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

Flow of Funds (Savings)

Seekers of funds
(mainly business Suppliers of Funds
firms and Flow of Financial Services (mainly households)
government)
Income and Financial Claims

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
 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)

Private Corporate
Year Household Sector Public Sector Total
Sector
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

3,000,000

2,500,000 Household Sector

2,000,000

1,500,000

1,000,000

500,000

-500,000

Source: Table-3.1
 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

Secondary Securities Primary Securities

Financial Intermediaries (+/-)
(Banks and Financial Institutions

and
Financial Markets
Primary Securities Primary
Securities

Ultimate Lenders (+) Financial System Ultimate Borrowers (-)

Surplus-spending Economic Capital Formation Deficit-spending

Units Y>(C+I) Economic Units Y<(C+I)
 Householder Sector  Government
 Rest of the World  Corporate'
Economic Growth

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.
 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 (1955 12, 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 Indian Financial System

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

Money Lenders
3. Financial Instruments 4. Financial Services Pawn Brokers
1. Financial Institutions and Traders
Financial Intermediaries 2. Financial Markets Land Lords
Local Banks

Public Term Type Depositories

(i) Banking (ii) Non-Banking (iii) Mutual Sector Custodial
Institutions Institutions Funds (iv) Insurance & Credit Rating
Housing Finance Factoring
Private Companies Merchant Banking
Sector Short Leasing
Medium Hire Purchase
Long Primary Secondary
Securities Securities Portfolio Management
Scheduled Scheduled Underwriting
Commercial Banks Cooperative Banks Development
NBFC's
Financial Institutions
Equity Time Deposits
Preference Debt Mutual Fund Units
and Various Insurance Policies
Public Private Foreign RRB's combinations
Sector Sector Banks
Banks Banks in India All India Financial Institutions: State Level Other F.I's
IFCI, IDBI, SIDBI, IDFC, F.I's: SFC's, ECGC,
NABARD, EXIM BANK, NHB SIDC's DICGC

RBI : Reserve Bank of India

(a) Capital Market (b) Money Market IRDA : Insurance Regulatory & Development Authority
MoF : Ministry of Finance
SEBI : Securities and Exchange Board of India
NBFCs : Non-Banking Financial Companies
Treasury Bills RRBs : Regional Rural Banks
Private Corporate Debt IFCI : Industrial Finance Corporation of India
Call Money Market IDBI : Industrial Development Bank of India
PSU Bond Market Commercial Bills SIDBI : Small Industries Development Bank of India
Equity Market Debt Market Government Securities Market Commercial Papers IDFC :Infrastructure Development Finance Company
Certificates of NABARD :National Bank for Agriculture & Rural Development
Deposit EXIM BANK :Export Import Bank of India
Term Money NHB :National Housing Bank
SFCs :State Financial Corporation
SIDCs :State Industrial Development Corporation
ECGC :Export Credit Guarantee Corporation of India Limited
Primary Market Secondary Derivatives Market Primary Secondary DICGC :Deposit Insurance and Credit Guarantee Corporation.
Market NSE :National Security Exchange
BSE :Bombay Security Exchange
Primary Secondary ISE :International Stock Exchange
Public Issues NSE Exchanges Traded PSU : Public Sector Units
Segment Segment
Private Placement BSE futures and Options
ISE
Regional Stock

92
Exchanges

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

Domestic Market International Market Index Stock
 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

Indian Financial System

I. Financial Institutions and Financial

Intermediaries

Public
Sector
Banking Non-Banking Mutual Insurance &
Institutions Institutions Funds Housing
Finance
Private Companies
Sector

Scheduled Scheduled
Commercial Banks Cooperative
Banks Non-Bank Development
Financial Companies Financial Institutions

Public Private Foreign Regional All India F.I.s: State Level Other
IFCI, IDBI, SIDBI,
Sector Sector Banks in Rural IDFC, NABARD, F.I's: SFC's, F.I's
Banks Banks India Banks EXIM BANK, SIDC's ECGC,
NHB DICGC

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
 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)

Total Assistance by
All - India Specialized
Investment Financial Percentage
Category Term Lending Financial
Institutions@ Institutions variation
Institutions* Institutions#
(2+3+4)

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

120000

100000

80000

60000 Sanction
Disbursement
40000

20000

0
2004-052005-062006-072007-082008-092009-102010-112011-12

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.
 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
989141 1131188 1311761 1504416 1700198 2109049
in India (`. in Crores)
Credit of Scheduled Commercial Banks in India
529271 609053 746432 840785 1100428 1507077
(` crore)
Investment of Scheduled Commercial Banks in India
367184 437482 547546 677588 739154 717454
(` crore)
Deposits of Scheduled Commercial Banks per office
1456 1659 1925 2265 2574 3047
(` Lakhs)
Credit of Scheduled Commercial Banks per Office
779 893 1143 1330 1700 2209
(` Lakhs)
Per capita Deposits of Scheduled Commercial
9770 11008 12253 14089 16281 19130
Banks(`)
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 56.0 54.4 58.8 59.4 60.0 65.4
prices)
Scheduled Commercial Banks' Advances to Priority
182255 205606 254648 263834 381476 510175
Sector (` crore)
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
2611934 3196940 3834110 4492826 5207969 5909082
in India (`. in Crores)
Credit of Scheduled Commercial Banks in India (`
1931190 2361913 2775549 3244788 3942083 4611852
crore)
Investment of Scheduled Commercial Banks in India
791516 971714 116410 1384753 1501619 1737787
(` crore)
Deposits of Scheduled Commercial Banks per office
3675 4344 4980 548 609 643
(` Lakhs)
Credit of Scheduled Commercial Banks per Office (`
2757 3222 3615 398 458 502
Lakhs)
Per capita Deposits of Scheduled Commercial
23382 28610 34372 39107 45505 51106
Banks(`)
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 70.1 74.4 78.1 74.2 73.6 72.5
prices)
Scheduled Commercial Banks' Advances to Priority
632647 738686 932459 1091510 1315859 147133
Sector (` crore)
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)

No. of
No. of COs registered Total Public Net Owned
Year Reporting
with RBI@ Assets* Deposits* Fund*
Companies
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)

Bank-sponsored FI-sponsored Private Sector

Year UTI Total
mutual Funds mutual funds mutual funds
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

2000
Private Sector mutual funds

1500 FI-sponsored mutual funds

Bank-sponsored mutual Funds
1000 UTI

500

-500

-1000

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.
 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
Indian Financial System

2. Financial Markets

(a) Capital Market (b) Money Market

Private Corporate Treasury Bills

Debt Call Money Market
Equity Debt PSU Bond Market Commercial Bills
Market Market Government Commercial Papers
Securities Market Certificates of Deposit
Term Money
Primary Secondary Derivatives
Market Market Market
Primary Secondary
Primary Secondary
Public NSE, BSE Exchanges Segment Segment
Issues ISE, Traded
Private Regional futures and
Placement Stock Options
Exchanges

Domestic Internationa Index Stock

Market l Market

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.
 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)

Stock Market Market Total Value

Year Capitalisation 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

350
300
250
200
150 Stock Market Capitalisation

100 Market Total Value Added

Stock Market Turnover
50
0

Source: Table-3.6.
 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

Indian Financial System

Financial Instruments

Term Type

Short
Medium
Long Primary Secondary
Securities Securities

Equity Preference Time Deposits

Debt and Various Mutual Fund Units
combinations Insurance Policies
Source: Chart-3-(iii)
 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

Indian Financial System

Financial Services

Depositories Custodial
Credit Rating
Factoring
Merchant Banking
Leasing
Hire Purchase
Portfolio Management
Underwriting

Source: Chart-3.(iii)
 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.