Unit 2

Financial System
• Meaning Functions, Importance and Components of Financial
System, Financial system and economic development.
• Indian Financial System- An Overview Inflation and Deflation-
Meaning, Effects and Measures to Control.
Meaning of Financial System

A financial system is a network that facilitates the exchange of

funds between lenders (savers) and borrowers (users). This system
comprises various entities such as financial institutions (banks,
insurance companies), financial markets (stock and bond
markets), financial instruments (shares, bonds, loans), and
regulatory bodies (central banks, financial regulators). Its primary
purpose is to channel resources from those who have surplus
funds to those who need funds for productive use.
Functions of Financial System
Mobilisation of Savings: The financial system encourages
individuals and businesses to save money by offering a variety of
financial instruments. For instance, bank savings accounts provide a
safe place for individuals to store money while earning interest.
Similarly, mutual funds pool money from multiple investors to invest
in diversified portfolios, offering potential returns on savings.
Allocation of Resources: The financial system ensures that the
collected savings are allocated to the most productive uses. For
example, venture capital firms invest in start-ups with high growth
potential, providing them with the necessary capital to expand.
Banks evaluate business proposals and extend loans to those projects
that promise substantial returns, thus fostering economic growth.
Facilitating Payments: The financial system provides mechanisms
for smooth and efficient payments for goods and services. Digital
payment systems like the Unified Payments Interface (UPI) in India
allow instant fund transfers between bank accounts via mobile
devices. Debit and credit cards issued by banks enable consumers to
make purchases and settle payments electronically, reducing the
need for cash transactions.
Risk Management: The financial system offers instruments to
manage and mitigate financial risks. Insurance companies provide
policies that protect against risks like health issues, accidents, and
property damage. The derivatives market offers products like futures
and options, which investors use to hedge against price fluctuations
in commodities, currencies, and securities.
Information Provision: Financial markets and institutions provide
critical information that helps investors make informed decisions.
Stock market indices like the S&P 500 or Nifty 50 offer insights into
market trends and economic conditions. Credit rating agencies
assess the creditworthiness of borrowers, providing ratings that
guide lenders and investors in their decisions.
Liquidity Provision: The financial system ensures that financial
instruments can be easily converted to cash. Money markets provide
short-term loans to businesses and governments, ensuring they have
the liquidity to meet immediate needs. Stock exchanges facilitate the
buying and selling of shares, allowing investors to liquidate their
holdings quickly when needed.
Importance of Financial System
Economic Growth: By efficiently mobilising and allocating
resources, the financial system supports investments that drive
economic growth. For instance, small and medium enterprises
(SMEs) rely on bank loans and microfinance to expand operations
and create jobs. Infrastructure development projects like highways
and power plants are often financed through bonds and public-private
partnerships facilitated by the financial system.
Capital Formation: The financial system facilitates capital
accumulation by providing platforms for savings and investments.
Equity markets allow companies to raise capital by issuing shares to
the public. Corporate bonds enable companies to borrow funds from
investors to finance expansion projects, research, and development.
Financial Stability: A robust financial system helps maintain economic
stability by managing risks and ensuring smooth financial operations.
Central banks, like the Reserve Bank of India (RBI), implement monetary
policies to control inflation and stabilise the currency. Regulatory
frameworks ensure financial institutions operate within safe and sound
parameters, preventing crises.
Development of Infrastructure: Financial systems support infrastructure
development by providing long-term financing options. Local
governments issue municipal bonds to fund public projects like schools,
hospitals, and transportation systems. Infrastructure investment funds pool
resources from various investors to finance large-scale projects, ensuring
sustained economic growth.
Encouragement of Entrepreneurship: The financial system encourages
innovation and entrepreneurship by providing access to capital. Start-up
incubators and accelerators provide early-stage companies with funding,
mentorship, and resources. Crowdfunding platforms like Kickstarter and
Indiegogo enable entrepreneurs to raise funds from many small investors,
turning innovative ideas into reality.
Global Integration: The financial system connects the domestic economy
with international markets, promoting trade and investment. Foreign direct
investment (FDI) brings in capital, technology, and expertise from abroad,
boosting local industries. International trade finance mechanisms, like
letters of credit and export credit insurance, facilitate cross-border
transactions, enhancing global economic integration.
 Financial System and Economic Development

Economic development is how a country improves people's

economic, political, and social well-being. It involves the
growth of income levels, reduction of poverty, enhancement of
living standards, and the creation of employment opportunities.
Economic development is characterised by industrialisation,
improved infrastructure, increased access to education and
healthcare, and the establishment of effective institutions. It
aims to create a sustainable and inclusive economy that benefits
all segments of society.
Phase Year Characteristics Role of Financial System Impact on Economic
Development
Traditional Pre- • Dominance of • Mobilization of Savings: Basic • Facilitates agricultural
or Agrarian 1950 agriculture. banking facilities encourage rural productivity
Economy • Limited industrial households to save, even on a small improvements through
activity. scale. access to credit.
• Rudimentary • Credit Provision: Microfinance • Encourages savings
financial institutions (MFIs) and rural banks habits among rural
infrastructure. offer credit for agricultural inputs households.
and needs.
Early 1950- • Emergence of • Investment in Infrastructure: • Supports industrial
Industrializ 1970 small-scale Financial institutions fund growth and urban
ation industries. infrastructure projects such as development.
• Increased roads, bridges, and utilities. • Enhances productivity
urbanization. • Credit to Small Industries: Banks and creates employment
• Development of and NBFCs provide loans to small opportunities.
basic infrastructure. and medium enterprises (SMEs) for
expansion.
Phase Year Characteristics Role of Financial System Impact on Economic
Development
Mature 1980-2 • Growth of large-scale • Capital Markets: Stock • Promotes large-scale
Industrial 000 industries. exchanges and bond markets industrial growth and
Economy • Expansion of the facilitate long-term funding for infrastructure
services sector. large projects. (BSE 1875) development.
• Advanced financial • Diversified Financial Services: • Increases financial
infrastructure. Introduction of insurance, stability and investor
mutual funds, and pension funds confidence.
for risk management and
investment. LIC
Knowledge- 2000 - • Innovation and • Venture Capital and Private • Encourages innovation
Based 2010 technology-driven Equity: Financial support for and entrepreneurial
Economy growth. startups and innovation-driven activities.
• High level of human enterprises. (Infosys and Wipro) • Enhances financial
capital. • Digital Financial Services: inclusion and access to
• Advanced and Fintech solutions like mobile capital.
integrated financial banking, digital payments, and
markets. online trading platforms. (Paytm
and Phonepe)
Phase Year Characteristics Role of Financial System Impact on Economic
Development
Globalised 2010- •Integration with •Foreign Exchange Markets: •Promotes global
Economy Present global markets. Facilitate international trade trade and economic
•High volume of and investment by providing integration.
international trade currency exchange services. •Attracts foreign
and investment. •Cross-Border Investment: investment, boosting
•Sophisticated Financial institutions support economic growth and
financial systems. foreign direct investment development.
(FDI) and portfolio
investments.
Financial System

Phase I (Up to 1951)

Phase II ( 1951 to mid-80s)
Phase III (After early 90s)
Phase I
Post-independence Scenarios and incapable of sustaining a
high rate of industrial growth

Phase II
1. Public/ Government ownership of financial institutions
2. Fortification of the institutional structure
3. Protection of the investors
4. Participation of Financial institutions in corporate
management
 Nationalisation of Financial Institutions
•RBI (Reserve Bank of India): Became a fully nationalised central bank in
1949, taking charge of monetary policy and regulation of the banking
sector.
•SBI (State Bank of India): Established in 1955 through the nationalisation
of the Imperial Bank of India, focusing on expanding banking services to
rural and semi-urban areas.
•LIC (Life Insurance Corporation of India): Formed in 1956 by
nationalising private insurers to mobilise savings through life insurance.
•Banks: In 1969, 14 major commercial banks were nationalised, followed
by six more in 1980 to improve credit flow to priority sectors.
•GIC (General Insurance Corporation): Created in 1972 by nationalising
private general insurance companies to regulate and develop the sector.
 New Institutions
•DFIs (Development Financial Institutions):
• Institutions like IFCI (Industrial Finance Corporation of India), ICICI,
IDBI, SFCs, and others were set up to finance industrial and
infrastructure projects.
• These institutions provided long-term loans to support industrialisation
and infrastructure development.
•UTI (Unit Trust of India): Established in 1964 to promote investment in
mutual funds, enabling small investors to participate in capital markets.
Fortification of Institutional Structure
•Expansion and diversification of the financial sector to support industrial and
economic growth.
•Banks undertook innovative practices to enhance functional coverage, such
as lending to priority sectors like agriculture and small-scale industries.
 Investor Protection
•Companies Act(2013): Governed the functioning and regulation of
companies to safeguard investor interests.
•Capital Issues (Control) Act: Controlled the issue of securities by
companies to prevent fraudulent practices.
•Securities Contracts (Regulation) Act: Regulated stock exchanges and
ensured transparency in trading.
•Foreign Exchange Regulation Act (FERA): Enacted in 1973 to control
foreign exchange operations and ensure proper use of foreign capital.
 Participation in Corporate Management
•Financial institutions actively managed corporations, ensuring their
efficient operation and accountability.
Monopolies and Restrictive Trade Practices Act (MRTP Act)
•Enacted in 1969 to curb monopolistic practices, prevent economic
concentration in a few hands, and promote competition.
 Phase III (After early 90s)
1. Privatisation of Financial Institutions
2. Reorganisation of institutional structure
3. Investors protection
 Privatisation of Financial Institutions
•Banks: Entry of private and foreign banks (e.g., HDFC Bank, ICICI Bank,
Axis Bank) enhanced competition and service quality.
•Mutual Funds: Opening the sector to private players increased investment
options for individuals (e.g., HDFC Mutual Fund, Reliance Mutual Fund).
•Insurance Companies: The entry of private insurers like ICICI Prudential
and HDFC Life broke LIC's monopoly, offering competitive and diverse
insurance products.
 Reorganisation of Structure
•Development Financial Institutions (DFIs) / Public Financial
Institutions (PFIs): Shifted focus to specialised financing for long-term
industrial and infrastructure projects (e.g., NABARD, SIDBI).
•Banks: Modernisation and computerisation improved efficiency,
enabling digital banking and core banking systems.
•Non-Banking Financial Companies (NBFCs): Provided credit to
underserved sectors like small businesses and consumers (e.g., Bajaj
Finance, Shriram Transport Finance).
 Financial Markets
•Mutual Funds: Allowed small investors to access diversified portfolios
of equity, debt, and hybrid funds.
•Capital Market: Facilitated long-term company funding via equity
(stocks) and debt (bonds).
•Money Market: Provided short-term funding and liquidity management
tools (e.g., treasury bills, commercial papers).
•Primary Market: Companies raise capital directly from investors
through IPOs.
•Stock Exchange: Secondary markets like BSE and NSE allow securities
trading, ensuring liquidity.
 Investor Protection: SEBI
•The Securities and Exchange Board of India (SEBI), established in
1992, regulates and protects investor interests by:
• Monitoring stock exchanges.
• Preventing fraudulent practices.
• Ensuring transparency in capital markets.
Prudential Norms
•Introduced to strengthen financial institutions and reduce risks:
• Credit/Advance Portfolio: Ensure proper assessment before
issuing loans.
• Investment Portfolio: Diversify investments to minimise risks.
• Capital Adequacy: Mandate minimum capital requirements to
absorb financial shocks (aligned with Basel norms).
 Management of Non-Performing Assets (NPAs)
•Various mechanisms were introduced to tackle rising NPAs:
• Debt Recovery Tribunals (DRTs): Special courts for speedy
recovery of debts.
• Corporate Debt Restructuring (CDR): Restructuring corporate
loans to prevent default.
• Securitization and Reconstruction of Financial Assets: ARCs
(e.g., ARCIL (Asset Reconstruction Company (India) Limited) help
recover bad loans.
• Enforcement of Security Interest: The SARFAESI (Securitisation
and Reconstruction of Financial Assets and Enforcement of
Security Interest Act 2002) Act enables banks to recover loans by
auctioning collateral.
 Risk Management
•Financial institutions adopted advanced frameworks for risk
management:
• Asset Liability Management (ALM): Match assets and liabilities
to manage liquidity and interest rate risks.
• Credit Risk Management: Assess creditworthiness to minimize
loan defaults.
• Operational Risk Management: Address risks from operational
failures (e.g., fraud, cyberattacks).
 Inflation and Deflation

Inflation
Meaning: Inflation is the persistent increase in the general price level of
goods and services over a specific period. It decreases the purchasing
power of money.
Key Indicators:
• Measured by indices such as the Consumer Price Index (CPI) and
Wholesale Price Index (WPI).
Example: CPI inflation was above 6% in 2022 due to rising fuel and food
prices.
Effects of Inflation
Positive Effects:
1. Encourages moderate investment: Firms are motivated to expand as prices and
profits rise. Example: Moderate inflation in India from 4%-6% is considered
beneficial by the Reserve Bank of India (RBI).
2. Reduces the real value of debt: Borrowers benefit by repaying loans with devalued
money.
Negative Effects:
1. Reduces purchasing power: Fixed-income earners face challenges as wages may not
rise proportionally.
2. Increases income inequality: Wealthy individuals with investments in
inflation-resistant assets benefit, while others suffer.
3. Discourages savings: High inflation erodes the real returns on savings.
Measures to Control Inflation
1. Monetary Policy (Implemented by RBI):
• Increase Repo Rates: Raising interest rates to reduce borrowing. Example: RBI
increased the repo rate multiple times in 2022 to control inflation.
• Open Market Operations (OMO): Selling government securities to reduce liquidity
in the market.
2. Fiscal Policy:
• Reduce Government Spending: Decreases aggregate demand.
• Increase Taxes: Discourages consumer spending.
3. Supply-Side Measures:
• Increase production, particularly in agriculture and essential goods, to ease supply
shortages. Example: Subsidies on fertilisers to boost agricultural output.
Types of Inflation
1. Demand-Pull Inflation:
Excessive demand for goods
exceeds supply. Example: Rising
housing prices in urban areas due
to high demand in India.
2. Cost-Push Inflation: Rising
production costs (e.g., raw
materials, wages) increase prices.
Example: Global crude oil price
hikes increased transport costs in
India.
 Aspect Demand-Pull Inflation Cost-Push Inflation
Excessive demand over Increased production
Cause
supply costs
Primary Trigger Consumer spending Rising input costs
Economic Generally occurs in a Can occur in a stagnant
Growth growing economy economy
Tight monetary policy Supply-side policies (e.g.,
Policy Solutions (e.g., higher interest subsidies, improved
rates) productivity)
Oil price shocks, natural
Post-COVID stimulus,
Examples disasters disrupting
festival shopping booms
supply
Deflation
Meaning: Deflation is the sustained decline in the general price level of goods and
services over time, increasing the value of money.
Effects of Deflation
Positive Effects:
1. Higher purchasing power: Goods become cheaper for consumers.
2. Benefits fixed-income groups: Savings and pensions retain higher real value.
Negative Effects:
1. Consumers delay spending: Expect further price declines, reducing demand and
economic growth.
2. Increased real debt burden: Borrowers face higher repayment costs as the real value of
debt increases.
3. Unemployment: Reduced demand forces firms to cut production and lay off workers.
Measures to Control Deflation
1. Monetary Policy:
∙ Lowering Interest Rates: Encourages borrowing and investment. Example:
RBI’s rate cuts during the COVID-19 pandemic in 2020.
∙ Quantitative Easing (QE): Injecting liquidity into the system by purchasing
bonds.
2. Fiscal Policy:
∙ Increased Public Spending: Infrastructure projects to boost demand.
Example: Indian government’s National Infrastructure Pipeline (NIP).
∙ Tax Cuts: Increases disposable income and stimulates consumer spending.
3. Supply-Side Adjustments:
∙ Reduce overproduction to stabilize prices.
 Aspect Inflation Deflation

Meaning Rise in general price levels Fall in general price levels

Delays spending and

Effects Reduces purchasing power
discourages investment
Tight monetary and fiscal Expansionary monetary
Control
policies and fiscal policies