INDIAN FINANCIAL SYSTEM

1. The Financial System Nature, Evolution and Structure

1.1 The Nature of Financial System What is a Financial System? A system is generally defined as an ordered, organized and comprehensive assemblage of facts, principles or components relating to a particular field and working for a specified purpose. A Financial System aims at proper redistribution of surplus financial resources for the equitable growth of an economy. Financial System is a set of complex and closely inter-mixed financial institutions, markets, instruments, services, practices, procedures and so on. An economy's financial system exists to organize the settlement of payments, to raise and allocate finance, and to manage the risks associated with financing and exchange. A developed financial system is one that has a secure and efficient payment system, security markets and financial intermediaries that arrange financing, and derivative markets and financial institutions that provide access to risk management instruments. It does so by transfer of various economic units. Goldsmith, R.W., The Flow of Capital funds in the war Economy, New York, Columbia, 1965, p.28 designated various economic units into three categories; (i) Savings-surplus units> those units whose savings are in excess of investments, (ii) Economic Units> in whose case the investments exceed their savings referred to as savings-deficit units and (iii) Neutral Units> in whose case savings are equal to the investments.

Savings-surplus units
SAVINGS

Savings- deficit units

INVESTMENTS

Main concerns of a Financial System are: Money, Finance and Credit function MONEY: as a medium of exchange FINANCE: represents the aggregate resources of monetary nature of an economy (include equity and debt funds of an individual, company, state or country. CREDIT: means the sum of money which was taken from other economic units as a debt and usually be returnable with some agreed interest. Why do we need an efficient Financial System? An Efficient Financial System performs the following roles: Provides a mechanism for payment for goods and services Helps in mobilization of savings and in allocation of financial resources A brief on INDIAN FINANCIAL SYSTEM compiled by Dr.Vighneswara Swamy, Associate Professor, Department of Finance, IBS-Hyderabad for class room discussion 1 |

Importance of an efficient Financial System? o It is a vital part of a modern economy. o Economic growth of a country is fundamentally dependent on the efficient and effective functioning of financial system. Essentials of an efficient Financial System Efficient monetary system Efficient financial markets Efficient financial tools 1.2 Evolution of Financial System Factors responsible: Requirements of Savers such as; Safety of funds Returns Liquidity Needs of the borrowers such as; Cost of funds Timely credit Terms of repayment Phase of Evolution of Financial System in India Phase 1: Active Government Intervention Phase 2: Narrow Liberalization Phase 3: Absolute Liberalization 1.3 Structure of a Financial System

Structure of a Financial System

Financial Services
Organized

Financial Markets
Unorganized
Primary / Secondary

Financial Instruments
Primary / Secondary
Regulatory

Financial Intermediaries

Intermediaries

Primary / Secondary Capital Markets

Non-Inter mediaries

Others

Short Term Medium Term

BANKING

A brief on SYSTEM compiled by Dr.Vighneswara Swamy, NONLong Term BANKING Associate Professor, Department of Finance, IBS-Hyderabad for class room discussion

Money Markets INDIAN FINANCIAL

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Financial Services -include services such as accepting deposits, dispensation of credit, insurance, funds transfer, Issuance of Guarantees and Solvencies, Leasing, Money Exchange, and various other facilities provided by the financial institutions as per rule of law. Financial Markets - are the centers or arrangements that provide facilities for buying and selling of financial claims and services - include primarily the dealings of demand side and supply side - classified as Organized and Unorganized markets - also classified as Primary (direct) and Secondary (indirect) markets - further classified as Capital and Money Markets - Money Market is a market for dealing in monetary assets of short-termed nature, generally less than one year. The participants include RBI, Commercial Banks. - Capital Market is market for long-term funds. Its focus is on financing of fixed investments in contrast to money market. Financial Instruments - Financial instruments also called financial assets represent the financial obligations that arise when the borrower raises funds in the financial market. - Wikipedia defines Financial instruments denote any form of funding medium - mostly those used for borrowing in money markets, e. g. bills of exchange, bonds, etc. - Financial assets play a key role in developing the financial markets in particular and the financial system in general. - Financial assets represent the obligations on the part of their issuer. - In terms of Accounting principle; Assets = Liabilities Types of financial assets: Deposits, Stocks, Debt Designing of financial products involves; Issuers considerations, Market conditions, Investors considerations Also, Other factors like; Cash flows, Taxation, Leverage, Dilution of Control, Transaction of Costs, Quantum of funds, Maturity plan, Investor profile, Past performance, Cost of funds, Regulatory aspects, Risk involved, Liquidity, Returns, Tax planning, Simplicity and others are vital in designing the financial products. - They represent claims on a stream of income and on or particular asset ( as said by Francis .J.C
Investment Analysis and Management, McGraw Hill Inc., 1991, p.31 )

Some of the financial instruments are Equity / Ordinary Shares, Debentures, Preference Shares, Innovative Instruments such as Participatory Notes, Convertible Debentures with options, Third Party Convertible Debentures, Convertible Debentures Redeemable at Premium, Debt Equity Swaps, Zero Coupon Convertible Notes, Secured Convertible Notes, Secured Premium Notes with Detachable warrants, Non-Convertible Debentures with Detachable Warrants, Zero interest fully convertible debentures (FCDs), Warrants, Other instruments issued by Financial institutions such as Floating Rate Bonds (FRBs), Zero Coupon Bonds, Deep Discount Bonds, Easy Exit Bonds with floating rate, Regular Income Bonds, Retirement Bonds, Step up Liquid Bonds(interest is stepped up every year), Growth Bonds(10 year maturity), Index Bonds, Encash Bonds and several others.

A brief on INDIAN FINANCIAL SYSTEM compiled by Dr.Vighneswara Swamy, Associate Professor, Department of Finance, IBS-Hyderabad for class room discussion

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Categorization
Financial instruments can be categorised by form depending on whether they are cash instruments or derivative instruments: Cash instruments are financial instruments whose value is determined directly by markets. They can be divided into securities, which are readily transferable, and other cash instruments such as loans and deposits, where both borrower and lender have to agree on a transfer. Derivative instruments are financial instruments which derive their value from some other financial instrument or variable. They can be divided into exchange-traded derivatives and overthe-counter (OTC) derivatives. Alternatively, financial instruments can be categorized by "asset class" depending on whether they are equity based (reflecting ownership of the issuing entity) or debt based (reflecting a loan the investor has made to the issuing entity). If it is debt, it can be further categorised into short term (less than one year) or long term. Foreign Exchange instruments and transactions are neither debt nor equity based and belong in their own category.

Matrix Table Combining the above methods for categorisation, the main instruments can be organized into a matrix as follows:
Asset Class Debt (Long Term) >1 year Securities Instrument Type Other cash Exchange-traded derivatives Bond futures Options on bond futures Bonds Bills, e.g. TBills Commercial paper Stock Loans Deposits Certificates of deposit N/A OTC derivatives Interest rate swaps Interest rate caps and floors Interest rate options Exotic instruments

Debt (Short Term) <=1 year Equity Foreign Exchange

Short term interest rate futures Stock options Equity futures

N/A

Spot foreign exchange

Currency futures

Forward rate agreements Stock options Exotic instruments Foreign exchange options Outright forwards Foreign exchange swaps Currency swaps

Some instruments defy categorisation into the above matrix, for example repurchase agreements.

A brief on INDIAN FINANCIAL SYSTEM compiled by Dr.Vighneswara Swamy, Associate Professor, Department of Finance, IBS-Hyderabad for class room discussion

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Measuring Financial Instrument's Gain or Loss The table below shows how to measure a financial instrument's gain or loss:
Instrument Type Categories Measurement Gains and losses Net income when asset is derecognized or impaired (foreign exchange and impairment recognized in net income immediately) Other comprehensive income (impairment recognized in net income immediately)

Assets Loans and receivables -- do -Available for sale financial assets Amortized costs Deposit account - Fair value

Financial Institutions Financial institutions are those organizations that are involved in providing various types of financial services to their customers. The financial institutions are controlled and supervised by the rules and regulations delineated by government authorities. Examples of financial institutions are the following: Banks Stock Brokerage Firms Non Banking Financial Institutions Building Societies Asset Management Firms Credit Unions Insurance Companies

Financial Institutions -include Regulatory bodies such as RBI, NABARD, SEBI, FMC (Forward Market Commission), IRDA, etc, -include Non-Regulatory bodies such as Stock Exchanges, LIC, GIC, NCDX, and also Industrial Development Bank of India (IDBI) Industrial Finance Corporation of India (IFCI) Export - Import Bank of India (Exim Bank) Industrial Reconstruction Bank of India (IRBI) now (Industrial Investment Bank of India) Small Industries Development Bank of India (SIDBI) National Housing Bank (NHB) Unit Trust of India (UTI) Life Insurance Corporation of India (LIC) General Insurance Corporation of India (GIC) Risk Capital and Technology Finance Corporation Ltd. (RCTC) Technology Development and Information Company of India Ltd.(TDICI) Tourism Finance Corporation of India Ltd. (TFCI) A brief on INDIAN FINANCIAL SYSTEM compiled by Dr.Vighneswara Swamy, Associate Professor, Department of Finance, IBS-Hyderabad for class room discussion 5 |

Shipping Credit and Investment Company of India Ltd. (SCICI) Discount and Finance House of India Ltd. (DFHI) Securities Trading Corporation of India Ltd. (STCI) Power Finance Corporation Ltd. Rural Electrification Corporation Ltd. Indian Railways Finance Corporation Ltd. Infrastructure Development Finance Co. Ltd. Housing and Urban Development Corporation Ltd. (HUDCO) Indian Renewable Energy Development Agency Ltd. (IREDA) - include Banks ( Public Sector Banks, Co-operative Banks, Private Sector Banks and Foreign Banks - and also include various non- banking financial companies and mutual funds The other way financial intermediaries can also be classified as; Depository institutions Commercial banks Savings and Loans Institutions Credit Unions Non-Depository Institutions Finance Companies Mutual Funds Security firms, Investment Bankers; such as Merrill Lynch, Salomon Brothers, Morgan Stanley, dean Writer, Nomura Securities etc, Brokers, Dealers etc., Insurance funds Pension Funds Insurance Companies

2. The Functions of Financial Intermediaries

To act as mobilisers and depositories of savings To act as purveyors of credit or finance To act as portfolio managers of the clients And various other functions The first function of financial institutions is the transformation of assets, which are acquired through markets, into a wider and more preferable form, which becomes their liability this function is performed mainly by financial intermediaries, which is undeniably the most important category of financial institutions. Also financial institutions are involved in exchanging of assets on behalf of their customers. Other than that, exchanging of assets for their own personal accounts is also part of their job. Furthermore, financial institutions create financial assets for their customers and sell those assets to other market participants for a definite emolument. In addition to all these functions, financial institutions are also involved in providing investment advice to market participants and managing the portfolios of market participants. A brief on INDIAN FINANCIAL SYSTEM compiled by Dr.Vighneswara Swamy, Associate Professor, Department of Finance, IBS-Hyderabad for class room discussion 6 |

The services provided by the various types of financial institutions may vary from one institution to another. For example, the services offered by the commercial banks are - insurance services, mortgages, loans and credit cards. There are several financial functions of financial institutions. These institutions are responsible for distributing financial resources in a planned way to the potential users. Nonetheless, there are a number of financial institutions that collect funds and provide the same for the necessary sector or individual. On the other hand, there are several financial institutions that act as the middleman and join the deficit and surplus units. There are several other functions of the financial institutions and investing money on behalf of the client is one of them. According to the functions of financial institutions, these financial institutions can be categorized in several categories. These are as follows: Deposit Taking Institutions Finance and Insurance Institutions Investment Institutions Pension Providing Institutions Risk Management Institutions

The primary functions of financial institutions of this nature are as follows:

Accepting Deposits Providing Commercial Loans Providing Real Estate Loans Providing Mortgage Loans Issuing Share Certificates

3. The Role of Financial System in Economic Development

Financial System plays an indispensable role in the economic development of any country. It creates opportunity and foundations for capital formation which is the direct origin for economic development process. It contributes immensely in the following ways: Higher savings and investment increase the human capital and the material Capital formation and output directly hinge on the efficiency of the financial system Liquidity function provided by the financial system augments the purchasing power between two time periods. Perform the maturity intermediation function by accepting deposits at different maturities and issuing loans at different maturities according to the needs of the clients. Risk reduction through diversification Reducing costs of transaction and information Providing a payments mechanism

A brief on INDIAN FINANCIAL SYSTEM compiled by Dr.Vighneswara Swamy, Associate Professor, Department of Finance, IBS-Hyderabad for class room discussion

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Strong and reputable financial sector is a must for healthy and growing real sector

Figure-3.1: Relationship between Financial System and Economic Development

Savings Surplus Econom ic Units

Financial System

Economic Develop ment

Savings Deficit Economic Units

Capital Format ion

The mechanism; Unemployed resources increase aggregate demand and thereby enhance the output and savings. Fully employed resources decrease the rate of return on financial claims and thereby inflation. More and more investment in goods and physical capital increases national income/output and savings.

Some expert views:

Chandler says, Capital alone cannot cause the growth in the real sector John Robinson says, If the industry progresses, the capital increases A brief on INDIAN FINANCIAL SYSTEM compiled by Dr.Vighneswara Swamy, Associate Professor, Department of Finance, IBS-Hyderabad for class room discussion 8 |

Habakkuk says that the economies in which the other conditions like social, political and economic conditions are favorable can create sufficient financial intermediaries. Newlyn says, the role of financial system in economic growth is only secondary

4. Indian Financial System

Regulatory Bodies
Reserve Bank of India as a regulator SEBI BIFR IRDA DICGC ECGC SHCI FMC

A Glimpse of Indian Financial System Financial Development Financial Intermediaries Institutions Services
Reserve Bank of India as a banker Commercial Bnaks Cooperative banks and Societies Post Office Savings Banks PF Organization Pension Funds Small savings organizations LIC of India GIC UTI Mutual Funds Investment Trusts EXIM Bank NABARD SCICI IDBI SIDBI TFCI Hire Purchase Deposit Insurance Insurance Guarantees Solvencies Acceptances Bill Discounting Merchant Banking Factoring Credit rating Credit information Economic consultancy Stock holding Refinancing Underwriting Leasing Technology development

Financial Instruments
Equity Shares Preference shares Debentures Bonds Government Securities KVP NSS NSC Bank Deposits Deposit with Companies

Summary
Financial System constitutes a vital part of a modern economy. The efficiency of the Financial System depends upon the existence of suitable financial services, financial instruments and financial institutions. Growth of financial system is an indication of the development of an economy Financial system exists both in organized and unorganized forms. Banks play a major role in economic development of a country. A proper regulation of the financial system is very much necessary in order to achieve the set national economic goals.

A brief on INDIAN FINANCIAL SYSTEM compiled by Dr.Vighneswara Swamy, Associate Professor, Department of Finance, IBS-Hyderabad for class room discussion

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