INDIAN FINANCIAL

SYSTEM
MODULE - 1
 Meaning of Financial System
• A Financial System is a set of complex and closely connected instructions,
services, transactions, institutions, markets and instruments relating to
financial aspects of an economy.

• A Financial System is a system that aims at establishing and providing a

regular, smooth, efficient and cost effective linkage between ‘those who have
money’ and ‘those who need money’, and thus plays a crucial role in the
functioning of the economy.
Sub-Systems/Components of Financial System
1. Financial Services…..(what is done)
2. Financial Institutions…..(who does them)
3. Financial Instruments…..(using what)
4. Financial Markets…..(where are those instruments traded)
1. Financial Services:
• Financial services are the economic services provided by the finance industry,
which includes a broad range of activities such as lease financing, hire
purchase, instalment payment systems, merchant banking, factoring,
forfaiting, credit rating, etc.
2. Financial Institutions:
• Financial institutions are the participants in a financial market.
• They are business organizations dealing in financial instruments.
• They collect resources by accepting deposits from individuals
and institutions and lend them to borrowers.
• On the basis of the nature of activities, financial institutions may
be classified as:
1. Regulatory Institutions
2. Banking Institutions
3. Non-Banking Institutions
1. Regulatory Institutions: Financial institutions, financial markets, financial
instruments and financial services are all regulated by regulators like
Ministry of Finance, the Company Law Board, RBI, SEBI, IRDA, Dept. of
Economic Affairs, Department of Company Affairs etc.
2. Banking Institutions: Banking Institutions mobilize 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 three basic categories of banking
institutions - Commercial Banks, Co-operative Banks and Developmental
Banks.
3. Non-Banking Institutions: The non banking financial institutions also
mobilize financial resources directly or indirectly from the people.
Companies like LIC, GIC, UTI, etc fall in this category. Non-banking financial
institutions can be categorized as investment companies, housing
companies, leasing companies, hire purchase companies, specialized
financial institutions.
3. Financial Instruments:
• Financial Instruments are contracts for monetary assets that can be
purchased, traded, created, modified, or settled for. In terms of contracts,
there is a contractual obligation between involved parties during a financial
instrument transaction.
• For example, if a company were to pay cash for a bond, another party is
obligated to deliver a financial instrument for the transaction to be fully
completed. One company is obligated to provide cash, while the other is
obligated to provide the bond.

• Basic examples of financial instruments are shares, debentures, bonds, etc.

4. Financial Markets:
• Financial Market refers to a space (platform) where trading of financial assets
(such as shares, debentures, bonds, derivatives, etc.) takes place.
• It plays a crucial role in allocating limited resources, in the country’s
economy.
• It acts as an intermediary between the savers and investors by mobilizing
funds between them.
 Evolution of Indian Financial System
1. Pre-Independence Phase (before 1947):

• Establishment of Bank of Hindustan in the year 1770 in Calcutta marks the

starting of the Indian financial system. The bank discontinued its services in 1832.
• There were various banks that evolved post to Hindustan banks such as General
Bank of India (1786-1791) and Oudh commercial bank (1881-1958). However,
these banks were not able to continue for a long.
• Few banks of the 19th century are existing even today such as Punjab National
bank formed in 1894 and Allahabad Bank formed in 1865.
• Three major banks of that time like Bank of Bengal, Bank of Madras and Bank of
Bombay were merged as one body which was termed as Imperial Bank of India.
This Imperial Bank was later on renamed to State Bank of India (SBI).
• During this phase, the Bombay Stock Exchange(BSE) also established in 1875.
• Hilton Young Commission in year 1935 recommended the establishment of
Reserve bank of India. And therefore, the Reserve Bank of India (RBI) was
established in 1935.
• This was a phase in which majority of small-sized banks failed to function
properly and were unable to gain people’s confidence. People were more
involved with money lenders and unregulated players.
2. Post-Independence Phase (1947 to 1991):

• The Post-Independence period is characterized by the Nationalization of Banks. Majority of

banks in India were privately owned at the time of independence and were serving only the big
corporates. Rural population, small-scale industries and agriculture sector were still dependent
on local money lenders. The government in order to overcome this situation decided to
nationalize the banks under the Banking Regulation Act (1949).
• RBI was nationalized in 1949 and later on, 14 commercial banks were nationalized in July 1969
during the tenure of Indira Gandhi.
• Narasimham Committee in 1975 recommended the establishment of Regional Rural Banks (RRB)
for development of rural sector and providing services to unserved ones.
• There were several other specialized banks which were constituted during this period to support
the development of the economy – NABARD in 1982 for supporting agricultural-related activities,
National Housing Bank in 1988 for the Housing sector, SIDBI in 1990 for assisting small-scale
firms.
• Over-The-Counter Exchange of India (OTCEI) was established in 1990. The purpose of the OTCEI
is for smaller companies to raise capital, which they cannot do at the national exchanges due to
their inability to meet the exchange requirements.
3. The Liberalization Era (1991 and beyond)

• This was a phase which saw remarkable changes in the banking industry.
• During this period, government opened up the economy the granted private
player’s entry to the banking industry. RBI granted license to 10 private sector
banks out of which only few notables survived like Axis Bank, HDFC Bank, DCB,
ICICI and IndusInd Bank.
• National Stock Exchange (NSE) was established in 1992 to provide fully
automated electronic trading.
• Narasimham Committee again in 1998 recommended the entry of more private
entities in banking industry. Therefore, license was provided to Kotak Mahindra in
2001 and Yes Bank in 2004 by RBI. Further in 2013-2014, a license was granted to
Bandhan and IDFC bank.
• Multi Commodity Exchange of India Ltd (MCX) and National Commodity &
Derivatives Exchange Limited (NCDEX) were established in 2003.
• On April 11, 2016, Airtel Payments Bank became the first entity in India to
receive a payments bank license from the Reserve Bank of India (RBI).
• State Bank of India and 5 associate banks were merged in the year 2017. This is
called the SBI Merger.
• https://www.enterpriseedges.com/banking-financial-service-trends-india
 Financial Market
• Financial Market refers to a space (platform) where trading of financial assets
(such as shares, debentures, bonds, derivatives, etc.) takes place.
• It plays a crucial role in allocating limited resources in the country’s economy.
• It acts as an intermediary between the buyers and sellers of Financial
Instruments.
 Structure of the Financial Market
1. Unorganised Market 2. Organised Market
1) Money Market
• Money Lenders • Short-Term Loans Market
• Indigenous Bankers • Call Money Market
• Chit Funds • Treasury Bills Market
• Commercial Bills Market
• Pawn Brokers • Commercial Paper Market

2) Capital Market
• Long-Term Loans Market
• Share Market
o Primary Market (New Issue Market)
o Secondary Market (Stock Market)
• Debentures Market
• Bonds Market
• Mutual Fund Market
• FOREX Market
• Derivatives Market
• Commodities Market
1. Unorganised Market: It refers to the portion of the financial market that is not
formally regulated by the RBI, SEBI, IRDA etc. They might be governed by certain
Acts, but they don’t fall under the strict scrutiny of the regulatory bodies. Hence
the name “Unorganised”.
• Money Lenders: A Money Lender is someone who lends small amounts of money at a higher
rate of interest out of the money lender’s own funds. The reason for charging higher rates of
interest is that the money lender faces a higher risk of default than normal banks due to
various reasons. People who are desperately in need of money but at the same time do not
have a bank account, people with bad credit histories and those who can’t get money from
friends or relatives approach a money lender for credit facilities. In India, money lenders are
governed by the Money Lenders Act in different states.
• Indigenous Bankers: Indigenous Bankers are private firms or individuals who act as banks by
providing financial services such as loans and accepting deposits, but do not fall under the
purview of the government. The indigenous banker is different from a moneylender. A
moneylender is not a banker; his business is only to lend money from his own funds. The
indigenous banker, on the other hand, lends money from the deposits accepted from the
public. Indigenous bankers formed the bulk of the Indian financial system in the ancient times.
These bankers provided credit facilities to the individuals and businesses as well as to the
governments at times. The indigenous banking system lost its charm with the advent of
commercial banks and foreign banks.
• Chit Funds: In a chit fund scheme, a group of people contribute periodically towards the
chit value for a duration equal to the number of investors (members or subscribers), so if
there are 10 members in the fund then the fund will last for 10 months. The amount
collected (called the “Pot”) is given to the person, who is either selected through a lucky
draw (lottery system) or an auction. In the auction allotment system, the person who
bids the lowest bid (agrees to claim the lowest amount) gets the money. This type of
auction system is known as a reverse auction. The amount forgone by the winning bidder
(i.e, the remaining amount) is then distributed among the other members equally after
deducting the foreman’s commission and other charges. This amount received by each
member is called dividend. Even after claiming the amount, the winning bidder has to
continue investing. Chit Fund Business in India is regulated by Chit Funds Act, 1982
• Pawn Brokers: A pawnbroker is an individual or business (pawnshop) that offers secured
loans to people, with items of personal property used as collateral. While many items
can be pawned, pawnshops typically accept jewelry, musical instruments, home audio
equipment, computers, video game systems, coins, gold, silver, televisions, cameras,
power tools, firearms, and other relatively valuable items as collateral.
2. Organised Market: It refers to the portion of the financial market that is
formally regulated by the RBI, SEBI, IRDA etc. They are governed by certain
Acts, they fall under the strict scrutiny of the regulatory bodies, and their
rules and regulations are highly consistent and set mostly by the regulatory
bodies. Hence the name “Organised”.
• Money Market: Money Market deals with Financial Instruments which have a maturity
period of less than 1 year (i.e, 364 days or less). Its main objective is to finance working
capital requirements of a company.
• Capital Market: Capital Market deals with Financial Instruments which have a maturity
period of more than 1 year. Its main objective is to finance long-term capital
requirements of a company.
 BASIS FOR
MONEY MARKET CAPITAL MARKET
COMPARISON

Meaning A segment of the financial market where lending A segment of the financial market where long term
and borrowing of short term securities are done. securities are issued and traded.

Financial Treasury Bills, Commercial Papers, Certificate of Shares, Debentures, Bonds, Mutual Funds, Asset
Instruments Deposit, etc. Securitization, etc.

Financial RBI, Commercial Banks, Bill Brokers, Acceptance RBI, SEBI, IRDA, Commercial Banks, Stock
Institutions Houses, Co-operative Banks, etc. Exchange, Clearing Houses, Depositories, etc.

To finance the working capital requirements of a To finance the long-term capital requirements of a
Objective company company

Purpose To fulfill short-term credit needs of the business. To fulfill long-term credit needs of the business.

Liquidity Comparatively High Comparatively Low

Risk Factor Comparatively Low Comparatively High

Return on Comparatively Low Comparatively High

Investment

Time Horizon Less than a year More than a year

 Money Market - Components
1. Short-Term Loans Market
2. Call Money Market: Call Money is a short-term financial loan that is payable
immediately, and in full, when the lender demands it. The general term for call
money is 1 day (call money) or 2 days to 14 days (notice money). The main lenders
of the fund in the call money market are SBI, LIC, GIC, UTI, IDBI, NABARD, and other
financial institutions, and the main borrowers are the scheduled commercial banks.
The interest rates in the market are market-driven and hence highly sensitive to
demands and supply.
3. Treasury Bills Market: Treasure Bills are money market instruments issued by the
Reserve Bank of India (RBI) acting on the behalf of the central government. These
bills (also known as Zero Coupon Bonds) are issued when there is a shortage of
funds, or when the RBI wants to control the cash liquidity in the market. The
maturity of such bills is always less than one year. They are highly liquid instruments
and are a very low-risk instrument. Treasury Bills are issued at a discount than the
face value and are redeemed at par. The difference is the interest received by the
holder, which in this case will be known as the ‘discount’. Currently, there are 3
types of treasury bills issued by the central government of India via auctions, which
are 91 days, 182 days, and 364 days treasury bills.
4. Commercial Paper Market: Commercial Paper is a promissory note. It is a short
term, uninsured debt instrument, generally issued by large companies and
corporations in need of quick short-term loans. Commercial papers have a
maturity date of between 15 days to 364 days. They are issued at a discount
and redeemed at par. They are highly liquid and easily transferable instruments
of the money market.
5. Commercial Bills Market: A Commercial Bill is essentially a bill of exchange. In a
credit sale, if the seller needs the payment immediately, the seller (drawer) will
draw a bill of exchange, the buyer (drawee) of the goods will accept that bill,
and the bill becomes a Trade Bill which is a marketable financial instrument.
The seller can then go to his bank (payee) and get the bill discounted. Here the
bank will promise to pay the amount if the buyer is unable to do so, and this
way a trade bill becomes a commercial bill. The bank accepts the bill drawn by
the seller and pays him immediately (after deducting some amount known as
“discount”). The bank then presents the bill to the buyer on the due date of the
bill and collects the total amount. If the bill is delayed, the seller or the buyer
pays the bank a predetermined interest depending upon the terms of the
transaction. The general term for such bills is 30, 60, or 90 days. The parties
involved in this market are the Seller (drawer), the Buyer (drawee) and the Bank
(payee).
6. Banker’s Acceptance Market: A Banker’s Acceptance is a form of short-term
debt that is issued by a firm but guaranteed by a bank. It is often used in
international credit trade because of the benefits to both the drawer and the
bearer. For example, if an Importer wants to order goods but the Exporter
won't give him credit, then the Importer (drawer) goes to his Bank (payee),
which guarantees the payment to the Exporter (holder). The bank is accepting
the responsibility for the payment, that if the importer does not pay the
exporter, this bank will pay the exporter on the importer’s behalf. The holder of
the Banker’s Acceptance may decide to sell it on a secondary market, and
investors can profit from the short-term investment. The maturity date usually
lies between 30 days, 60 days, 90 days or 180 days from the issuing date.
7. Certificate of Deposit (CD) Market: A Certificate of Deposit (CD) is an
investment instrument issued by banks or financial institutions, requiring
investors to lock in funds for a fixed term to earn high returns. CDs essentially
require investors to set aside their savings and leave them untouched for a fixed
period. This makes CDs similar to Fixed Deposits (FDs), however FDs cannot be
traded but some CDs can be traded in the secondary market. CDs are issued at
a discount and redeemed at par. They also earn an interest on the deposited
amount. They are issued with a maturity ranging anywhere from 7 days to 1
year.
 Capital Market - Components
1. Long-Term Loans Market
2. Share Market: A share is share (portion) of the share capital of a company. A
share represents a unit of equity ownership in a company. Shareholders are
entitled to any profits that the company may earn in the form of dividends. The
Share Market deals with the issue and trading of shares.
1) Primary Market (New Issue Market): This is the market where new shares
are created and ISSUED for the first time in the market through IPO (Initial
Public Offer), FPO (Follow-on Public Offer), Private Placement, etc. The
company issuing the shares is involved in the transactions.
2) Secondary Market (Stock Market): This is the market where shares that
have already been issued in the primary market are now TRADED between
traders and/or investors. The company that issued the shares is not
involved in the transactions.
3. Debentures Market: A Debenture is a type of medium term business debt
usually not secured by any collateral issued by firms. A debenture is a
marketable security that businesses can issue to obtain medium to long term
financing without needing to put up collateral or dilute their equity. Bonds are
backed by the collateral or asset of the issuer. On the other hand, debentures
are not usually backed by any of the physical assets or collateral. Debentures
are more risky than bonds (because most debentures are unsecured) and
therefore debentures earn higher interest than bonds.
4. Bonds Market: Bonds are long-term debt securities where an investor lends
money to a company or a government for a set period of time, in exchange for
regular interest payments. Once the bond reaches maturity, the bond issuer
returns the investor’s money. Bonds can be issued by companies or by the
government to fund various projects, and are usually secured against the assets
of the issuer. Bonds can be traded amongst investors through bond brokers.
Bonds earn a lower rate of interest compared to debentures because bonds are
less risky. Also, bondholders are paid before debenture holders are paid (i.e.,
bondholders have a higher priority).
5. Mutual Funds Market: A Mutual Fund is a professionally-managed investment
scheme, made up of a pool of money collected from many investors which is
invested in securities like shares, bonds, money market instruments, and other
assets. Mutual funds are operated by a professional Fund Manager who works
for an Asset Management Company (AMC), who allocates the fund's assets into
various assets and attempts to produce capital gains or income for the fund's
investors. A mutual fund's portfolio is structured and maintained to match the
investment objectives stated in its prospectus.
6. Derivatives Market: A “derivative” is a financial asset (contract) that derives its
value from the value of an underlying asset. As the value of the underlying
asset changes, it affects the value/worth of the derivative. Types of derivatives
are Forwards, Futures, Options and Swaps. The market that deals with
derivatives is called the Derivatives Market.
7. FOREX Market: The Foreign Exchange (FOREX) Market is a global decentralized
or over-the-counter (OTC) market for the trading of currencies. This market
determines foreign exchange rates for every currency. It includes all aspects of
buying, selling and exchanging currencies at current or determined prices. In
terms of trading volume, it is by far the largest market in the world, and is made
up of banks, companies, central banks, investment management firms, hedge
funds, retail forex brokers, and investors. Spot FOREX transactions involve
immediate delivery, while Derivatives transactions entail delivery in the future.
8. Commodities Market: A Commodity Market is a platform for investors to trade
in commodities like precious metals, crude oil, natural gas, energy, and spices,
etc. There are hard commodities (which are generally natural resources) and
soft commodities (which are livestock or agricultural goods). Spot Commodity
transactions involve immediate delivery, while Derivatives transactions entail
delivery in the future.
 Primary Market vs Secondary Market
Primary Market Secondary Market

This is the market where new shares are This is the market where shares that have
created and ISSUED for the first time in the already been issued in the primary market are
market now TRADED between traders and/or investors

It is also known as New Issue Market It is also known as Aftermarket or Stock Market

The company issuing the shares is involved in The company issuing the shares is not involved
the transaction, since the transaction is in the transaction, since the transactions are
between the company and investors amongst investors or traders

The primary market transactions provides The secondary market transactions do not
funding to companies for their expansion and provide funding to companies, since the
growth transactions are only amongst investors
 Primary Market Secondary Market

The beneficiary in the primary market is the The beneficiary in the secondary market is the
company investor or trader

A share is transacted only once in the primary A share can be traded multiple times in the
market secondary market

The Prices of a security in the primary market Prices of a security in the secondary market
do not fluctuate, i.e., they are Fixed fluctuate a lot based on Demand and Supply

Underwriters are the main intermediary Stock Brokers are the main intermediary

Primary Markets lack a specific geographical Secondary Markets have a physical presence in
presence. It cannot be attributed to a specific
location as such the form of Stock Exchanges
 Stock Market - Merits
1. Liquidity: Liquidity in transacting – Stock Markets were established to facilitate the sale of
securities and the subsequent transfer of value. Because you can easily convert long-term
capital back into a short-term one, it's useful for both short-term liquidity and medium-term
investments.
2. Marketability: Easy to Buy and Sell Securities. Shares are “self-marketed”, because thanks to
the stock market, the people who want to buy a share can clearly and easily know if there are
people willing to sell that share, therefore the seller doesn’t have to manually advertise his
willingness to sell.
3. Provides useful and vital data: Investors, governments and creditors benefit from secondary
markets. Data from the stock market might help investors estimate how much money they've
put in their shares and to predict future share prices. t comes in handy when figuring out
taxes or how much money to borrow from the bank for future share purchases. As a result,
the government has a better understanding of the financial situation of its residents. It aids in
tax revenue collection. The government uses data instead of reacting to pending tax
payments. To determine a borrower's creditworthiness, lenders use valuations.
4. Diversification: Because various securities in different industries are available, investors can
increase the diversification of their investments.
5. Transparency: Access to company’s financial information and other information; Access to
bid and ask prices of the shares being bought or sold.
6. Regulated Market: The market is regulated and monitored by SEBI; Listed companies,
brokers, clearing houses, and all intermediaries should follow the regulations set by SEBI,
Depositories Act, etc.
7. Security and Validity of transactions: All participants are verified; The transactions are
validated and are secured every step of the way.
8. Clearing of Transactions: There are specific clearing houses responsible for clearing the
transactions. Therefore transactions are cleared easily and systematically.
9. Economic Indicator (Barometer): The secondary market serves as an excellent gauge of a
country's overall economic health. To put it another way, every significant change in the
country has an impact on share prices. During economic cycles, every increase or fall
corresponds to a corresponding uptick or downtick. It's possible to think of the Secondary
Market as a way to check on the general well-being of the economy.
 Stock Market - Demerits
1. Brokerage Fees: Brokerage fees could end up being high if the investor deals in
large volume of transactions, since a brokerage is charged per transaction.
2. Price Fluctuations: Price fluctuations are very high in secondary markets, which
can even lead to sudden losses for investors.
3. Very Sensitive to Changes: Stock Markets are usually very sensitive to changes
in economic situations, government policies, politics, public sentiments, etc.
4. Government Regulations: Sometimes, too many regulations issued by the
government (to be followed by companies listed in the stock market) can be too
cumbersome or complex for some companies to keep up with.
5. Lack of Secrecy: Since the financials and the annual report of the company
(whose shares are registered under the stock exchange) have to be made
public, there is lack of scope for company secrecy especially in case of long
term strategic decisions. This might not be suitable for companies especially
when they don’t want their competitors to figure out what they are planning.