Introduction to Financial System

The economic scene in the post-independence period has seen a sea change; the
end result being that the economy has made enormous progress in diverse fields.
There has been a quantitative expansion as well as diversification of economic
activities. The experiences of the 1980s have led to the conclusion that to obtain all
the benefits of greater reliance on voluntary, market-based decision-making, India
needs efficient financial systems. The financial system is possibly the most
important institutional and functional vehicle for economic transformation. Finance
is a bridge between the present and the future and whether it is the mobilization of
savings or their efficient, effective and equitable allocation for investment, it is the
success with which the financial system performs its functions that sets the pace
for the achievement of broader national objectives.
1.1 Significance and Definition

The term financial system is a set of inter-related activities/services working

together to achieve some predetermined purpose or goal. It includes different
markets, the institutions, instruments, services and mechanisms which influence
the generation of savings, investment capital formation and growth. Van Horne
defined the financial system as the purpose of financial markets to allocate savings
efficiently in an economy to ultimate users either for investment in real assets or
for consumption. Christy has opined that the objective of the financial system is to
"supply funds to various sectors and activities of the economy in ways that
promote the fullest possible utilization of resources without the destabilizing
consequence of price level changes or unnecessary interference with individual
desires." According to Robinson, the primary function of the system is "to provide
a link between savings and investment for the creation of new wealth and to permit
portfolio adjustment in the composition of the existing wealth." From the above
definitions, it may be said that the primary function of the financial system is the
mobilization of savings, their distribution for industrial investment and stimulating
capital formation to accelerate the process of economic growth.

The Concept of the Financial System The process of savings, finance and
investment involves financial institutions, markets, instruments and services.
Above all, supervision control and regulation are equally significant. Thus,
financial management is an integral part of the financial system. On the basis of the
empirical evidence, Goldsmith said that "... a case for the hypothesis that the
separation of the functions of savings and investment which is made possible by
the introduction of financial instruments as well as enlargement of the range of
financial assets which follows from the creation of financial institutions increase
the efficiency of investments and raise the ratio of capital formation to national
production and financial activities and through these two channels increase the rate
of growth" The inter-relationship between varied segments of the economy is
illustrated below:-

Inter-relationship in the Financial System

A financial system provides services that are essential in a modern economy. The
use of a stable, widely accepted medium of exchange reduces the costs of
transactions. It facilitates trade and, therefore, specialization in production.
Financial assets with attractive yield, liquidity and risk characteristics encourage
saving in financial form. By evaluating alternative investments and monitoring the
activities of borrowers, financial intermediaries increase the efficiency of resource
use. Access to a variety of financial instruments enables an economic agent to pool,
price and exchange risks in the markets. Trade, the efficient use of resources,
saving and risk taking are the cornerstones of a growing economy. In fact, the
country could make this feasible with the active support of the financial system.
The financial system has been identified as the most catalyzing agent for growth of
the economy, making it one of the key inputs of development
1.2 The Organization of the Financial System in India The Indian financial
system is broadly classified into two broad groups:
i) Organized sector and (ii) unorganized sector.
"The financial system is also divided into users of financial services and providers.
Financial institutions sell their services to households, businesses and government.
They are the users of the financial services. The boundaries between these sectors
are not always clear cut. In the case of providers of financial services, although
financial systems differ from country to country, there are many similarities.
(i) Central bank (ii) Banks
(iii) Financial institutions (iv) Money and capital markets and (v) Informal
financial enterprises.
i) Organized Indian Financial System
The organised financial system comprises of an impressive network of banks,
other financial and investment institutions and a range of financial instruments,
which together function in fairly developed capital and money markets. Short-term
funds are mainly provided by the commercial and cooperative banking structure.

Nine-tenth of such banking business is managed by twenty-eight leading banks

which are in the public sector. In addition to commercial banks, there is the
network of cooperative banks and land development banks at state, district and
block levels. With around two-third share in the total assets in the financial system,
banks play an important role. Of late, Indian banks have also diversified into areas
such as merchant banking, mutual funds, leasing and factoring.
The organised financial system comprises the following sub-systems:
1. Banking system
2. Cooperative system
3. Development Banking system
(i) Public sector (ii) Private sector
4.Money markets and 5. Financial companies/institutions.
Over the years, the structure of financial institutions in India has developed and
become broad based. The system has developed in three areas - state, cooperative
and private. Rural and urban areas are well served by the cooperative sector as well
as by corporate bodies with national status. There are more than 4,58,782
institutions channellising credit into the various areas of the economy.
ii) Unorganised Financial System
On the other hand, the unorganised financial system comprises of relatively less
controlled moneylenders, indigenous bankers, lending pawn brokers, landlords,
traders etc. This part of the financial system is not directly amenable to control by
the Reserve Bank of India (RBI). There are a host of financial companies,
investment companies, and chit funds etc., which are also not regulated by the RBI
or the government in a systematic manner. However, they are also governed by
rules and regulations and are, therefore within the orbit of the monetary authorities.

Indigenous Banking in India

At independence, India had an indigenous banking system with a centuries-old
tradition. This system had developed the hundi, a financial instrument still in use
that is similar to the commercial bill of Western Europe. Hundi were used to
finance local trade as well as trade between port towns and inland centers of
production. They were often discounted by banks, especially if they were endorsed
by indigenous bankers. Indigenous bankers combined banking with other activities,
much as the goldsmiths, merchants, and shippers of eighteenth and nineteenthcentury Europe had done. They usually belonged to certain castes or communities,
such as the Multanis, Marwaris and Chettiars, and they differed in the extent to
which they relied on their own resources, rather than deposits and other funds for
their lending. Indigenous bankers often endorsed hundis issued by traders and
sometimes provided personal guarantees for loans from commercial banks. Such
bankers were collectively known as Shroffs, a term that probably originally
referred to money changers but over time came to refer to the more sophisticated
and influential indigenous bankers. The main moneylenders were the Sowkars
(who lent to farmers from their own
resources or funds borrowed from the Chettiars and other indigenous bankers) and
the Pathans (who lent mainly to poor people and often resorted to intimidation to
ensure repayment). Indigenous banking was based on an elaborate and extensive
network of personal relations that overcame the problems of dealing with a large
number of customers. Brokers were used for making introductions and vouching
for the creditworthiness of individual borrowers but did not offer personal
guarantees. Some brokers specialized in introducing indigenous bankers to
commercial banks, while others brought together traders and indigenous bankers.

Rural Financial System.

Rural financial system has been evolved over a period of time from the year 1904,
when the first Primary Agricultural Credit Society was organized, by accepting and
implementing important recommendations of expert committees appointed by the
Government of India/RBI from time to time. During the pre-reform period, more
particularly, after the advent of the scientific and technological revolution in the
sphere of agriculture, the Government of India and the RBI have evolved several
new concepts, innovations and novel approaches, which, the Rural Financial

Institutions (RFls) have responded very favorably by implementing them.

The Banking System

The structure of the baking system is determined by two basic factors economic
and legal. The Development of the economy and the spread of banking habit call
for increasing banking services. The demand for these banking services affects the
banks' structure and organization. National objectives and aspirations result in
government regulations, which have a profound influence on the banking
structure. These regulations are basically of two types. First, regulations which
result in the formation of new banks to meet the specific needs of a group of
economic activities. Secondly, legislation that affects the structure by means of
nationalization, mergers or liquidation.
RBI
The Reserve Bank of India as the central bank of the country is at the head of this
group. Commercial banks themselves may be divided into two groups, the
scheduled and the non-scheduled.
The commercial banking system may be distinguished into:
A. Public Sector Banks i) State Bank of India State Bank Group ii) Associate
Bank iii) 14 Nationalized Banks (1969) Nationalized Banks iv) 6 Nationalized
Banks (1980) v) Regional Rural Banks Mainly sponsored by Public Sector Banks
B. Private Sector Banks i) Other Private Banks; ii) New sophisticated Private
Banks; iii) Cooperative Banks included in the second schedule; iv) Foreign banks
in India, representative offices, and v) One non-scheduled banks
Cooperative Sector
The cooperative banking sector has been developed in the country to supplant the
village moneylender, the predominant source of rural finance, as the terms on
which he made finance available have generally been usurious and detrimental to
the development of Indian agriculture. Although the sector receives concessional
finance from the Reserve Bank, it is governed by the state legislation. From the

point of view of the money market, it may be said to lie between the organized
and the unorganized markets.
OLD FINANCIAL SYSTEM
The history of accounting or accountancy is thousands of years old and can be
traced to ancient civilizations.
The early development of accounting dates back to ancient Mesopotamia, and is
closely related to developments in writing, counting and money and early auditing
systems by the ancient Egyptians and Babylonians. By the time of the Emperor
Augustus, the Roman government had access to detailed financial information.
According to some Indian scriptures, the Indian Chanakya wrote a manuscript
similar to a financial management book, during the period of the Mauryan Empire.
His book "Arthashasthra" contains few detailed aspects of maintaining books of
accounts for a Sovereign State.
The Italian Luca Pacioli, recognized as The Father of accounting and book keeping
was the first person to publish a work on double-entry bookkeeping, and
introduced the field in Europe. Accounting began to transition into an organized
profession in the nineteenth century, with local professional bodies in England
merging to form the Institute of Chartered Accountants in England and Wales in
1880.

Advantages
Credit Unions typically pay higher dividend rates on savings
Credit Unions typically offer lower rates on loans
Credit Unions typically provide better service; since they are owned and governed
by their membership, they tend to prioritize the needs of their members above all
else
Credit Unions operate on a not-for-profit business model, so excess earnings are
returned back to the membership in form of competitive rates and lower fees, and
sometimes even special dividends

Many Credit Unions offer the same products and services found at banks
Credit Unions often have added-value benefits, such as free financial education,
discounted theme park tickets, and special member rates for services such as home
alarm systems...even discounts at online retailers like Barnes & Noble.

Disadvantages
Credit Unions, and in particular smaller local credit unions, struggle to match the
level of convenience (ATMs and branches) that many banks provide their
customers, although many CUs are part of shared networks which enhance the
breadth of delivery channels available to their members
Some Credit Unions are limited in their product offerings
One must qualify for membership
One must pay a membership fee to join

EVOLUTION OF MODERN BANKING SYSTEM