importance of the creation of financial infrastructure by the central bank in the

development process. The First five Year Plan Document stated that "Central

banking in a planned economy can hardly be confined to the regulation of overall

supply of credit or to a somewhat negative regulation of the flow of bank credit. It

would have to take on a direct and active role, firstly in creating or helping to create

the machinery needed for financing developmental activities all over the country and

secondly ensuring that the finance available flows in the direction intended"16.

In 1954, the Parliament of India declared "socialistic pattern of society" as the

basic objective of economic policy wherein the "basic criterion for determining lines

of advance must not be private profit, but social gain and that the pattern of

development and the structure of socio-economic relatives should be so planned that

they result not only in appreciable increase in national income and employment but

also in greater equality in incomes and wealth. Major decisions regarding production,

distribution, consumption and investment - and in fact all significant social economic

relationships - must be made by agencies informed by Social Purpose.17

However, the turning point was the nationalisation of Reserve Bank of India

and the enactment of the Banking Regulation Act in 1949. The number of banks and

branches had gone up, notwithstanding the consolidation of small banks, and the

support given to co-operative credit movement. Functionally, banks catered to the

needs of the organised industrial and trading sectors. The primary sector consisting of

'agriculture, forestry and fishing', which formed more than 50 per cent of GDP during

15 Government of India, First Five Year Plan Document (1950), Planning Commission, p. 37

16 Ibid, First Five Year Plan (1950), p. 38.

17 Government of India, Second Five Year Plan (1956), Planning Commission, p. 21.

90

this period had to depend largely on self financing and on sources outside the

commercial banks like money lenders and indigenous bankers. It is against this

backdrop that the process of financial development was given impetus with the

adoption of the policy of social control over banks in 1967, further reinforced in 1969

by the nationalisation of 14 major scheduled commercial banks. Since then, the

banking system has formed the core of the Indian Financial system. Driven largely by

public sector initiative and policy activism, commercial banks have a dominant share

in the total financial assets and are the main source of finance for the private corporate

sector. They also channel a sizeable share of household savings to the public sector.

Besides, in recent years, they have been performing most of the payment system

functions. With increased diversification in recent years, banks in both public and

private sectors have been providing a wide range of financial services.

In the three decades following the first wave of bank nationalisation (the

second wave consisted of six commercial banks in 1980), the number of scheduled

commercial banks has quadrupled and the number of bank branches has increased

eight-fold. Aggregate deposits of scheduled commercial banks have also increased.

The financial system outside the banks has also exhibited considerable dynamism.

The system today is varied, with a well-diversified structure of financial institutions,

financial companies and mutual funds. The setting up of some specialised financial

institutions and refinance institutions during last three decades and the onset of

reforms from about the early nineties, provided depth to financial intermediation

outside the banking sector. These developments, coupled with increased financial

market liberalisation, have enhanced competition. Financial development is also

reflected in the growing importance of mutual funds. Capital markets themselves

have become an important source of financing corporatized investments.

Financial development in the banking and non-banking financial sector has

supported saving and investment in the economy and contributed to economic growth.

By pooling risks, reaping economies of scale and scope, and by providing maturity

transformation, financial intermediation supports economic activity of the non-

financial sectors.

91

3.5: Structure of Indian Financial System

Financial structure refers to shape, components and their order in the financial

system. A well-structured financial system is a precondition to economic growth. The

structure of the financial system becomes important in determining the nature of

growth. The Indian financial system has made rapid strides in facilitating

intermediation, innovation of new instruments and institutions. The structure of

Indian Financial System is depicted in (Chart-3.(iii)). It can be broadly classified into

the formal (organised) financial system and the Informal (unorganised) financial

system. The formal financial system comes under the purview of the Ministry of

Finance (MoF), the Reserve Bank of India (RBI), the Securities and Exchange Board

of India (SEBI) and other regulatory bodies. The informal financial system consists

of:

Individual moneylenders such as neighbours, relatives, landlords, traders, and

storeowners.

Groups of persons operating as 'funds' or 'associations'. These groups function

under a system of their own rules and use names such as 'fixed fund',

'association', and 'saving club'.

Partnership firms consisting of local brokers, pawnbrokers, and non-bank

financial intermediaries such as finance, investment, and chit-fund companies.

92

Chart-3.(iii): STRUCTURE OF INDIAN FINANCIAL SYSTEM

I. Formal or Organised Financial System II. Informal or Unorganised Financial System

1. Financial Institutions and Financial Intermediaries 2. Financial Markets

3. Financial Instruments 4. Financial Services

Money Lenders Pawn Brokers

Traders Land Lords Local Banks

(i) Banking Institutions

(ii) Non-Banking Institutions

(iii) Mutual Funds (iv) Insurance &

Housing Finance Companies

Public Sector

Private Sector

Scheduled Commercial Banks

Scheduled Cooperative Banks

NBFC's Development Financial Institutions

Public Sector Banks

Private Sector Banks

Foreign Banks

in India

RRB's

All India Financial Institutions: IFCI, IDBI, SIDBI, IDFC,

NABARD, EXIM BANK, NHB

State Level F.I's: SFC's,

SIDC's

Other F.I's ECGC, DICGC

(a) Capital Market (b) Money Market

Equity Market Debt Market

Treasury Bills Call Money Market Commercial Bills

Commercial Papers Certificates of

Deposit Term Money

Primary Market Secondary Market

Derivatives Market

Public Issues Private Placement

Domestic Market International Market

NSE BSE ISE

Regional Stock Exchanges

Exchanges Traded futures and Options

Stock Index

Private Corporate Debt PSU Bond Market

Government Securities Market

Secondary Primary

Secondary Segment

Primary Segment

Depositories Custodial

Credit Rating Factoring

Merchant Banking Leasing

Hire Purchase Portfolio Management

Underwriting

Type Term

Time Deposits Mutual Fund Units Insurance Policies

Equity Preference Debt

and Various combinations

Secondary Securities

Primary Securities

Short Medium

Long

RBI : Reserve Bank of India IRDA : Insurance Regulatory & Development Authority MoF : Ministry of Finance SEBI : Securities and Exchange Board of India NBFCs : Non-Banking Financial Companies RRBs : Regional Rural Banks IFCI : Industrial Finance Corporation of India IDBI : Industrial Development Bank of India SIDBI : Small Industries Development Bank of India IDFC :Infrastructure Development Finance Company NABARD :National Bank for Agriculture & Rural Development EXIM BANK :Export Import Bank of India NHB :National Housing Bank SFCs :State Financial Corporation SIDCs :State Industrial Development Corporation ECGC :Export Credit Guarantee Corporation of India Limited DICGC :Deposit Insurance and Credit Guarantee Corporation. NSE :National Security Exchange BSE :Bombay Security Exchange ISE :International Stock Exchange PSU : Public Sector Units

Indian Financial System

Source: Pathak, Bharti V, (2009) The Indian Financial System, p.4

92

93

3.5.(i): Financial Institutions

The formal financial system in India consists of four components i.e., (i)

Financial Institutions, (ii) Financial Markets, (iii) Financial Instruments and (iv)

Financial Services. The Institutional structure of the Indian financial system is shown

in Chart 3.(iv)

Chart-3.(iv): Institutional Structure of Indian Financial System

Source: Chart-3.(iii).

Financial Institutions are intermediaries that mobilise savings and facilitate the

allocation of funds in an efficient manner. Financial institutions can be classified as

banking and non-banking financial institutions. Banking institutions are creators and

purveyors of credit while non-banking financial institutions are purveyors of credit.

While the liabilities of banks are part of the money supply, this may not be true of

Indian Financial System

I. Financial Institutions and Financial Intermediaries

Banking Institutions

Non-Banking Institutions

Mutual Funds

Public Sector

Private Sector

Insurance & Housing Finance

Companies

Scheduled Commercial Banks

Scheduled Cooperative

Banks Non-Bank Financial Companies

Development Financial Institutions

Public Sector Banks

Private Sector Banks

Foreign Banks in

India

Regional Rural Banks

All India F.I.s: IFCI, IDBI, SIDBI, IDFC, NABARD,

EXIM BANK, NHB

State Level F.I's: SFC's,

SIDC's

Other F.I's

ECGC, DICGC

94

non-banking financial institutions. In India, non-banking financial institutions,

namely, the Developmental Financial Institutions (DFIs), and Non-Banking Financial

Companies (NBFCs) as well as Housing Finance Companies (HFCs) are the major

institutional purveyors of credit. The role of the financial institutions can be well-

understood with the help of Table-3.2.

Table- 3.2 Financial Assistance Sanctioned and Disbursed by Financial Institutions

(2004 – 2005 to 2011 – 2012)

(Amount in Crores)

Category

All - India

Term Lending

Institutions*

Specialized

Financial

Institutions#

Investment

Institutions@

Total Assistance by

Financial

Institutions

(2+3+4)

Percentage

variation

1 2 3 4 5 6

Year S D S D S D S D S D

2004-05 9,091 6,279 111 72 10,404 8,972 19,606 15,323

2005-06 11,975 9,287 133 88 15,558 11,771 27,666 21,146 41 38

2006-07 11,102 10,225 0 0 18,862 27,757 29,964 37,982 12.9 82.8

2007-08 18,696 17,379 366 189 39,670 28,460 58,732 46,028 86.2 14.6

2008-09 33,232 31,629 597 283 71,400 62,357 1,05,229 94,269 70.2 93.3

2009-10 42,552 37,987 590 320 63,637 53,762 1,06,779 92,069 3.4 -0.9

2010-11 48,010 47,200 900 500 45,000 40,100 1,00,400 87,800 2.9 14.15

2011-12 54,500 47,490 1,090 850 54,410 51,970 1,03,510 1,00,310 -5 -4.5

Note: S = Sanctions, and D = Disbursements

* Relating to IFCI, SIDBI and IIBI

# Relating to IVCF, ICICI Venture and TFCI.

@ Relating to LIC and GIC and erstwhile subsidiaries (NIA, UIIC and OIC)

Source: Reserve Bank of India, Report on Trend and Progress of Banking India, Compiled from

various issues

The Development Financial Institutions (DFIs) were established in India to

resolve a typical market inadequacy problem, viz., the shortage of long-term resources

and the perceived risk aversion of savers and creditors to part with funds of long

gestation projects. In view of the inadequate provision of long term finance through

banks and markets, many of these institutions were established by the government.

The endorsement of planned industrialisation at the national level provided critical

inducement for the establishment of DFIs at both the all-India and state levels.

95

Besides DFIs at both the all-India and state levels, there are also investment

institutions and specialised financial institutions. These institutions provided financial

assistance in the form of term loans, underwriting/direct subscription to

shares/debentures and guarantees.18 There has been a secular increase in the sanctions

and disbursements (Table 3.2) of financial institutions. Financial assistance

sanctioned and disbursed by AIFIs exhibited a steady trend in 2005-06. The gap

between sanctioned and disbursed amounts also narrowed down. During 2006-07, the

disbursements were larger than the sanctions. The financial assistance sanctioned by

financial institutions accelerated sharply during 2007-08 as against the deceleration

witnessed during the previous year. The acceleration in sanctions was accounted for

mainly by investment institutions especially LIC. Therefore, on balance even though

both financial assistance sanctioned and disbursed by financial institutions increased

during 2007-08, the increase was more pronounced in respect of sanctions (86.2 per

cent) than the disbursements (14.6 per cent). However, the sanctions and

disbursements sharply increased during 2008-09 as compared to that in the previous

year. A major part of the increase in this was accounted for mainly by investment

institutions.

During 2008-09, though there was increase in both financial assistance

sanctioned and disbursed by financial institutions, the increase in disbursements (93.3

per cent) was more pronounced than the sanctions. Although the financial assistance

sanctioned by financial institutions increased marginally during 2009-10, there was a

decline in the disbursements made by these institutions during the year. This was on

account of a decline in the disbursements made by investment institutions mainly

LIC. There was again a decline in both sanctions and disbursements during 2010-11,

and this was mainly due to the decline in sanctions and disbursements made by

investment institutions especially LIC. There was an increase in financial assistance

by financial institutions during 2011-12 due to increase in sanctions and

disbursements made by investment institutions such as LIC and GIC and specified

financial institutions such as IVCF and TFCI. However, sanctions and disbursements

made by IFCI have declined in 2011-12. The total assistance by financial institutions

has been depicted in Graph-3.B.

18 Reserve Bank of India, Report on Currency and Finance, 1999-2000.

96

Graph-3.B: Financial Assistance Sanctioned and Disbursed by Financial Institutions

Source: Table-3.2.

3.5.(ii): Banking Institutions

Banking institutions mobilise the savings of the people. They provide a

mechanism for the smooth exchange of goods and services. They extend credit while

lending money. They not only supply credit but also create credit. There are two

basic categories of banking institutions. They are Scheduled Commercial Banks,

Scheduled Co-operative Banks. The banking system in India consists of scheduled

commercial banks and scheduled cooperative banks, but it is the former which is

dominant in terms of deposits, advances and investments. Commercial banks include

foreign banks operating in India in addition to Indian banks in the public sector and

the private sector, including regional rural banks. Since 1969, after nationalisation of

14 banks, commercial banks have made rapid strides in all the spheres of banking

operations. Be it, the mobilisation of deposits, deployment of credit or geographical

coverage they have accounted for most of the growth in the banking system.

0

20000

40000

60000

80000

100000

120000

2004-052005-062006-072007-082008-092009-102010-112011-12

Sanction

Disbursement

97

Table-3.3 Progress of Commercial Banking In India (2011 – 2012 end March)

Indicators 2001 2002 2003 2004 2005 2006

No. of Commercial Banks 300 297 292 290 289 222

No. of Bank Offices in India 67937 68195 68500 69170 70373 71685

Population per Office (in 000's) 15 15 16 16 16 16

Aggregate deposits of Scheduled Commercial Banks

in India (`. in Crores) 989141 1131188 1311761 1504416 1700198 2109049

Credit of Scheduled Commercial Banks in India

(` crore) 529271 609053 746432 840785 1100428 1507077

Investment of Scheduled Commercial Banks in India

(` crore) 367184 437482 547546 677588 739154 717454

Deposits of Scheduled Commercial Banks per office

(` Lakhs) 1456 1659 1925 2265 2574 3047

Credit of Scheduled Commercial Banks per Office

(` Lakhs) 779 893 1143 1330 1700 2209

Per capita Deposits of Scheduled Commercial

Banks(`) 9770 11008 12253 14089 16281 19130

Per capita Credit of Scheduled Commercial Banks (`) 5228 5927 7257 8273 10752 13869

Deposits of Scheduled Commercial Banks as per of

National Income (NNP at Factor Cost, at current

prices)

56.0 54.4 58.8 59.4 60.0 65.4

Scheduled Commercial Banks' Advances to Priority

Sector (` crore) 182255 205606 254648 263834 381476 510175

Credit Deposit Ratio (per cent) 53.5 53.8 56.9 55.9 62.6 70.1

Investment Deposit Ratio (per cent) 37.1 38.7 41.3 45.0 47.3 40.0

Cash Deposit Ratio (per cent) 8.4 7.1 6.3 7.2 6.4 6.7

Indicators 2007 2008 2009 2010 2011 2012

No. of Commercial Banks 183 174 170 167 167 173

No. of Bank Offices in India 74346 78666 82408 88203 94019 101261

Population per Office (in 000's) 15 15 14 14 13 13

Aggregate deposits of Scheduled Commercial Banks

in India (`. in Crores) 2611934 3196940 3834110 4492826 5207969 5909082

Credit of Scheduled Commercial Banks in India (`

crore) 1931190 2361913 2775549 3244788 3942083 4611852

Investment of Scheduled Commercial Banks in India

(` crore) 791516 971714 116410 1384753 1501619 1737787

Deposits of Scheduled Commercial Banks per office

(` Lakhs) 3675 4344 4980 548 609 643

Credit of Scheduled Commercial Banks per Office (`

Lakhs) 2757 3222 3615 398 458 502

Per capita Deposits of Scheduled Commercial

Banks(`) 23382 28610 34372 39107 45505 51106

Per capita Credit of Scheduled Commercial Banks (`) 17541 21218 24945 28431 34187 39909

Deposits of Scheduled Commercial Banks as per of

National Income (NNP at Factor Cost, at current

prices)

70.1 74.4 78.1 74.2 73.6 72.5

Scheduled Commercial Banks' Advances to Priority

Sector (` crore) 632647 738686 932459 1091510 1315859 147133

Credit Deposit Ratio (per cent) 73.5 74.6 73.9 73.7 76.5 78.6

Investment Deposit Ratio (per cent) 35.3 35.5 35.7 36.4 34.3 34.6

Cash Deposit Ratio (per cent) 7.2 9.7 7.3 7.7 8.2 5.8

Note:(1) Number of bank offices includes Administrative Offices

(2) Classification of bank offices according to population, for years upto March 2004 it is based on 1991 census.

(3) Population per office, per capita deposits and per capita credit are based on the estimated

population figures as on March 1, supplied by the Office of the Registrar General, India.

(4) For working out cash-deposit ratio, cash is taken as the total of 'cash in hand' and 'balances with the Reserve

Bank of India'.

(5) Investments of Scheduled Commercial Banks in India include only investments in government securities and

other approved securities.

Source: Reserve Bank of India, Statistical Tables relating to Banks in India 2008-09 & 2011-12

98

Table 3.3 gives a clear picture of trends and progress of banking in India.

Illustratively, while the number of scheduled commercial banks has gone up

moderately until 2006 (222 branches) but thereafter it started declining, by 2012 there

were only 173 commercial banks. The number of bank branches has increased

manifold over the years, as a result of which the population per bank office improved

from 15,000 to 13,000 over the period. Both per capita deposit and per capita credit

has witnessed a rapid growth. While the deposit expanded from `. 9,770 in 2001 to

`.51,106 in 2012. The increase in other indicators like advances to priority sector,

credit-deposit ratio, investment-deposit ratio and cash-deposit ratio too was more

pronounced.

3.5.(iii): Non-Banking Institutions

The Non-Banking Financial Institutions also mobilize financial resources

directly or indirectly from the people. They lend the financial resources mobilized.

They lend funds but do not create credit. Companies like LIC, GIC, UTI,

Development Financial Institutions, Organisation of pension and Provident Funds etc.

fall in this category. The other non-banking financial institutions can be categorized

as investment companies, housing companies, leasing companies, hire purchase

companies, specialized financial institutions (EXIM Bank etc.) investment

institutions, state level institutions etc.

Non-Banking Financial Companies (NBFCs) have emerged as an important

part of the Indian Financial System. These companies have grown rapidly in the

second half of the eighties and the first half of the nineties (Table-3.4). The number

NBFCs registered with the RBI which was 13,815 in 2001 came down to 12,409 in

2012 on account of resistance by the banking sector. The number of reporting

companies also reduced. However, there was an increase in the total assets of the

companies (from `. 53,878 crores during 2001 to `. 1,16,897 crores during 2011). The

public deposits with the companies decreased to `. 11,964 in 2011 from `. 18,085 in

2001. However, the net owned fund has witnessed a steady growth over the years.

99

Table-3.4: Profile of Non-Bank Finance Companies in India (2001-2011 end-March)

(Amount ` in Crores)

Year No. of COs registered

with RBI@

No. of

Reporting

Companies

Total

Assets*

Public

Deposits*

Net Owned

Fund*

2001 13,815 981 53,878 18,085 4,943

2002 14,077 910 58,290 18,822 4,383

2003 13,849 875 58,071 20,100 7,950

2004 13,764 981 53,878 8,085 4,943

2005 13,261 573 52,900 20,246 5,510

2006 13,014 466 57,453 22,842 6,663

2007 12,968 362 71,171 24,665 8,601

2008 12,809 364 94,744 24,395 12,261

2009 12,740 336 97,408 21,548 13,458

2010 12,630 308 1,12,131 17,352 16,424

2011 12,409 297 1,16,897 11,964 17,975

@ This includes all NBFCs (both deposit taking and non-deposit taking)

* NBFCs include Deposit taking NBFCs (NBFCs-D), Mutual Benefit Financial Companies

(MBFCs) (Notified Nidhis), Mutual Benefits Companies (MBCs) (Potential Nidhis) etc. till

2004-05 and only NBFCs-D thereafter

Source: Karunagaran, (2011), "Inter-connectedness of Banks and NBFCs in India: Issues and Policy

Implications, RBI Working Paper Series, WPS (DEPR): 21/2011

3.5.(iv): Mutual Funds

Mutual funds provide households an option for portfolio diversification and

relative risk-aversion through collection of funds from the households and make

investments in the stock and debt markets. Table 3.5 gives data related to the net

resources mobilised by mutual funds.

UTI was the only mutual fund until 1987-88. As shown in Graph-3.C, the

resource mobilisation of UTI was 3.22 billion in 2000-0. It has been witnessing some

variation since then and was 46.29 billion in 2012-13. The bank sponsored mutual

funds and financial institution sponsored mutual funds also witnessed several

variations over the period. The private sector mutual funds commercial operations in

1993-94, and their growth though disappointing in some years, has been relatively

better than the others.

100

Table-3.5: Trends and Composition of Resources Mobilised by

Mutual Funds in India 2000-2001 to 2012-2013 (Amount ` in Billions)

Year UTI Bank-sponsored

mutual Funds

FI-sponsored

mutual funds

Private Sector

mutual funds Total

2000-01 3.22 2.49 12.73 92.92 111.36

2001-02 -72.84 8.63 4.06 161.34 101.19

2002-03 -94.34 10.33 8.61 121.22 45.82

2003-04 10.50 45.26 7.87 415.10 478.73

2004-05 -24.67 7.06 -33.84 79.33 27.88

2005-06 34.24 53.65 21.12 415.81 524.82

2006-07 73.26 30.33 42.26 794.77 940.62

2007-08 106.78 75.97 21.78 1382.24 1586.77

2008-09 -41.12 44.89 59.54 -305.38 -242.08

2009-10 156.53 98.55 48.71 479.68 783.47

2010-11 -166.33 13.04 -169.88 -162.81 -486.00

2011-12 -31.79 3.89 -30.98 -395.25 -454.13

2012-13 46.29 67.08 22.41 652.84 788.62

Source: Reserve Bank of India, Handbook of Statistics on Indian Economy, 2014-15, p.139

Graph-3.C: Resources Mobilised by Mutual Funds in India

Source: Table-3.5.

There are state-level financial institutions such as the State Financial

Corporations (SFCs) and State Industrial Development Corporations (SIDCs) which

are owned and managed by the State Governments.

-1000

-500

0

500

1000

1500

2000

Private Sector mutual funds

FI-sponsored mutual funds

Bank-sponsored mutual Funds

UTI

101

In the post-reforms era, the role and nature of activity of these financial

institutions have undergone a tremendous change. Banks have now undertaken non-

bank activities and financial institutions have taken up banking functions. Most of the

financial institutions now resort to financial markets for raising funds.

3.5.(v): Financial Markets

Financial Markets are a mechanism enabling participants to deal in financial

claims. The markets also provide a facility in which their demands and requirements

interact to set a price for such claims.

The main organised financial markets in India are the money market and the

capital market. The first is a market for short-term securities while the second is a

market for long-term securities, i.e., securities having a maturity period of one year or

more.

Financial markets can also be classified as primary and secondary markets.

While the primary market deals with new issues, the secondary market is meant for

trading in outstanding or existing securities. There are two components of the

secondary market: Over-The-Counter (OTC) market and the exchange traded market.

The government securities market is an OTC market. In an OTC market, spot trades

are negotiated and traded for immediate delivery and payment while in the exchange-

traded market, trading takes place over a trading cycle in stock exchanges. Recently,

the derivatives market (exchange traded) has come into existence. The market

structure of Indian financial system is depicted in Chart-3.(v).

The role of stock markets as a source of economic growth has been widely

debated. It is well-recognised that stock markets influence economic activity through

the creation of liquidity. Liquid financial market was an important enabling factor

behind most of the early innovations that characterised the early phases of the

Industrial Revolution. Recent advancements in this area reveal that stock markets

remain an important conduit for enhancing development. Many profitable

investments necessitate a long-term commitment of capital, but investors might be

reluctant to relinquish control of their savings for long period. Liquid equity markets

make investments less risky and more attractive. At the same time, companies enjoy

permanent access to capital raised through equity issues. By facilitating long-term

102

and more profitable investments, liquid markets improve the allocation of capital and

enhance the prospects for long-term economic growth. Furthermore, by making

investments relatively less risky, stock market liquidity can also lead to more savings

and investments.

Chart-3.(v): Market Structure of Indian Financial System

Source: Chart-3.(iii)

Over the years the stock market in India has become strong. The number of

stock exchanges increased from 8 in 1971 to more than 20 at present. The number of

listed companies also moved up. The market capitalisation (Table 3.6) which is also

the market value is the share price times the number of shares outstanding as a

percentage of GDP has decreased from 106.9 per cent in 2000-01 to 40.3 per cent in

2011-12, it further decreased to 33.98 per cent in 2012-13 on account of the variations

in the global stock markets. Though the Indian stock market was founded more than a

century ago, it remained quite dominant from independence in 1947. The traded total

value which refers to the total value of shares traded during the period. This indicator

complements the market capitalisation ratio by showing whether market size is

matched by trading. The stock market total value added as a percentage of GDP

increased considerably from 31 per cent in 2000-01 to 68.9 per cent in 2012-13.

Indian Financial System

2. Financial Markets

(a) Capital Market (b) Money Market

Equity Market

Debt Market

Primary Market

Secondary Market

Derivatives Market

Private Corporate Debt

PSU Bond Market Government

Securities Market

Treasury Bills Call Money Market Commercial Bills

Commercial Papers Certificates of Deposit

Term Money

Primary Segment

Secondary Segment

Primary Secondary

Public Issues Private

Placement

NSE, BSE ISE,

Regional Stock

Exchanges

Exchanges Traded

futures and Options

Domestic Market

International Market

Index Stock

103

Table-3.6: Trends in Stock Market Capitalization, Market Total Value Added,

and Total Market Turnover in India (1999-2000 to 2001-2013) (% of GDP)

Year Stock Market

Capitalisation

Market Total Value

Added Stock Market Turnover

1999-2000 59.72320863 39.54114403 192.4328054

2000-2001 106.9664639 31.06609065 306.4985616

2001-2002 50.46991652 22.34937167 192.9109363

2002-2003 37.62015402 25.00358409 163.3076907

2003-2004 46.05784123 45.13461809 138.8924827

2004-2005 52.53497239 53.74984695 113.6781516

2005-2006 52.01298009 66.29873555 92.22839492

2006-2007 67.27138751 86.27796876 93.07668278

2007-2008 89.41235748 146.8557212 83.96958555

2008-2009 85.75696131 52.7309352 85.18685682

2009-2010 79.75036079 86.36734427 119.3490404

2010-2011 61.85739045 94.57997625 75.61875695

2011-2012 40.31874225 55.30896656 56.2609347

2012-2013 33.98214639 68.96758629 54.63441212

Source: World Bank Data Repository.

Graph-3.D: Trends in Market Capitalization, Total Value Added and Turnover

Source: Table-3.6.

0

50

100

150

200

250

300

350

Stock Market Capitalisation

Market Total Value Added

Stock Market Turnover

104

However, the patterns of demand for capital have undergone significant

changes during the last two decades and improved stock market activity. With the

onset of the reforms process in the nineties, institutions had to raise resources at

market related rates. The turnover ratio which is the total value of shares traded

during the period divided by the average market capitalisation is calculated as the

average of the end-of-period values for the current period and the previous period.

The turnover ratio has been witnessing variations as from 192.9 per cent in 2001-02, it

has come down to 54.6 per cent in 2012-13, the global financial crisis and many

changes in the stock markets abroad have triggered the slowdown. These trends have

been clearly presented in the bar Graph-3.D.

Over the years, the Indian capital market has experienced a significant

structural transformation, in that it now compares well with those in developed

markets. This was deemed necessary because of the gradual opening of the economy

and the need to promote transparency in alternative sources of financing. The

regulatory and the supervisory structure has been overhauled with the powers for

regulating the capital market being vested with the Securities and Exchange Board of

India (SEBI).

3.5.(vi): Financial Instruments

A financial instrument is a claim against a person or an institution for

payment, at a future date, of a sum of money and/or a periodic payment in the form of

interest or dividend. The term 'and/or' implies that either of the payments will be

sufficient but both of them may be promised. Financial instruments represent paper

wealth shares, debentures, like bonds and notes. Many financial instruments are

marketable (Chart 3.(vi)) as they are denominated in small amounts and traded in

organised markets. This distinct feature of financial instruments has enabled people

to hold a portfolio of different financial assets which, in turn, helps in reducing risk.

Different types of financial instruments can be designed to suit the risk and return

preferences of different classes of investors.

Savings and investments are linked through a wide variety of complex

financial instruments known as 'securities'. Securities are defined in the Securities

Contracts Regulation Act (SCRA), 1956 as including shares, scrip's, stocks, bonds,

105

debentures, debenture stocks or other marketable securities of a similar nature or of

any incorporate company or body corporate, government securities, derivatives of

securities, units of collective investment scheme, security receipts, interest and rights

in securities, or any other instruments so declared by the central government.

Financial securities are financial instruments that are negotiable and tradable.

Financial securities may be primary or secondary securities. Primary securities are

also termed as direct securities as they are directly issued by the ultimate borrowers of

funds to the ultimate savers. Examples of primary or direct securities include equity

shares and debentures. Secondary securities are also referred to as indirect securities,

as they are issued by the financial intermediaries to the ultimate savers. Bank

deposits, mutual fund units, and insurance policies are secondary securities.

Financial instruments differ in terms of marketability, liquidity, reversibility,

type of options, return, risk, and transaction costs. Financial instruments help

financial markets and financial intermediaries to perform the important role of

channelising funds from lenders to borrowers. Availability of different varieties of

financial instruments helps financial intermediaries to improve their own risk

management.

Chart-3.(vi): Instruments Structure of Indian Financial System

Source: Chart-3-(iii)

Financial Instruments

Type Term

Time Deposits Mutual Fund Units Insurance Policies

Equity Preference Debt and Various

combinations

Secondary Securities

Primary Securities

Short Medium

Long

Indian Financial System

106

3.5.(vii): Financial Services

Services that help with borrowing and funding, lending and investing, buying

and selling securities, making and enabling payments and settlements, and managing

risk exposures in financial markets. The major categories of financial services are

funds intermediation, payments mechanism, provision of liquidity, risk management,

and financial engineering. (Chart 3.(vii))

Funds intermediating services link the saver and borrower which, in turn,

leads to capital formation. New channels of financial intermediation have come into

existence as a result of information technology. Payment services enable quick, safe,

and convenient transfer of funds and settlement of transactions.

Liquidity is essential for the smooth functioning of a financial system.

Financial liquidity of financial claims is enhanced through trading in securities.

Liquidity is provided by brokers who act as dealers by assisting sellers and buyers and

also by market markers who provide buy and sell quotes.

Financial services are necessary for the management of risk in the increasingly

complex global economy. They enable risk transfer and protection from risk. Risk

can be defined as a chance of loss. Risk transfer of services help the financial market

participants to move unwanted risks to others who will accept it. The speculators who

take on the risk need a trading platform to transfer this risk to other speculators. In

addition, market participants need financial insurance to protect themselves from

various types of risks such as interest rate fluctuations and exchange rate risk.

Growing competition and advances in communication and technology have

forced firms to look for innovative ways for value creation. Financial engineering

presents opportunities for value creation. These services refer to the process of

designing, developing, and implementing innovative solutions for unique needs in

funding, investing, and risk management. Restructuring of assets and/or liabilities,

off balance sheet items, development of synthetic securities, and repackaging of

financial claims are some examples of financial engineering.

107

The producers of these financial services are financial intermediaries, such as,

banks, insurance companies, mutual funds, and stock exchanges. Financial

intermediaries provide key financial services such as merchant banking, leasing, hire

purchase, and credit-rating. Financial services rendered by the financial

intermediaries bridge the gap between lack of knowledge on the part of investors and

the increasing sophistication of financial instruments and markets. These financial

services are vital for creation of firms, industrial expansion, and economic growth.

Before investors lend money, they need to be reassured that it is safe to

exchange securities for funds. The financial regulator who regulates the conduct of

the market and intermediaries to protect the investors' interests provides this

reassurance. The regulator regulates the conduct of issuers of securities and the

intermediaries to protect the interests of investors in securities and increases their

confidence in markets which, in turn, helps in the growth and development of the

financial system. Regulation is necessary not only to develop a system, but a system

once developed needs to be regulated. The RBI regulates the money market and the

SEBI regulates the capital market. The securities market is regulated by the

Department of Economic Affairs (DEA), the Department of Company Affairs (DCA),

the RBI, and the SEBI. A high-level committee on capital and financial markets

coordinates the activities of these agencies.

Chart-3.(vii): Services Structure of Indian Financial System

Source: Chart-3.(iii)

Financial Services

Depositories Custodial Credit Rating

Factoring Merchant Banking

Leasing Hire Purchase

Portfolio Management Underwriting

Indian Financial System

108

3.6: Interaction among Financial System Components

The four financial system components discussed do not function in isolation.

They are interdependent and interact continuously with each other. Their interaction

leads to the development of a smoothly functioning financial system19.

Financial institutions or intermediaries mobilise savings by issuing different

types of financial instruments which are traded in the financial markets. To facilitate

the credit-allocation process, these institutions acquire specialisation and render

specialised financial services.

Financial intermediaries have close links with the financial markets in the

economy. Financial institutions acquire, hold, and trade financial securities which not

only help in the credit-allocation process but also makes the financial markets larger,

more liquid, stable, and diversified. Financial intermediaries rely on financial markets

to raise funds whenever the need arises. This increases the competition between

financial markets and financial intermediaries for attracting investors and borrowers.

The development of new sophisticated markets has led to the development of complex

securities, portfolios, and strategies require financial expertise which financial

intermediaries provide through financial services.

Financial markets have also made an impact on the functioning of financial

intermediaries such as banks and other financial institutions. the latter are, today,

radically changed entities as the bulk of the service fees and non-interest income that

they derive is directly or indirectly linked to financial market-related activities.

"The progressive globalisation of financial institutions and services over the

last two decades has led to a complex web of interconnected markets, institutions,

services and products. Institutions transcended borders; markets became accessible in

real time and financial services were available from everywhere. In short, financial

markets and institutions declared 'death of distance' and 'conquest of location'".20

19 Op.cit. Pathak, Bharti V, (2009) The Indian Financial System.

20 Subarao, Duvvuri (2009), Should Banking be made Boring?-An Indian Perspective, Keynote address by Governor, Reserve

Bank of India at the International Finance and Banking Conference organised by the Indian Merchant's Chamber of 'Banking-

Crisis and Beyond' on November 25, 2009, Mumbai, RBI Bulletin.

109

Moreover, liquid and broad markets make financial instruments a more

attractive avenue for savings, and financial services may encourage further savings if

the net returns to investors are raised or increased.

The discussion in this chapter gives an overview of the growth and

development of the financial sector in India. The structure of the Indian financial

system exhibits heterogeneity and the financial institutions and financial markets have

emerged to become the major contributors of development. The financial assistance

provided by the financial institutions has witnessed variations over the years. But,

the progress of banking is satisfactory and the growth of non-banking financial

institutions is pronounced. The mutual fund industry and stock market development

is adequate. The satisfactory development of the Indian Financial System can also be

attributed to the various committees, commissions, working groups and their

recommendations. This will be discussed in detail in the succeeding chapter.