Department of Commerce

IFS-Indian Financial System

UNIT 1
INTRODUCTION TO INDIAN FINANCIAL SYSTEM
Introduction
The economic development of a nation is reflected by the progress of the various economic units,
broadly classified into the corporate sector, government and household sector. There are areas or
people with surplus funds and there are those with a deficit. A financial system or financial
sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to
the areas of deficit. A Financial System is a composition of various institutions, markets,
regulations and laws, practices, money manager, analysts, transactions and claims and liabilities.
Financial system comprises of set of subsystems of financial institutions, financial markets,
financial instruments and services which helps in the formation of capital. It provides a
mechanism by which savings are transformed to investment.
Meaning of Financial System
A financial system functions as an intermediary between savers and investors. It facilitates the
flow of funds from the areas of surplus to the areas of deficit. It is concerned about money, credit
and finance.
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.
Features of financial system
The characteristics of a financial system define how it operates, its role in the economy, and the
qualities that make it effective.
1. Intermediation

The financial system acts as an intermediary between savers and borrowers. It channels funds
from those who have surplus capital (savers) to those who need capital (borrowers), facilitating
investment and consumption.
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2. Diversity

A financial system includes a wide range of institutions, markets, instruments, and services. This
diversity allows it to meet the varying needs of different participants, from individuals to large
corporations and governments.

3. Liquidity

The financial system ensures liquidity by allowing assets to be easily bought or sold in the
market without causing significant price changes. This provides participants with the ability to
quickly convert their investments into cash when needed.

4. Risk Management

The financial system offers various tools and mechanisms to manage and mitigate financial risks.
Instruments like derivatives, insurance products, and diversified portfolios help participants
protect against market volatility, credit risks, and other uncertainties.

5. Regulation and Supervision

A strong regulatory framework is a key characteristic of a sound financial system. Regulatory

bodies oversee the operations of financial institutions and markets, ensuring stability,
transparency, and protection for investors and consumers.

6. Transparency

Transparency in the financial system is essential for maintaining trust and confidence. It involves
the clear and timely disclosure of financial information, which enables participants to make
informed decisions and ensures fair market practices.
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7. Innovation

The financial system is characterized by continuous innovation in products, services, and

technologies. This adaptability allows the system to evolve with changing economic conditions
and meet the emerging needs of its participants.

8. Global Integration

Modern financial systems are globally interconnected, allowing for the flow of capital across
borders. This integration enables access to global financial markets, increases opportunities for
investment, and spreads economic risks internationally.

9. Economic Growth

The financial system plays a critical role in promoting economic growth by efficiently allocating
resources, funding productive investments, and enabling entrepreneurial activities. A
well-functioning financial system is vital for sustaining long-term economic development.

10. Stability

Stability is a fundamental characteristic of a healthy financial system. It involves maintaining a

balance between risk-taking and caution, ensuring that the system can absorb shocks and
continue functioning effectively during economic downturns or crises.

Objectives of financial system

The objectives of a financial system are centered around supporting economic activities,
ensuring stability, and fostering growth.

1. Efficient Allocation of Resources

The financial system aims to allocate resources efficiently by directing savings to their most
productive uses. By channeling funds from savers to borrowers, it ensures that capital is invested
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in projects and businesses with the highest potential for returns, thus promoting economic
growth.

2. Facilitation of Savings and Investments

One of the core objectives is to encourage savings and channel them into productive investments.
The financial system provides various instruments and platforms for individuals and institutions
to save money and invest in diverse opportunities, thereby contributing to wealth creation and
economic development.

3. Provision of Liquidity

The financial system ensures that participants have access to liquidity, allowing them to quickly
convert assets into cash. This is crucial for meeting short-term obligations, managing risks, and
ensuring the smooth functioning of markets and institutions.

4. Risk Management and Diversification

Another key objective is to provide mechanisms for managing and diversifying risks. Through
financial instruments like insurance, derivatives, and diversified investment portfolios, the
system helps individuals and businesses mitigate various financial risks, including market
volatility, credit risk, and interest rate fluctuations.

5. Support for Economic Stability

The financial system aims to contribute to the overall stability of the economy. By maintaining a
balance between risk and return, ensuring the soundness of financial institutions, and providing
tools for managing economic shocks, the system helps prevent and mitigate financial crises
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6. Facilitation of Payment Systems

An efficient payment system is a fundamental objective of the financial system. It enables

smooth transactions between individuals, businesses, and governments, facilitating trade,
commerce, and economic activity on both a domestic and international scale.

7. Mobilization of Savings

The financial system seeks to mobilize idle savings by offering various savings instruments and
accounts. By attracting savings and making them available for investment, the system supports
economic growth and increases the overall capital available for productive use.

8. Promotion of Financial Inclusion

Ensuring access to financial services for all segments of society is a crucial objective. The
financial system works to promote financial inclusion by extending banking, credit, insurance,
and investment services to underserved and marginalized populations, thereby fostering social
and economic equity.

9. Facilitation of Economic Development

By providing the necessary infrastructure for savings, investments, and risk management, the
financial system plays a vital role in promoting economic development. It supports the growth of
businesses, the creation of jobs, and the overall improvement of living standards.

10. Ensuring Market Integrity and Consumer Protection

The financial system seeks to maintain market integrity by ensuring transparency, fairness, and
adherence to regulations. It also aims to protect consumers from fraud, unfair practices, and
financial losses, thereby maintaining trust and confidence in the financial system.
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Structure/Components of Indian financial system

1. Financial Institutions
Financial institutions are the participants in a financial market. They are business organizations
dealing in financial resources. They collect resources by accepting deposits from individuals and
institutions and lend them to trade, industry and others. They buy and sell financial instruments.
They generate financial instruments as well. They deal in financial assets. They accept deposits,
grant loans and invest in securities.

a. 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
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supply credit but also create credit. There are three basic categories of banking institutions. They
are commercial banks, co-operative banks and developmental banks.

1. Commercial Banks

● Definition: Commercial banks are financial institutions that accept deposits from the
public, offer loans, and provide a wide range of financial services. They are
profit-oriented institutions and are usually regulated by a country's central bank.
● Examples:
○ State Bank of India (SBI) - A large public sector bank in India.
○ ICICI Bank - A major private sector bank in India.

2. Cooperative Banks

● Definition: Cooperative banks are financial entities that are owned and operated by their
members. These banks function on a cooperative basis and are usually set up to cater to
the needs of small businesses, rural areas, and low-income groups. Profits are distributed
among the members.
● Examples:
○ Punjab and Maharashtra Cooperative Bank - A well-known cooperative bank
in India.
○ Saraswat Bank - One of the largest cooperative banks in India.
○ Rabobank - A Dutch cooperative bank known globally for its strong presence in
agribusiness.

3. Regional Rural Banks (RRBs)

● Definition: RRBs are specialized financial institutions created to provide banking

services in rural areas. They primarily serve farmers, small entrepreneurs, and rural
artisans by offering financial services at a low cost. RRBs are typically sponsored by a
commercial bank, the central government, and the state government.
●
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● Examples:
○ Prathama Bank - One of the first RRBs established in India.
○ Baroda Uttar Pradesh Gramin Bank - Sponsored by Bank of Baroda.

4. Foreign Banks

● Definition: Foreign banks are banks that are based in one country but operate branches or
subsidiaries in other countries. They bring international banking practices to the local
market and cater to both individuals and corporations.
● Examples:
○ Citibank - A major global bank headquartered in the United States with
operations in many countries.
○ Standard Chartered - A British multinational bank with significant operations in
Asia, Africa, and the Middle East.

5. Specialized banks

Definition: they are financial institutions that focus on a specific area or type of financial activity,
rather than offering a broad range of banking services like commercial banks. These banks are
designed to meet particular needs within the financial system and often cater to specific sectors,
such as agriculture, industry, or export-import.

Examples

Export-Import Bank (EXIM Bank)

○ Focus: Facilitates and promotes foreign trade by providing financial assistance to

exporters and importers.
○ Example: Export-Import Bank of India (EXIM Bank) - Established by the
Government of India to finance, facilitate, and promote foreign trade.
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Small Industries Development Bank of India (SIDBI)

○ Focus: Promotes the development of small-scale industries by providing

financing and other support services.
○ Example: SIDBI - Focuses on the growth and development of Micro, Small, and
Medium Enterprises (MSMEs) in India.
b. 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.

2. Financial Markets

Financial market deals in financial securities (or financial instruments) and financial services.
Financial markets are the centres or arrangements that provide facilities for buying and selling of
financial claims and services. These are the markets in which money as well as monetary claims
is traded in. Financial markets exist wherever financial transactions take place.
Financial transactions include issue of equity stock by a company, purchase of bonds in the
secondary market.
The participants in the financial markets are corporations, financial institutions, individuals and
the government. These participants trade in financial products in these markets. They trade either
directly or through brokers and dealers.

Classification of Financial markets

Money market: A market where short term funds are borrowed and lend is called money
market. It deals in short term monetary assets with a maturity period of one year or less. Liquid
funds as well as highly liquid securities are traded in the money market.
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Examples of money market are Treasury bill market, call money market, commercial bill
market etc. The main participants in this market are banks, financial institutions and government.
In short, money market is a place where the demand for and supply of short term funds are met.

Capital market: Capital market is the market for long term funds. This market deals in the
long term claims, securities and stocks with a maturity period of more than one year. It is the
market from where productive capital is raised and made available for industrial purposes. The
stock market, the government bond market and derivatives market are examples of capital
market. In short, the capital market deals with long term debt and stock.

Classification of capital market into primary market and secondary market.

Primary market: Primary markets are those markets which deal in the new securities.
Therefore, they are also known as new issue markets. These are markets where securities are
issued for the first time. In other words, these are the markets for the securities issued directly by
the companies. The primary markets mobilise savings and supply fresh or additional capital to
business units.

Secondary market: Secondary markets are those markets which deal in existing securities.
Existing securities are those securities that have already been issued and are already outstanding.
Secondary market consists of stock exchanges. Stock exchanges are self regulatory bodies under
the overall regulatory purview of the Govt. /SEBI

3. Financial Instruments (Securities)/Assets

Financial instruments/asset refers to a claim to the repayment of a certain sum of money at the
end of a specified period together with interest or dividend.
The financial instruments may be capital market instruments or money market instruments or
hybrid instruments. The financial instruments that are used for raising capital through the capital
market are known as capital market instruments. These include equity shares, preference shares,
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warrants, debentures and bonds. These securities have a maturity period of more than one year.
The financial instruments that are used for raising and supplying money in a short period not
exceeding one year through money market are called money market instruments. Examples are
treasury bills, commercial paper, call money, short notice money, certificates of deposits,
commercial bills, money market mutual funds.

4. Financial Services

Financial services refer to a broad range of services provided by the finance industry, which
encompasses businesses and organizations that manage money. These services are critical for the
functioning of the economy and include a variety of offerings, such as:

The financial services include all activities connected with the transformation of savings into
investment. Important financial services include lease financing, hire purchase, instalment
payment systems, merchant banking, factoring, forfaiting etc
Financial services provided by various financial institutions, commercial banks and merchant
bankers can be broadly classified into two categories
1. Asset based/fund based services.
2. Fee based/advisory services.

1. Fund-Based Services

Fund-based services involve activities where financial institutions use their own funds or
customer deposits to earn income. The primary revenue comes from the interest or returns on
these funds. Examples include:

● Loans and Advances: Banks and financial institutions lend money to individuals,
businesses, and governments, earning interest on these loans. This is a typical example of
a fund-based service.
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● Leasing: In leasing, a financial institution purchases an asset and then rents it out to a
client for a specific period. The institution earns lease payments, which are often
structured to cover the cost of the asset plus a profit margin.
● Investments: Financial institutions invest in securities, bonds, stocks, or other financial
instruments using their own funds or customer deposits. The income comes from
dividends, interest, or capital gains.
● Discounting Bills of Exchange: In this service, financial institutions purchase bills of
exchange (a form of short-term credit) at a discount before they are due, earning interest
when the bill matures.

2. Fee-Based Services

Fee-based services involve financial institutions offering specialized services for which they
charge a fee. These services do not involve the use of the institution's own funds but instead
focus on providing expertise, advice, and transaction processing. Examples include:

● Investment Advisory: Financial advisors provide investment recommendations and

strategies to clients, earning fees for their expertise and guidance.
● Brokerage Services: Brokers facilitate the buying and selling of securities, such as
stocks and bonds, on behalf of clients. They earn commissions or fees on the transactions
they handle.
● Underwriting: In underwriting, especially in investment banking, financial institutions
assess the risk and determine the price of securities (like stocks or bonds) before they are
issued to the public. They earn fees for this service.
● Wealth Management: Financial institutions provide personalized financial planning and
management services for high-net-worth individuals, earning fees based on the assets
under management (AUM).
● Credit Card Services: Banks and financial institutions earn fees from merchants and
customers for processing credit card transactions. These fees are separate from the
interest income from credit card balances, making this a fee-based service.
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● Mutual Fund Management: Companies managing mutual funds charge fees to investors
for managing the fund, which is a fee-based revenue.

Role of Financial system in Economic development

The financial system plays a critical role in driving economic growth by efficiently allocating
resources, facilitating investment, managing risks, and supporting overall economic stability.

1. Mobilization of Savings

The financial system enables the mobilization of savings from individuals and businesses,
channeling these funds into productive investments. Banks, mutual funds, pension funds, and
other financial institutions collect savings and make them available for businesses and
governments to invest in infrastructure, technology, and other growth-enhancing activities.

2. Efficient Allocation of Resources

Financial markets and institutions play a crucial role in directing resources to the most
productive uses. Through various mechanisms like loans, equity financing, and bond markets,
the financial system allocates capital to projects and companies with the highest potential for
growth and returns. This efficient allocation supports innovation, entrepreneurship, and
expansion of businesses, leading to higher economic growth.

3. Facilitation of Trade and Commerce

The financial system supports trade and commerce by providing payment services, credit
facilities, and risk management products. Banks, for instance, offer credit lines, trade finance,
and currency exchange services, which are essential for both domestic and international trade.
This enhances economic activities, boosts productivity, and contributes to economic growth.
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4. Investment Promotion

The financial system encourages investment by providing various instruments like stocks, bonds,
and derivatives that allow individuals and institutions to invest their capital. By offering diverse
investment opportunities, the financial system helps investors manage risk and seek returns,
which in turn stimulates economic activity and growth.

5. Risk Management

Financial institutions and markets offer a variety of products to manage risk, such as insurance,
derivatives, and hedging instruments. By reducing uncertainty and providing protection against
risks like price volatility, interest rate changes, or natural disasters, the financial system enables
businesses and individuals to undertake investments and activities that contribute to economic
growth.

6. Support for Innovation and Entrepreneurship

The financial system supports innovation and entrepreneurship by providing funding to startups
and innovative projects. Venture capital, angel investors, and crowdfunding platforms are
examples of financial mechanisms that help entrepreneurs turn their ideas into viable businesses.
This process of funding innovation drives technological advancement and economic
development.

7. Creation of Employment

As businesses grow and expand with the help of financial resources, they create jobs and reduce
unemployment. The financial system's ability to finance business expansion, infrastructure
development, and new ventures leads to job creation, which in turn boosts income levels and
aggregate demand, fueling further economic growth.
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8. Promotion of Economic Stability

A well-functioning financial system contributes to economic stability by providing a framework

for monetary policy, managing inflation, and regulating financial markets. Central banks and
regulatory institutions oversee the financial system, ensuring that it operates smoothly and
mitigates risks of financial crises. Stability in the financial system is essential for sustained
economic growth.

9. Facilitation of Government Policies

The financial system plays a key role in implementing government economic policies. For
example, through monetary policy, central banks can influence interest rates and money supply,
which affect investment, consumption, and overall economic growth. Governments also use the
financial system to raise funds through the issuance of bonds, which are critical for financing
public projects and social programs.

10. Encouraging Foreign Investment

A robust financial system attracts foreign investment, which brings in capital, technology, and
expertise from abroad. Foreign direct investment (FDI) and portfolio investment contribute to
economic growth by creating jobs, improving infrastructure, and enhancing productivity.

Conclusion:

The financial system is the backbone of economic growth, enabling the efficient flow of funds,
fostering investment, and ensuring stability. By providing the necessary infrastructure for saving,
investing, risk management, and monetary policy implementation, the financial system drives
economic development and improves living standards across society.
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SWOT/SWOC of Indian financial system

The SWOC (Strengths, Weaknesses, Opportunities, and Challenges) analysis of the Indian
financial system provides a comprehensive view of its current state, highlighting both the areas
where it excels and the challenges it faces. Here's a detailed breakdown:

Strengths

1. Diverse Financial Institutions:

○ India has a wide range of financial institutions, including commercial banks,
cooperative banks, non-banking financial companies (NBFCs), insurance
companies, and mutual funds, which cater to various segments of the population.
2. Robust Regulatory Framework:
○ The Indian financial system is supported by a strong regulatory framework, with
institutions like the Reserve Bank of India (RBI), Securities and Exchange Board
of India (SEBI), and Insurance Regulatory and Development Authority of India
(IRDAI) overseeing and regulating financial activities to ensure stability and
transparency.
3. Increasing Financial Inclusion:
○ Initiatives like the Pradhan Mantri Jan Dhan Yojana (PMJDY), Aadhaar, and the
expansion of digital payment systems have significantly increased financial
inclusion, bringing millions of people into the formal financial sector.
4. Growth of Digital Finance:
○ India has seen a rapid growth in digital finance, with widespread adoption of
digital payment platforms like UPI (Unified Payments Interface), mobile banking,
and fintech innovations, which have enhanced accessibility and convenience in
financial transactions.
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5. Strong Capital Markets:

○ The Indian capital markets have matured over the years, with a well-developed
stock exchange system, a growing mutual fund industry, and increasing
participation from both domestic and international investors.

Weaknesses

1. High Non-Performing Assets (NPAs):

○ Indian banks, particularly public sector banks, have struggled with high levels of
NPAs, which have impacted their profitability and lending capacity. This issue has
been exacerbated by economic slowdowns and poor credit risk management.
2. Limited Penetration in Rural Areas:
○ Despite improvements, financial penetration in rural and semi-urban areas
remains limited. A significant portion of the population still lacks access to formal
banking and financial services, leading to financial exclusion.
3. Underdeveloped Bond Market:
○ India’s corporate bond market is relatively underdeveloped compared to other
countries. This limits the options for companies to raise long-term capital and for
investors seeking diverse investment opportunities.
4. Dependence on Public Sector Banks:
○ The Indian financial system is heavily reliant on public sector banks, which have
been criticized for inefficiency, bureaucratic management, and slower adoption of
technological innovations compared to private sector counterparts.
5. Regulatory Complexity:
○ The financial system is sometimes hampered by complex and overlapping
regulations, which can create confusion, slow down decision-making processes,
and increase compliance costs for financial institutions.
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Opportunities

1. Expansion of Financial Inclusion:

○ There is a significant opportunity to further expand financial inclusion through the
use of technology, microfinance, and rural banking initiatives, thereby bringing
more people into the formal financial system.
2. Growth of Fintech and Digital Services:
○ The rise of fintech offers vast opportunities to innovate and improve the delivery
of financial services, particularly in payments, lending, insurance, and wealth
management. The continued integration of AI, blockchain, and big data analytics
could revolutionize the financial landscape.
3. Infrastructure Financing:
○ India’s growing infrastructure needs present a significant opportunity for the
financial system to participate in large-scale infrastructure financing, attracting
both domestic and foreign investments.
4. Foreign Investment:
○ India's large and growing economy continues to attract foreign direct investment
(FDI) and portfolio investment. Liberalizing investment norms further and
improving the ease of doing business can enhance this inflow, contributing to
economic growth.
5. Development of Green Finance:
○ With global emphasis on sustainability, there is an opportunity to develop green
finance initiatives, such as green bonds and sustainable investment funds, to
support environmental and climate-related projects.

Challenges

1. Economic Slowdowns and Global Uncertainty:

○ Economic slowdowns, both domestic and global, pose a significant challenge to
the Indian financial system. Global uncertainties, such as geopolitical tensions or
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international trade issues, can impact capital flows, market stability, and overall
economic growth.
2. Regulatory Risks and Compliance:
○ Navigating the complex regulatory environment, adapting to changing
regulations, and ensuring compliance can be challenging for financial institutions,
especially with the rapid pace of technological change and the need for stringent
data protection measures.
3. Cybersecurity Threats:
○ The increasing digitization of financial services has heightened the risk of
cyberattacks, data breaches, and fraud. Ensuring robust cybersecurity measures
and protecting customer data are critical challenges for the financial system.
4. Managing Non-Performing Assets (NPAs):
○ Reducing NPAs and improving the quality of assets remain a critical challenge,
particularly for public sector banks. Effective resolution mechanisms and credit
risk management practices need to be strengthened.
5. Balancing Growth with Stability:
○ While pursuing growth, the financial system must also focus on maintaining
stability. This includes managing inflation, ensuring liquidity in the market, and
avoiding asset bubbles that could lead to financial crises.

Conclusion:

The Indian financial system has made significant strides in recent years, supported by a strong
regulatory framework and advancements in digital finance. However, challenges like high NPAs,
regulatory complexities, and the need for greater financial inclusion in rural areas must be
addressed to unlock its full potential. Opportunities in fintech, infrastructure financing, and green
finance, if effectively leveraged, could drive further growth and stability in the Indian economy.

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