FINANCIAL INSTITUTIONS AND SERVICES

UNIT-I

INTRODUCTION OF INDIAN FINANCIAL SYSTEM

The Indian Financial System is one of the most important aspects of the
economic development of our country. This system manages the flow of funds between
the people (household savings) of the country and the ones who may invest it wisely
(investors/businessmen) for the betterment of both the parties.

Indian Financial System

The Indian financial system is a complex network of financial institutions,

markets, instruments, and services that facilitate the flow of funds between savers and
investors. It comprises of various entities such as banks, non-banking financial
companies (NBFCs), insurance companies, stock exchanges, mutual funds, pension
funds, and other financial intermediaries.

The Indian Financial System plays a crucial role in mobilizing savings, allocating
capital, and facilitating economic growth and development in the country.

Thus, a financial system can be said to play a significant role in the economic
growth of a country by mobilizing the surplus funds and utilizing them effectively for
productive purposes.
Indian Financial System Functions
The Indian financial system has several functions that help to meet the financial
needs of individuals and businesses. Here are some of the key functions of the Indian
financial system:
Mobilization of Savings:

The Indian financial system helps to mobilize savings from various sectors of the
economy and channel them towards productive investments. This is achieved through
various financial intermediaries such as banks, mutual funds, and insurance companies.
Allocation of Credit: The Indian financial system also plays a key role in allocating
credit to different sectors of the economy. Banks and other financial institutions provide
loans and credit facilities to businesses and individuals to help them meet their financial
needs.

Payment System: The financial system provides a safe and efficient payment
mechanism to facilitate transactions between different individuals and businesses. This
is achieved through various payment systems such as NEFT, RTGS, and IMPS.

Risk Management: The financial system helps to manage risks associated with
financial transactions. Financial intermediaries such as insurance companies provide
risk management products such as life insurance, health insurance, and property
insurance.

Price Discovery: The Indian financial system also helps in the discovery of prices of
financial assets such as stocks, bonds, and commodities. This is achieved through
various financial intermediaries such as stock exchanges and commodity exchanges.

Economic Development: The financial system plays a critical role in the economic
development of the country. It provides financial resources for investment in
infrastructure, industries, and other productive sectors of the economy.

Financial Inclusion: The Indian financial system also strives to promote financial
inclusion by providing access to financial services to individuals and businesses in
remote and underdeveloped areas of the country.
Concept of Financial services
Financial services are intermediary services in financial market place.Financial
Services are provided by the banks and financial institution in financial system. It is a
process by which funds are mobilised from a large number of savers and made available
to all those who are in need. It is defined as all activities, benefits and satisfactions
connected with sale of money, that offers to users and customers financial related value.
Objectives of financial services are
 Maintain the public’s confidence in the financial system.
  Facilitate the deterrence of financial crimes.
 Supervise financial services licensees in accordance with legislation, regulations
and codes.
 Ensure periodic evaluation of the legislative and regulatory framework in
accordance with developments in the financial services sector.
 Promote best practices, mutual assistance and exchange of information by
maintaining contact and forging relations with foreign regulatory authorities,
international associations of regulatory authority bodies or groups relevant to its
functions.
 Facilitate the development of the financial services sector.

Functions of Financial System

Provision of Liquidity : The provision of liquidity is one of the primary functions
of financial system. It states the ability of meeting the obligations as and when they are
required. In other words, it states the ability of converting the assets into liquid cash
without any loss.

Mobilization of savings: The Indian financial system helps to mobilize savings from
various sectors of the economy and channel them towards productive investments. This
is achieved through various financial intermediaries such as banks, mutual funds, and
insurance companies.
Small Savings to big investment: It helps in establishing a link between the savers and
the investors.
Maturity Transformation functions.
Risk Transformation function. Financial system helps in risk transformation by
diversification, as in case of mutual funds.

Payment function. The financial system ensures the efficient functioning of the
payment mechanism in an economy. All transactions between the buyers and sellers of
goods and services are effected smoothly because of financial system.
Pooling of funds.
Monitor corporate performance
  Provide price related information: Financial system helps price discovery of
financial assets resulting from the interaction of buyers and sellers. For example,
the prices of securities are determined by demand and supply forces in the capital
market.
Information function.

Transfer function: Financial system allows ‘asset-liability transformation’. Banks

create claims (liabilities) against themselves when they accept deposits from customers
but also create assets when they provide loans to clients

 Reformatory function.
 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 investibl 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 investibl 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 investibl
The following are the functions performed by the financial system of a
nation. These are the aggregate functions performed by the sub classes of financial
system viz. financial markets, financial institutions and financial services.
Functions of financial system

 Financial system works as an effective conduit for optimum allocation of

financial resources in an economy.
 It helps in establishing a link between the savers and the investors.
 Financial system allows ‘asset-liability transformation’. Banks create claims
(liabilities) against themselves when they accept deposits from customers but
also create assets when they provide loans to clients.
 Economic resources (i.e., funds) are transferred from one party to another
through financial system.
 The financial system ensures the efficient functioning of the payment
mechanism in an economy. All transactions between the buyers and sellers of
goods and services are effected smoothly because of financial system.
 Financial system helps in risk transformation by diversification, as in case of
mutual funds.
 Financial system enhances liquidity of financial claims.
 Financial system helps price discovery of financial assets resulting from the
interaction of buyers and sellers. For example, the prices of securities are
determined by demand and supply forces in the capital market.
 Financial system helps reducing the cost of transactions.

Financial markets play a significant role in economic growth through their role of
allocation capital, monitoring managers, mobilizing of savings and promoting
technological changes among others. Economists had held the view that the
development of the financial sector is a crucial element for stimulating economic
growth. Financial development can be defined as the ability of a financial sector
acquire effectively information, enforce contracts, facilitate transactions and create
incentives for the emergence of particular types of financial contracts, markets and
intermediaries, and all should be at a low cost. Financial development occurs when
financial instruments, markets and intermediaries ameliorate through the basis of
information, enforcement and transaction costs, and therefore better provide
financial services.

The financial functions or services may influence saving and investment

decisions of an economy through capital accumulation and technological innovation
and hence economic growth. Capital accumulation can either be modeled through
capital externalities or capital goods produced using constant returns to scale but
without the use of any reproducible factors to generate steady-state per capita
growth. Through capital accumulation, the functions performed by the financial
system affect the steady growth rate thereby influencing the rate of capital
 formation. The financial system affects capital accumulation either by altering the
savings rate or by reallocating savings among different capital producing levels.
Through technological innovation, the focus is on the invention of new production
processes and goods.
Components of Indian Financial System
There are four main components of the Indian Financial System. This includes
1. Financial Institutions
2. Financial Assets
3. Financial Services
4. Financial Markets
Let’s discuss each component of the system in detail.
1. Financial Institutions

The Financial Institutions act as a mediator between the investor and the borrower. The
investor’s savings are mobilised either directly or indirectly via the Financial Markets.

The main functions of the Financial Institutions are as follows

 A short term liability can be converted into a long term investment
 It helps in conversion of a risky investment into a risk-free investment
 Also acts as a medium of convenience denomination, which means, it can match
a small deposit with large loans and a large deposit with small loans
The best example of a Financial Institution is a Bank. People with surplus amounts
of money make savings in their accounts, and people in dire need of money take loans.
The bank acts as an intermediate between the two.
The financial institutions can further be divided into two types
Banking Institutions or Depository Institutions – This includes banks and other
credit unions which collect money from the public against interest provided on the
deposits made and lend that money to the ones in need.
Non-Banking Institutions or Non-Depository Institutions – Insurance, mutual funds
and brokerage companies fall under this category. They cannot ask for monetary
deposits but sell financial products to their customers.
Further, Financial Institutions can be classified into three categories:

 Regulatory – Institutes that regulate the financial markets like RBI, IRDA,
SEBI, etc.
 Intermediates – Commercial banks which provide loans and other financial
assistance such as SBI, BOB, PNB, etc.
 Non Intermediates – Institutions that provide financial aid to corporate
customers. It includes NABARD, SIBDI, etc.
Financial Assets
The products which are traded in the Financial Markets are called Financial
Assets. Based on the different requirements and needs of the credit seeker, the securities
in the market also differ from each other. Some important Financial Assets have been
discussed briefly below:
 Call Money – When a loan is granted for one day and is repaid on the second
day, it is called call money. No collateral securities are required for this kind of
transaction.
 Notice Money – When a loan is granted for more than a day and for less than 14
days, it is called notice money. No collateral securities are required for this kind
of transaction.
 Term Money – When the maturity period of a deposit is beyond 14 days, it is
called term money.
 Treasury Bills – Also known as T-Bills, these are Government bonds or debt
securities with maturity of less than a year. Buying a T-Bill means lending
money to the Government.
 Certificate of Deposits – It is a dematerialised form (Electronically generated)
for funds deposited in the bank for a specific period of time.
 Commercial Paper – It is an unsecured short-term debt instrument issued by
corporations.
3. Financial Services
Services provided by Asset Management and Liability Management Companies.
They help to get the required funds and also make sure that they are efficiently invested.
The financial services in India include
 Banking Services – Any small or big service provided by banks like granting a
loan, depositing money, issuing debit/credit cards, opening accounts, etc.
 Insurance Services – Services like issuing of insurance, selling policies,
insurance undertaking and brokerages, etc. are all a part of the Insurance services
 Investment Services – It mostly includes asset management
 Foreign Exchange Services – Exchange of currency, foreign exchange, etc. are
a part of the Foreign exchange services
The main aim of the financial services is to assist a person with selling, borrowing or
purchasing securities, allowing payments and settlements and lending and investing.
4. Financial Markets
The marketplace where buyers and sellers interact with each other and participate
in the trading of money, bonds, shares and other assets is called a financial market.
The financial market can be further divided into four types.
Capital Market – Designed to finance the long term investment, the Capital market
deals with transactions which are taking place in the market for over a year. The capital
market can further be divided into three types
(a)Corporate Securities Market
(b)Government Securities Market
(c)Long Term Loan Market
Money Market – Mostly dominated by Government, Banks and other Large
Institutions, the type of market is authorised for small-term investments only. It is a
wholesale debt market which works on low-risk and highly liquid instruments. The
money market can further be divided into two types.
(a) Organised Money Market
(b) Unorganised Money Market
Foreign exchange Market – One of the most developed markets across the world, the
Foreign exchange market, deals with the requirements related to multi-currency. The
transfer of funds in this market takes place based on the foreign currency rate.
Credit Market – A market where short-term and long-term loans are granted to
individuals or Organisations by various banks and Financial and Non-Financial
Institutions is called Credit Market.

Financial intermediaries

Financial intermediaries move funds from parties with excess capital to parties
needing funds. The process creates efficient markets and lowers the cost of conducting
business. For example, a financial advisor connects with clients through purchasing
insurance, stocks, bonds, real estate, and other assets.

Role of Financial Intermediary

Financial intermediaries function basically by connecting an entity with a surplus fund

to a deficit fund. They ease the money flow in the economy and support economic
growth . Based on the type of services and products offered by the intermediaries, the
complexity in their roles changes. They take the form of channel providing loans,
mortgages, investment vehicles, leasing, and insurances, etc.

Types of Financial Intermediary

Various types of entities provide financial intermediary services ranging from banking
institutions accepting deposits like Federal Reserve Banks, commercial banks, savings
banks, and other depository organizations like credit unions to entities that do not take
deposits such as NBFCs. In a nutshell, it is distinguished as bank and nonbank
intermediaries. Moreover, it can be government or private entities.
Other types from the insurance sector include property insurance companies, private life
insurance organizations, and government insurances. Furthermore, stock exchanges,
investment banks, brokers, dealers, and clearinghouses are some examples signifying
the heterogeneity in types.

It can also be segregated based on the source of their funds as primary and secondary
financial intermediaries. The primary intermediary entities collect their funds from
households, business enterprises, or governments and provide loan services to the same
groups. In contrast, secondary intermediaries deal with the primary intermediary
entities. An example of secondary intermediaries is factoring companies.

The intermediary definition may vary by country and change as time passes. It is also
influenced by the prevailing country’s legal arrangements and financial customs.
Furthermore, the evolution of decentralized finance (DeFi) provides ways to disinter
mediate.

Banks: Banks primarily utilize the deposits made by clients to support other eligible
clients in need. The interest earned for providing loans serves as income for the banks.
Banks also offer several other services like forex services, insurance for deposits, and
credit cards.

Insurance companies: Insurance companies provide various insurance policies like life
insurance, home insurance, and liability insurance designed to give financial protection
to the customers. They deal with different entities like brokers and agents for
completing the transactions. It pools policy holders’ premiums and invests them in
various investment vehicles like bonds and other money market instruments.

Stock exchanges: The stock exchange reflects a marketplace where buyers and sellers
engage in trading financial instruments like stocks and derivatives. It connects
companies that need funding and investors who have excess funds to invest as an
intermediary. Even with a small amount of money, one can have an ownership interest
in a blue-chip company which may have otherwise been impossible.
Mutual fund companies: Generally, fund managers in mutual fund companies invest
the money collected from retail investors in different financial assets and distribute the
return to the retail investors proportional to their investment. Based on the client
preferences and investment fund managers focusing on growing the investors’ wealth

, select appropriate securities and compile them to form the portfolio. Mutual fund
companies help clients with investment management.

Credit unions: Credit unions are usually non-profit entities owned by their members. It
functions similar to banks; however, they offer better savings rates and reduced
borrowing costs, that is, loans at competitive rates.

What Is a Rate of Return (RoR)?

A rate of return (RoR) is the net gain or loss of an investment over a specified
time period, expressed as a percentage of the investment's initial cost. When calculating
the rate of return, you are determining the percentage change from the beginning of the
period until the end.

KEY TAKEAWAYS

 The rate of return (RoR) is used to measure the profit or loss of an investment
over time.
 The metric of RoR can be used on a variety of assets, from stocks to bonds, real
estate, and art.
 The effects of inflation are not taken into consideration in the simple rate of
return calculation but are in the real rate of return calculation.
 The internal rate of return (IRR) takes into consideration the time value of
money.

Understanding a Rate of Return (RoR)

A rate of return (RoR) can be applied to any investment vehicle, from real estate
to bonds, stocks, and fine art. The RoR works with any asset provided the asset is
purchased at one point in time and produces cash flow at some point in the future.
Investments are assessed based, in part, on past rates of return, which can be compared
against assets of the same type to determine which investments are the most attractive.
Many investors like to pick a required rate of return before making an investment
choice.

The Formula for RoR

The formula to calculate the rate of return (RoR) is:

Rate of return = [Current value−Initial value) ] ×100

Initial value

This simple rate of return is sometimes called the basic growth rate, or
alternatively, return on investment (ROI). If you also consider the effect of the time
value of money and inflation, the real rate of return can also be defined as the net
amount of discounted cash flows (DCF) received on an investment after adjusting for
inflation.

FINANCIAL INSREUMENTS

A financial instrument is an agreement between two parties with monetary value. In

other words, any asset that holds capital and which can be traded is a financial
instrument. It is noteworthy that financial instruments can be palpable or virtual
documents representing a legal agreement of any monetary value.
Some examples of financial instruments include life insurance policies, shares, bonds,
stocks, SIPs, etc. Now, let us understand more about the different types of financial
instruments that are popular in India.

Financial Instruments Available in India

There is an array of financial instruments that are available in India. They serve as a
medium of wealth creation. People prefer to invest in financial instruments instead of
keeping their money in a savings account, as the former has an appreciative trend.

1. Life Insurance Policies

These are financial instruments offering you protection against different types of
financial risks, such as – sudden death and old age. As the untimely demise of a
breadwinner places the family members in economic instability, life insurance plans
become critical.

Secondly, they are also helpful during retirement, as the income-generating ability of
individuals recede. Few popular life insurance plans include:

a) Term Life Insurance:

Acts as long-term financial protection for family

b) Savings Plans:

Safe long-term investments with guaranteed returns.

c) Pension Plans or Annuities:

Helps you turn your retirement corpus into a reliable and lifetime income.

d) ULIPs (Unit-linked Investment Plans):

ULIPs are insurance instruments with investment benefits. In other words, ULIPs
allow you to build wealth over time and protect your loved ones and yourself.

2. Small Savings Schemes

Small Savings Schemes aim to encourage citizens to save regularly as they are
generally government-backed. They are popular as they come with a sovereign
guarantee of returns and tax benefits. Few saving schemes that you can consider are
listed below:

a) Post office recurring deposits

b) Public Provident Fund (PPF)
c) Kisan Vikas Patra
d) National Savings Certificate (NSC)
Also Read - Personal Finance
3. Fixed Deposits (FDs)

They entail cash investments in banks or post-office and are highly popular. FDs come
with a zero risk factor, and you are guaranteed returns. However, the annual returns on
FDs can range from 6 to 9 per cent.
4. Certificate of Deposits (CDs)

A certificate of deposits is a negotiable money market instrument issued in

dematerialized form and used as a promissory note for funds deposited at a bank for a
stipulated period.
 a) Financial institutions to raise large sums of money issue CDs.
b) They are available in denominations of INR 1 lakh and multiples.
5. Equity Stocks

It is a type of security that represents the ownership of a company and is traded in stock
markets.

a) It represents the money you can return to shareholders of a company if all the assets
are liquidated and the entire company debt is paid off.
b) Equity is one of the most typical financial indicators investors use to determine a
company's health.
6. Bonds

They are fixed-income instruments you can issue to raise working capital.

 Private entities and government ventures, including the central and state governments,
issue bonds to raise funds
 Bonds that the government issues have a lower risk rate but ensure returns; on the other
hand, bonds raised by private entities have high risks.