Chapter 9

INDIAN FINANCIAL SYSTEM

Financial System
Financial system", implies a set of complex and

closely connected or interlined institutions, agents,

practices, markets, transactions, claims, and liabilities
in the economy.
is the system that allows the transfer of money
between savers (and investors) and borrowers.
is the set of Financial Intermediaries, Financial
Markets and Financial Assets.
helps in the formation of capital.
meets the short term and long term capital needs of
households, corporate houses, govt. and foreigners.
its responsibility is to mobilize the savings in the form
of money and invest them in the productive manner.

FLOW OF FUNDS IN FINANCIAL

SYSTEM

Functions of the Financial system

To link the savers & investors.
To inspire the operators to monitor the

performance of the investment.

To achieve optimum allocation of risk
bearing.
It helps in economic growth.
It helps in promoting the process of financial
deepening and broadening.

Indian Financial System

Financial system
Organized FinancialOrganized
System

Financial
Intermediaries
Come

in
between
the
ultimate
borrowers and ultimate lenders.
provide key financial services such as
merchant banking, leasing, credit rating,
factoring etc.
Services
provided
by them are:
Convenience( maturity and divisibility),
Lower Risk (diversification), Expert
Management and Economies of Scale.

Types of Financial Intermediaries

1. Commercial Banks
Collect savings primarily in the form of

deposits and traditionally finance working

capital requirement of corporates/businesses.
With the emerging needs of economic and
financial system, banks have entered into:
Term

lending business particularly in the

infrastructure sector,
Capital market directly and indirectly,
Retail finance such as housing finance,
consumer finance, etc.
Enlarged geographical and functional coverage

2. Non-Banking Finance
Companies
A Non-Banking Financial Company (NBFC) is a

company registered under the Companies Act,

1956 engaged in the business of loans and
advances, acquisition of shares, stocks, bonds,
debentures, securities issued by Government or
local authority. It also indulges in leasing, hirepurchase, insurance, chit business, etc.
Provide variety of fund/asset-based and nonfund based/advisory services.
Their funds are raised in the form of public
deposits ranging between 1 to 7 years maturity.

Contd..
Depending upon the nature and type of service

provided, they are categorized into:

Asset finance companies
Housing finance companies
Venture capital funds
Merchant banking organisations
Credit rating agencies
Factoring and forfaiting organisations
Housing finance companies
Stock brokering firms
Depositories

Bank vs NBFC
1. NBFC cannot collect deposits in the manner of a

bank
2. NBFC cannot issue checks drawn on itself
3. NBFC cannot issue Demand Drafts like banks
4. NBFC cannot indulge primarily in agricultural or
industrial activity
5. NBFC cannot engage in construction of
immovable property
6. NBFC cannot accept demand deposits
7. While banks are incorporated under banking
companies act, NBFC is incorporated under
company act of 1956

3. Mutual funds
A mutual fund is a company that pools money from

many investors and invests in well diversified portfolio

of sound investment.
issues securities (units) to the investors (unit holders)
in accordance with the quantum of money invested by
them.
profit shared by the investors in proportion to their
investments.
set up in the form of trust and has a sponsor, trustee,
asset management company and custodian.
advantages in terms of convenience, lower risk, expert
management and reduced transaction cost.

Mutual Fund Operation Flow

Chart

4. Insurance Organizations
They invest the savings of their policy

holders in exchange promise them a

specified sum at a later stage or upon the
happening of a certain event.
Provide the combination of savings and
protection.
Through the contractual payment of
premium creates the desire in people to
save.

Financial Market
It is a place where funds from surplus units

are transferred to deficit units.

It is a market for creation and exchange of
financial assets .
They are not the source of finance but link
between savers and investors.
Corporations,
financial
institutions,
individuals and governments trade in
financial products on this market either
directly or indirectly.

Components of Financial Market

Money

Money Market
A market for dealing in monetary assets of short

term nature, less than one year.

enables raising up of short term funds for meeting
temporary shortage of fund and obligations and
temporary deployment of excess fund.
Major participant are: RBI and Commercial Banks
Major objectives:
equilibrium mechanism for evening out short term

surpluses and deficits

focal point for influencing liquidity in economy
access to users of short term funds at reasonable cost

Components of Money
Market
Call

Money

Capital Market
A market for long term funds
focus on financing of fixed investments
main participants are mutual funds,

insurance
organizations,
foreign
institutional investors, corporate and
individuals.
two segments: Primary market and
Secondary market

Primary/New Issue
Market
A market for new issues i.e. a market for fresh

capital.
provides the channel for sale of new
securities, not previously available.
provides opportunity to issuers of securities;
government as well as corporates.
to raise resources to meet their requirements
of
investment
and/or
discharge
some
obligation.
does not have any organizational setup
performs triple-service function: origination,
underwriting and distribution.

Secondary Market/Stock Market

A market for old/existing securities.
a place where buyers and sellers of securities can

enter into transactions to purchase and sell shares,

bonds, debentures etc.
enables
corporates,
entrepreneurs
to
raise
resources for their companies and business
ventures through public issues.
has physical existence
vital functions are:
nexus between savings and investments
liquidity to investors
continuous price formation

Financial Instruments
Financial instruments: the commodities that

are
traded in financial market are financial
assets/securities or instruments.
A real or virtual document representing a legal
agreement involving some sort of monetary
value.
In today's financial marketplace, financial
instruments can be classified generally as
equity based, representing ownership of the
asset, or debt based, representing a loan made
by an investor to the owner of the asset.

Financial Instruments

Primary Securities
Securities issued by the non-financial economic
units
Equity Shares: An equity share are the ownership
securities. They bear the risk and enjoy the rewards
of ownership.
Preference Shares:
Holders enjoy preferential
right as to: (a) payment of dividend at a fixed rate
during the life time of the Company; and (b) the
return of capital on winding up of the Company
Debentures: An creditorship security. Holders are
entitled to predetermined interest and claim on the
assets of the company.

Primary Securities
Innovative Debt instruments: A variety of debt

innovative instruments emerges with the growth

of financial system to make them more attractive.
Participative Debentures:

participate in the
excess profits of the company after the payment of
dividend.
Convertible debentures with options:

Third party convertible debentures: entitle the holder

to subscribe to the equity of another firm at a preferential
price.
Convertible debenture redeemable at premium:
issued at face value with option to sell at premium.
Debt equity swap: offers to swap debentures for equity.
Zero coupon convertible notes : convertible in to
shares and all the accrued /unpaid interest is forgone.

Indirect Securities/Financial Assets

Issued by financial intermediaries.
such as units of mutual funds, policies

of insurance companies, deposits of

banks, etc.
Better suited to small investors
Benefits of pooling of funds by
intermediaries
Convenience, lower risk and expert
management.

DERIVATIVES
Derivative is a product whose value is derived from

the value of one or more basic variables called base,

in a contractual manner
The underlying asset can be equity/forex or any
other assets.
The Securities Contracts (Regulation) Act, 1956
(SCIA) defined derivative to include1. A security derived from a debt instrument, share, loan
whether secured or unsecured, risk instrument or
contract for differences or any other form of security.
2. A contract which derives its value from the
fluctuations of prices, or index of prices, of underlying
securities.

DERIVATIVES
Derivatives

Forward Contract
is a customized contract between

two entities, where settlement takes

place on a specific date in the future
at today's pre-agreed price.
At the end, offsetting is done by

paying the difference in the price.

Future Contract
is an agreement between two parties

to buy or sell an asset at a certain

time in the future at a certain price.
They are special types of forward

contracts which are standardized

exchange-traded contracts.

Options
Contracts that give the buyer the right to buy or

sell securities at a predetermined price within/at

the end of a specified period.
Two types - calls and puts.
Calls give the buyer the right but not the obligation
to buy a given quantity of the underlying asset, at
a given price on or before a given future date.
Puts give the buyer the right, but not the
obligation to sell a given quantity of the underlying
asset at a given price on or before a given date.

Indian Financial System An

Overview
PHASES
* Upto 1951
Pvt. Sector
* 1951 to 1990
Public Sector
* Early Nineties
Privatisation
* Present Status Globalisation

Pre 1951
1.
2.
3.
4.
5.
6.
7.
8.
9.

Control of Money Lenders

No Laws / Total Private Sector
No Regulatory Bodies
Hardly any industrialization
Banks Traditional lenders for Trade and that
too short term
Main concentration on Traditional Agriculture
Narrow industrial securities market (i.e.
Gold/Bullion/Metal but largely linked to London
Market)
Absence of intermediatary institutions in longterm financing of industry
Industry had limited access to outside
saving/resources.

1951 to 1990
Moneylenders ruled till 1951. No worth-while
Banks at that time. Industries depended upon
their own money. 1951 onwards - 5 years PLAN
commenced.
PVT. SECTORS TO PUBLIC SECTOR MIXED
ECONOMY
First 5 year plan in 1951 Planned Economic
Process. As part of Alignment of Financial Systems
Priorities laid down by Govt. Policies.
Main Elements of Financial Organisations
i.
Public ownership of Financial Institution
ii.
Strengthening of Institutional Structure
iii. Protection to Investors
iv. Participation in Corporate Management

1951-1990
Nationalization
RBI
1948
SBI
1956 (take-over of Imperial Bank of India)
LIC
1956 (Merges of over 250 Life Insurance
Companies)
Banks
1969 (14 major banks with Deposits of over Rs.
50
crores nationalised)
1980 (6 more Banks)
Insurance 1972 (General Insurance Corp, GIC formed New India,
Oriental, United and
National.

Post 1990s
IMPORTANT DEVELOPMENTS
Development Financial Institutions : (DFIs)
Started providing Working Capital also
Set up CREDIT RATING AGENCIES
CRISIL (IPO IN 1993-94; standard & poor acquires 9.68% in 1996-97
S & P acquires shares / holding up to 58.46%)
ICRA Set up in 1991 by leading FIs/Banks/Fin. Ser. Cos. And
Moodys
CARE Set-up by IFCI/Banks.
FITCH a 100% subsidiary of FITCH Group.
Privatisation of DFI

Reduction in Govt. holding & Public Participation e.g. IFCI Ltd., IDBI
Ltd., ICICI Ltd.
Conversion into Banking / Merger into Banking Companies IDBI
Bank & ICICI Bank
Issuance of Bond by DFIs without Govt.s Guarantees to mobilize
resources.
Reduction in holding of Govt. in Banks, i.e. Public Participation /
Listing

POST 1990
INDUSTRIES
Rise & Growth of Service Sector industries.
Reliance & dependence on technology.
E-mail & mobile made sea-change in

communication, data

collection etc.
Computerization a catch phrase and inevitable need of an hour.
Dependent on Capital Market rather than only Debts dependency.
Scalability of operations through globally competitive size.
Broad basing of Board.
Professional Management.

NBFC
NBFC under RBI governance to finance retail assets and mobilize

small/medium sized savings.

Very large NBFCs are emerging (Shri Ram Transport Finance, Birla,
Tata Finance, Sundaram Finance, Reliance Finance, DLF, Religare
etc.)