Report on " Role of Financial System : With Specific References to Indian Financial System "

For Presentation at IIT Bombay

March 15, 2013

Under the Guidance of: Dr.Puja Padhi, Asst. of. Economics, Dept of Humanities and Social Sciences, IIT Bombay

Prepared by: Manav Saurav & Swatilekha Thakur M.Phil(Plan. & Dev.) IIT Bombay

Contents
1. Financial System................................................................................................................................. 3 1.1 Components of Financial System ................................................................................................ 3 2. Structure Indian Financial System ...................................................................................................... 4 3. Role of the Financial System .............................................................................................................. 6 3.1. Changing roles of the Financial System ...................................................................................... 8 3.2 Need for Financial Reform: Post 2008 crisis ................................................................................ 8 Refrences............................................................................................................................................... 10

1. Financial System
A financial system can be defined at the global, regional or firm specific level. The firm's financial system is the set of implemented procedures that track the financial activities of the company. On a regional scale, the financial system is the system that enables lenders and borrowers to exchange funds. The global financial system is basically a broader regional system that encompasses all financial institutions, borrowers and lenders within the global economy. There are multiple components making up the financial system of different levels: Within a firm, the financial system encompasses all aspects of finances. For example, it would include accounting measures, revenue and expense schedules, wages and balance sheet verification. Regional financial systems would include banks and other financial institutions, financial markets, financial services In a global view, financial systems would include the International Monetary Fund, central banks, World Bank and major banks that practice overseas lending. (www.investopedia.com/ n.d.) Gurusamy (2009), in Financial Services and Systems has defined financial system as : "a set of complex and closely interconnected financial institutions, markets, instruments, services, practices, and transactions. A more functional definition of Financial system by Franklin Allen and Douglas Gale (2001)in Comparing Financial Systems: Financial systems are crucial to the allocation of resources in a modern economy. They channel household savings to the corporate sector and allocate investment funds among firms; they allow intertemporal smoothing of consumption by households and expenditures by firms; and they enable households and firms to share risks. These functions are common to the financial systems of most developed economies. Yet the form of these financial systems varies widely."

1.1 Components of Financial System

A financial system is based on four basic components such as : Financial Institution, Financial Services, Financial Market and Financial Instrument. These components are closely related and work in the conjunction with each others. Financial institutions operate in financial markets-generating, purchasing and selling financial instruments and rendering various financial services in accordance with the practices and procedures established by law or tradition. The different components of

financial system can be explained as follows : Financial institution is a institution that provides financial services for its clients and members. This basically deals with credit and credit related services. It was found that the most important financial services that the financial institution provides is acting as financial intermediaries. Most of the financial institutions are regulated by the Government. Financial institution can be further classified into two types- Banking and Non-Banking. Banking as a financial institution mainly deals with 3

accepting deposits and providing loans and it can be of public sector and private sector banks. NonBanking institutions such as : UTI, LIC etc on the other hand are generally engaged in obtaining funds from depositors indirectly. Financial Services Comprise of various functions that are provided by the financial institutions in a financial system. These are the economic services provided by the industry which covers a broad range of organisations that manage money including Credit Unions, Banks, Credit Card Companies, Insurance Companies, Brokerage, Investment Funds etc. Now in the pace of technological advancement, new services like Mobile and Internet Banking, ATM networking, Consultancy Service, Promotional Discounts, Low Interest Rate, Innovation of new schemes are being provided by the financial institutions. Financial market is a mechanism in which people can trade financial services, assets and securities and low transaction cost and prices that reflects demand and supply. The players like financial institutions ,investors, depositors, lenders, borrowers and agents etc take active part in driving demand and supply in financial market. A financial market is further classified into two types like- An Unorganised Financial Market where market has no adequate regulations relating to financial dealings. On the other hand in an Organised Financial Market, there are a set of rules and

regulations in governing financial dealings. Financial instrument is a tradable asset of any kind, either Cash or a contractual right to receive or deliver cash. Moreover the Financial claims such as financial assets and securities dealt in financial market is referred as financial instruments. Some of the characteristics that a financial instrument bears are - Liquidity, Collateral value, marketability, convertibility, maturity period, transaction

cost, tax status, risk and uncertainty, price fluctuations etc. Financial instruments are classified into three types such as : Short-Term, Medium-Term and Long-Term Instruments. Further it can be separated into types like - Primary Securities, Secondary Securities and Innovative Instruments.

2. Structure Indian Financial System

India has a financial system that is regulated by independent regulators in the sectors of banking, insurance, capital markets, competition and various services sectors. In a number of sectors the Government plays the role of regulator.

Ministry of Finance, Government of India looks after financial sector in India. Finance Ministry every year presents annual budget on February 28 in the Parliament. The annual budget proposes changes in taxes, changes in government policy in almost all the sectors and budgetary and other allocations for

all the Ministries of Government of India. The annual budget is passed by the Parliament after debate and takes the shape of law.

Reserve bank of India (RBI) established in 1935 is the Central bank. RBI is regulator for financial and banking system, formulates monetary policy and prescribes exchange control norms. The Banking Regulation Act, 1949 and the Reserve Bank of India Act, 1934 authorize the RBI to regulate the banking sector in India.

India has commercial banks, co-operative banks and regional rural banks. The commercial banking sector comprises of public sector banks, private banks and foreign banks. The public sector banks comprise the State Bank of India and its seven associate banks and ninete en other banks owned by the government and account for almost three fourth of the banking sector. The Government of India has majority shares in these public sector banks.

India has a two-tier structure of financial institutions with thirteen all India financial institutions and forty-six institutions at the state level. All India financial institutions comprise term-lending institutions, specialized institutions and investment institutions, including in insurance. State level institutions comprise of State Financial Institutions and State Industrial Development Corporations providing project finance, equipment leasing, corporate loans, short-term loans and bill discounting facilities to corporate. Government holds majority shares in these financial institutions. Non-banking Financial Institutions provide loans and hire-purchase finance, mostly for retail assets andare regulated by RBI.

Insurance sector in India has been traditionally dominated by state owned Life Insurance Corporation and General Insurance Corporation and its four subsidiaries. Government of India has now allowed FDI in insurance sector up to 26%. Since then, a number of new joint venture private companies have entered into life and general insurance sectors and their share in the insurance market in rising. Insurance Development and Regulatory Authority (IRDA) is the regulatory authority in the insurance sector under the Insurance Development and Regulatory Authority Act, 1999.

RBI also regulates foreign exchange under the Foreign Exchange Management Act (FERA). India has liberalized its foreign exchange controls. Rupee is freely convertible on current account. Rupee is also almost fully convertible on capital account for non-residents. Profits earned, dividends and proceeds out of the sale of investments are fully repatriable for FDI. There are restrictions on capital account for resident Indians for incomes earned in India.

Securities and Exchange Board of India (SEBI) established under the Securities and Exchange aboard of India Act, 1992 is the regulatory authority for capital markets in India. India has 23 recognized stock exchanges that operate under government approved rules, bylaws and regulations. These exchanges constitute an organized market for securities issued by the central and state governments, public sector companies and public limited companies. The Stock Exchange, Mumbai and National Stock Exchange are the premier stock exchanges. Under the process of de-mutualization, these stock exchanges have been converted into companies now, in which brokers only hold minority share holding. In addition to the SEBI Act, the Securities Contracts (Regulation) Act, 1956 and the Companies Act, 1956 regulates the stock markets.

3. Role of the Financial System

The financial system basic objective is to allocate the resource to its most productive location and minimize the risk. Joseph Stilgetz has once commented that financial system is the brain of the economy.The financial system of the economy provides direction to productivity, efficiency, effectiveness as well as welfarism. Analysing this in Indian context require us to study the financial System which existed before a major overhaul of the financial system was undertaken.These major overhaul can be categorised into PreNationalization of the financial system which basically deals with the peroid 1950's as RBI was nationalizied in 1949 after which the SBI in 1956 and then 14 banks were nationalized in 1969 and finally in 1980 nationalization of 4 more banks took place.Like wise the life insurance sector was nationalized in 1956 and general insurance was nationalized in 1970's.The next phase for study of financial system is Post Nationalization phase.But due to many deficiencies emerged during this peroid and Indian facing Balance of Payment crisis led to era of Liberalization,Privatization and Globalization.Finally looking the phase of post 2008 crisis clearly reflects the changing role of financial system in India. Pre-Nationalization the financial system was mainly involved in the process of allocating resources from surplus to deficit location.It was having limited role in equitable development process.The priority sector was neglected.Besides there were unfair practices in the financial system.All this led to the inititaion of Nationalization process.After nationalization the financial system was directed towards welfarism.The schemes like Priority Sector Lending which was started in 1970's was aimed at providing loan to the sectors where credit was not considerd profitable for the finanacial institions. Besides the lead banking scheme was aimd to provide financial services to remote corners of the country. Financial System operations came to be marked by some serious deficiencies over the years. The banking sector suffered from lack of competition, low capital base, low Productivity and high intermediation cost. After the nationalization of large banks in 1969 and 1980, the Government6

owned banks dominated the banking sector. The role of technology was minimal and the quality of service was not given adequate importance. Banks also did not follow proper risk management systems and the prudential standards were weak. All these resulted in poor asset quality and low profitability. Among non-banking financial intermediaries, development finance institutions (DFIs) operated in an over-protected environment with most of the funding coming from assured sources at concessional terms. In the insurance sector, there was little competition. The mutual fund industry also suffered from lack of competition and was dominated for long by one institution, viz., the Unit Trust of India. Non-banking financial companies (NBFCs) grew rapidly, but there was no regulation of their asset side. Financial markets were characterized by control over pricing of financial assets, barriers to entry, high transaction costs and restrictions on movement of funds/participants between the market segments. This apart from inhibiting the development of the markets also affected their efficiency.

It was in this backdrop that wide-ranging financial sector reforms in India were introduced as an integral part of the economic reforms initiated in the early 1990s with a view to improving the macroeconomic performance of the economy. The reforms in the financial sector focused on creating efficient and stable financial institutions and markets. The approach to financial sector reforms in India was one of gradual and non-disruptive progress through a consultative process. The Reserve Bank has been consistently working towards setting an enabling regulatory framework with prompt and effective supervision, development of technological and institutional infrastructure, as well as changing the interface with the market participants through a consultative process. Persistent efforts have been made towards adoption of international benchmarks as appropriate to Indian conditions. While certain changes in the legal infrastructure are yet to be effected, the developments so far have brought the Indian financial system closer to global standards. The reform of the interest regime constitutes an integral part of the financial sector reform. With the onset of financial sector reforms, the interest rate regime has been largely deregulated with a view towards better price discovery and efficient resource allocation. Initially, steps were taken to develop the domestic money market and freeing of the money market rates. The interest rates offered on Government securities were progressively raised so that the Government borrowing could be carried out at market-related rates. In respect of banks, a major effort was undertaken to simplify the administered structure of interest rates. Banks now have sufficient flexibility to decide their deposit and lending rate structures and manage their assets and liabilities accordingly. At present, apart from savings account and NRE deposit on the deposit side and export credit and small loans on the lending side, all other interest rates are deregulated. Indian banking system operated for a long time with high reserve requirements both in the form of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). This was a consequence of the high fiscal deficit and a high degree of monetisation of fiscal 7

deficit. The efforts in the recent period have been to lower both the CRR and SLR. The statutory minimum of 25 per cent for SLR has already been reached, and while the Reserve Bank continues to pursue its medium-term objective of reducing the CRR to the statutory minimum level of 3.0 per cent, the CRR of SCBs is currently placed at 5.0 per cent of NDTL. As part of the reforms programme, due attention has been given to diversification of ownership leading to greater market accountability and improved efficiency. Initially, there was infusion of capital by the Government in public sector banks, which was followed by expanding the capital base with equity participation by the private investors. This was followed by a reduction in the Government shareholding in public sector banks to 51 per cent. Consequently, the share of the public sector banks in the aggregate assets of the banking sector has come down from 90 per cent in 1991 to around 75 per cent in2004. With a view to enhancing efficiency and productivity through competition, guidelines were laid down for establishment of new banks in the private sector and the foreign banks have been allowed more liberal entry. Since 1993, twelve new private sector banks have been set up. As a major step towards enhancing competition in the banking sector, foreign direct investment in the private sector banks is now allowed up to 74 per cent, subject to conformity with the guidelines issued from time to time.

3.1. Changing roles of the Financial System

The post LPG era provide a new approach to the Financial System with focus on private sector participation in providing financial services.This definitely brought the needed efficiency in the financial system. But mid-term asessments by various Government agencies and NGO's reveled that infact inequality in India has increased post LPG era.This brought the government to intorduce the approach if inclusive approach in development process.Thus financial system was too oriented to take up the responsibility of Inclusive deelopment initiative.Under this the agenda of Financial Inclusion was introduced in 2005 in RBI document.The priority sector lending was broadened and emphasis is given for MSME sector credit infusion.Secondly the capital market reforms are introduced and initiatives are taken to broden and deepning the market participation.The listing PSU to the stock exchanges to get status like 'Maharatna' are the mechanism of directed towards brodening the capital market.All these initatives towards libralization , privatization and globalization hit a road block when there emergers a global financial crisis in 2008.

3.2 Need for Financial Reform: Post 2008 crisis

Indian finanacial system because of its fundamental kept strong by the regulatory authorities like RBI in banking sector,SEBI in capital market,IRDA in insurance sector and PFRDA in the pension sector was able to with stand the liquidity burst of 2008 whose origin was the sub-prime lending in USA. Following it was the Euro crisis where PIGS (Portugal, Ireland, Greece and Spain) came on the verge of soverign debt default.Cosidering the need to avoid such crisis in Indian financial system steps are 8

taken like resorting to BASEL 3 norms in Banking sector , reducing Fiscal deficit at fiscal policy level, capital market to be more stable and others. BASEL Norms : Basel I In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as Basel 1. It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks. The minimum capital requirement was fixed at 8% of risk weighted assets (RWA). Basel II In 2004, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord. The guidelines were based on three parameters. Banks should maintain a minimum capital adequacy requirement of 8% of risk assets, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that is credit and increased disclosure requirements. Banks need to mandatorily disclose their risk exposure, etc to the central bank. Basel II norms in India and overseas are yet to be fully implemented. Basel III In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008. A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding. Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk. Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive. The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity. Besides that the Government of India has constituted a committee on Financial Sector Legislative Reform Committee under the Chairmanship of Dr B.N Srikrishna.The Committee has emphasised on consumer protection,micro prudential regulation which is at the firm level.Combined with these two aspect is constitution of Resolution Corporation for effective and quick redressal of consumer grievances.Other than these emphasis is on accountability of the finanacial Insitutions and financial stability.

4.Conclusion
The Indian financial system has undergone structural transformation over the past decade. The financial sector has acquired strength, efficiency and stability by the combined effect of competition, regulatory measures, and policy environment. This dynamic and adaptive feature of the Indian financial system have provided the robustness to deal with the cyclic slumps and abrupt shocks in the economy.There by aiding in socio-economic development.

Refrences
Allen, Franklin, Rajesh Chakrabarti, and Sankar De. India's Financial System. 2007. Gurusamy. Financial Services and Systems. 2001. http://en.wikipedia.org/. Ministry of Finance, Government of India. Financial Sector Legislative Reforms Commission. 2012. www.investopedia.com/.

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