An Overview of Indian Financial System

Financial System;

The word "system", in the term "financial system", implies a set of complex and closely
connected or interlined institutions, agents, practices, markets, transactions, claims, and
liabilities in the economy. The financial system is concerned about money, credit and
finance-the three terms are intimately related yet are somewhat different from each
other. Indian financial system consists of financial market, financial instruments and
financial intermediation. These are briefly discussed below;
FINANCIAL MARKETS
A Financial Market can be defined as the market in which financial assets are created or
transferred. As against a real transaction that involves exchange of money for real goods
or services, a financial transaction involves creation or transfer of a financial asset.
Financial Assets or Financial Instruments represents a claim to the payment of a sum of
money sometime in the future and /or periodic payment in the form of interest or
dividend.
Money Market- The money market ifs a wholesale debt market for low-risk, highlyliquid, short-term instrument. Funds are available in this market for periods ranging
from a single day up to a year. This market is dominated mostly by government, banks
and financial institutions.
Capital Market - The capital market is designed to finance the long-term investments.
The transactions taking place in this market will be for periods over a year.
Forex Market - The Forex market deals with the multicurrency requirements, which are
met by the exchange of currencies. Depending on the exchange rate that is applicable,
the transfer of funds takes place in this market. This is one of the most developed and
integrated market across the globe.
Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short,
medium and long-term loans to corporate and individuals.

Constituents of a Financial System

FINANCIAL INTERMEDIATION
Having designed the instrument, the issuer should then ensure that these financial
assets reach the ultimate investor in order to garner the requisite amount. When the
borrower of funds approaches the financial market to raise funds, mere issue of
securities will not suffice. Adequate information of the issue, issuer and the security
should be passed on to take place. There should be a proper channel within the financial
system to ensure such transfer. To serve this purpose, Financial intermediariescame
into existence. Financial intermediation in the organized sector is conducted by a
widerange of institutions functioning under the overall surveillance of the Reserve Bank
of India. In the initial stages, the role of the intermediary was mostly related to ensure
transfer of funds from the lender to the borrower. This service was offered by banks,
FIs, brokers, and dealers. However, as the financial system widened along with the
developments taking place in the financial markets, the scope of its operations also
widened. Some of the important intermediaries operating ink the financial markets
include; investment bankers, underwriters, stock exchanges, registrars, depositories,
custodians, portfolio managers, mutual funds, financial advertisers financial consultants,
primary dealers, satellite dealers, self regulatory organizations, etc. Though the markets
are different, there may be a few intermediaries offering their services in move than one
market e.g. underwriter. However, the services offered by them vary from one market to
another.

Intermediary

Market

Role

Stock Exchange

Capital Market

Secondary Market to
securities

Investment Bankers

Capital Market, Credit Market

Corporate advisory services,

Issue of securities

Capital Market, Money

Market

Subscribe to unsubscribed
portion of securities

Registrars, Depositories,
Custodians

Capital Market

Issue securities to the

investors on behalf of the
company and handle share
transfer activity

Primary Dealers Satellite

Dealers

Money Market

Market making in
government securities

Forex Dealers

Forex Market

Ensure exchange ink

currencies

Underwriters

FINANCIAL INSTRUMENTS
Money Market Instruments
The money market can be defined as a market for short-term money and financial assets
that are near substitutes for money. The term short-term means generally a period upto
one year and near substitutes to money is used to denote any financial asset which can
be quickly converted into money with minimum transaction cost.
Some of the important money market instruments are briefly discussed below;
1.
2.
3.
4.
5.

Call/Notice Money
Treasury Bills
Term Money
Certificate of Deposit
Commercial Papers

1. Call /Notice-Money Market

Call/Notice money is the money borrowed or lent on demand for a very short period.
When money is borrowed or lent for a day, it is known as Call (Overnight) Money.
Intervening holidays and/or Sunday are excluded for this purpose. Thus money,
borrowed on a day and repaid on the next working day, (irrespective of the number of
intervening holidays) is "Call Money". When money is borrowed or lent for more than a
day and up to 14 days, it is "Notice Money". No collateral security is required to cover
these transactions.
2. Inter-Bank Term Money
Inter-bank market for deposits of maturity beyond 14 days is referred to as the term
money market. The entry restrictions are the same as those for Call/Notice Money
except that, as per existing regulations, the specified entities are not allowed to lend
beyond 14 days.

3. Treasury Bills.
Treasury Bills are short term (up to one year) borrowing instruments of the union
government. It is an IOU of the Government. It is a promise by the Government to pay a
stated sum after expiry of the stated period from the date of issue (14/91/182/364 days
i.e. less than one year). They are issued at a discount to the face value, and on maturity
the face value is paid to the holder. The rate of discount and the corresponding issue
price are determined at each auction.
4. Certificate of Deposits
Certificates of Deposit (CDs) is a negotiable money market instrument nd issued in
dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or
other eligible financial institution for a specified time period. Guidelines for issue of CDs
are presently governed by various directives issued by the Reserve Bank of India, as
amended from time to time. CDs can be issued by (i) scheduled commercial banks
excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select allIndia Financial Institutions that have been permitted by RBI to raise short-term
resources within the umbrella limit fixed by RBI. Banks have the freedom to issue CDs
depending on their requirements. An FI may issue CDs within the overall umbrella limit
fixed by RBI, i.e., issue of CD together with other instruments viz., term money, term
deposits, commercial papers and intercorporate deposits should not exceed 100 per cent
of its net owned funds, as per the latest audited balance sheet.
5. Commercial Paper
CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper
the debt obligation is transformed into an instrument. CP is thus an unsecured
promissory note privately placed with investors at a discount rate to face value
determined by market forces. CP is freely negotiable by endorsement and delivery. A
company shall be eligible to issue CP provided - (a) the tangible net worth of the
company, as per the latest audited balance sheet, is not less than Rs. 4 crore; (b) the
working capital (fund-based) limit of the company from the banking system is not less
than Rs.4 crore and (c) the borrowal account of the company is classified as a Standard
Asset by the financing bank/s. The minimum maturity period of CP is 7 days. The
minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies.
(for more details visit www.indianmba.com faculty column)
Capital Market Instruments
The capital market generally consists of the following long term period i.e., more than
one year period, financial instruments; In the equity segment Equity shares, preference
shares, convertible preference shares, non-convertible preference shares etc and in the
debt segment debentures, zero coupon bonds, deep discount bonds etc.
Hybrid Instruments
Hybrid instruments have both the features of equity and debenture. This kind of
instruments is called as hybrid instruments. Examples are convertible debentures,
warrants etc.

What are the main Constituents of Financial

System
There are three main constituents of the financial system: (a) the financial assets, (b) the
financial market and (c) the financial institutions.
1. Financial Assets:
The financial assets or near-money assets are the claims to money and perform some functions of
money. They have high degree of liquidity but are not as liquid as money is. Financial assets are
of two types: (a) primary or direct assets, and (b) secondary or indirect assets.
Primary assets are the financial claims against real-sector units created by real-sector units as
ultimate borrowers for raising funds to finance their deficit spending; they are the obligations of
ultimate borrowers.
The examples of Primary assets are bills, bonds, equities, book debits, etc. Secondary assets are
financial claims issued by financial institutions against themselves to raise funds from the public;
these assets are the obligations of the financial institutions.
The examples of secondary assets are bank deposits, life insurance policies, Unit Trust of India
units, etc.
2. Financial Markets:
The financial system of a country works through the financial markets and the financial
institutions. The financial markets deal with the financial assets of different types, currency
deposits, cheques, bills, bonds, etc.
Financial markets perform the following functions: (a) They create and allocate credit, (b) They
serve as intermediaries in the process of mobilisation of saving, (c) They provide convenience and
benefits to the lender and borrowers, (d) They promote economic development through a
balanced regional and sectoral allocation of investible funds.
Financial markets are credit markets which cater the credit needs of individuals, firms and
institutions. Since credit is required and supplied for short period and long period, the financial
markets are broadly divided into two types: (a) money market and (b) capital market.
Money market deals with the short-period borrowing and lending of funds; in the money market,
the short term securities are exchanged. Capital market deals with the long period borrowing and
lending of funds; in the capital market, long-term securities are exchanged.
Financial market may also be categorized into: (a) primary market, and (b) secondary market.
Primary market is a market in which newly issued credit instruments are sold and purchased.

Secondary market, on the other hand, is market in which previously issued credit instruments are
bought and sold.
3. Financial Institutions:
Financial institutions or financial inter-mediaries act as half- way houses between the primary
lenders and the final borrowers.
They borrow funds (or accept deposits) from those who are willing to give up their current
purchasing power and lend to (or buy securities from) those who require the funds for meeting
the current expenditures.
Financial institutions are generally divided into two categories (a) banks, and (b) non-bank
financial intermediaries. The main difference between banks and non bank financial
intermediaries is that the former possess, while the latter do not possess the demand deposits or
credit-creating power.

- Development and Growth of Financial and Market in India

India Financial market is one of the oldest in the world and is considered to be the
fastest growing and best among all the markets of the emerging economies. The history
of Indian capital markets dates back 200 years toward the end of the 18th century when
India was under the rule of the East India Company.
The development of the capital market in India concentrated around Mumbai where no
less than 200 to 250 securities brokers were active during the second half of the 19th
century. The financial market in India today is more developed than many other
sectors because it was organized long before with the securities exchanges of Mumbai,
Ahmedabad and Kolkata were established as early as the 19th century.
By the early 1960s the total number of securities exchanges in India rose to eight,
including Mumbai, Ahmedabad and Kolkata apart from Madras, Kanpur, Delhi,
Bangalore and Pune.
Today there are 21 regional securities exchanges in India in addition to the centralized
NSE (National Stock Exchange) and OTCEI (Over the Counter Exchange of India).
However the stock markets in India remained stagnant due to stringent controls on the
market economy that allowed only a handful of monopolies to dominate their respective
sectors.
The corporate sector wasn't allowed into many industry segments, which were

dominated by the state controlled public sector resulting in stagnation of the economy
right up to the early 1990s.
Thereafter when the Indian economy began liberalizing and the controls began to be
dismantled or eased out, the securities markets witnessed a flurry of IPOs that were
launched. This resulted in many new companies across different industry segments to
come up with newer products and services.
A remarkable feature of the growth of the Indian economy in recent years has been the
role played by its securities markets in assisting and fuelling that growth with money rose
within the economy. This was in marked contrast to the initial phase of growth in many of
the fast growing economies of East Asia that witnessed huge doses of FDI (Foreign
Direct Investment) spurring growth in their initial days of market decontrol. During this
phase in India much of the organized sector has been affected by high growth as the
financial markets played an all-inclusive role in sustaining financial resource
mobilization. Many PSUs (Public Sector Undertakings) that decided to offload part of
their equity were also helped by the well-organized securities market in India.
The launch of the NSE (National Stock Exchange) and the OTCEI (Over the Counter
Exchange of India) during the mid 1990s by the government of India was meant to usher
in an easier and more transparent form of trading in securities. The NSE was conceived
as the market for trading in the securities of companies from the large-scale sector and
the OTCEI for those from the small-scale sector. While the NSE has not just done well to
grow and evolve into the virtual backbone of capital markets in India the OTCEI
struggled and is yet to show any sign of growth and development. The integration of IT
into the capital market infrastructure has been particularly smooth in India due to the
countrys world class IT industry. This has pushed up the operational efficiency of the
Indian stock market to global standards and as a result the country has been able to
capitalize on its high growth and attract foreign capital like never before.
The regulating authority for capital markets in India is the SEBI (Securities and
Exchange Board of India). SEBI came into prominence in the 1990s after the capital
markets experienced some turbulence. It had to take drastic measures to plug many
loopholes that were exploited by certain market forces to advance their vested interests.
After this initial phase of struggle SEBI has grown in strength as the regulator of Indias
capital markets and as one of the countrys most important institutions.

Functions and Role of financial system, market are given below .

Pooling of Funds,
Capital Formation,

Facilitates Payment,
Provides Liquidity,
Short and Long Term Needs,
Risk Function,
Better Decisions,
Finances Government Needs,
Economic Development.
Functions of financial system are discussed in brief.
1. Pooling of Funds

In a financial system, the Savings of people are transferred from households to business
organizations. With these production increases and better goods are manufactured, which
increases the standard of living of people.
2. Capital Formation

Business require finance. These are made available through banks, households and different
financial institutions. They mobilize savings which leads to Capital Formation.
3. Facilitates Payment

The financial system offers convenient modes of payment for goods and services. New methods of
payments like credit cards, debit cards, cheques, etc. facilitates quick and easy transactions.
4. Provides Liquidity

In financial system, liquidity means the ability to convert into cash. The financial market
provides the investors the opportunity to liquidate their investments, which are in instruments
like shares, debentures, bonds, etc. Price is determined on the daily basis according to the
operations of the market force of demand and supply.
5. Short and Long Term Needs

The financial market takes into account the various needs of different individuals and
organizations. This facilitates optimum use of finances for productive purposes.
6. Risk Function

The financial markets provide protection against life, health and income risks. Risk Management
is an essential component of a growing economy.
7. Better Decisions

Financial Markets provide information about the market and various financial assets. This helps
the investors to compare different investment options and choose the best one. It helps in
decision making in choosing portfolio allocations of their wealth.
8. Finances Government Needs

Government needs huge amount of money for the development of defense infrastructure. It also
requires finance for social welfare activities, public health, education, etc. This is supplied to
them by financial markets.
9. Economic Development

India is a mixed economy. The Government intervenes in the financial system to influence
macro-economic variables like interest rate or inflation. Thus, credits can be made available to
corporate at a cheaper rate. This leads to economic development of the nation

Regulations in India

Indian Capital Markets are regulated and monitored by the Ministry of Finance,
The Securities and Exchange Board of India and The Reserve Bank of India.

The Ministry of Finance regulates through the Department of Economic Affairs

- Capital Markets Division. The division is responsible for formulating the
policies related to the orderly growth and development of the securities markets
(i.e. share, debt and derivatives) as well as protecting the interest of the
investors. In particular, it is responsible for

i.
ii.
iii.
iv.

institutional reforms in the securities markets,

building regulatory and market institutions,
strengthening investor protection mechanism, and
providing efficient legislative framework for securities markets.

The Division administers legislations and rules made under the

i.

Depositories Act, 1996,

ii. Securities Contracts (Regulation) Act, 1956 and
iii. Securities and Exchange Board of India Act, 1992.
THE REGULATORY AUTHORITY.

The Regulators
Securities & Exchange Board of India (SEBI)
The Securities and Exchange Board of India (SEBI) is the regulatory
authority established under the SEBI Act 1992 and is the principal
regulator for Stock Exchanges in India. SEBIs primary functions
include protecting investor interests, promoting and regulating the
Indian securities markets. All financial intermediaries permitted by
their respective regulators to participate in the Indian securities
markets are governed by SEBI regulations, whether domestic or
foreign. Foreign Institutional Investors are required to register with
SEBI in order to participate in the Indian securities markets.
More Information on : www.sebi.gov.in
Reserve Bank of India (RBI)
The Reserve Bank of India (RBI) is governed by the Reserve Bank of
India Act, 1934. The RBI is responsible for implementing monetary
and credit policies, issuing currency notes, being banker to the

government, regulator of the banking system, manager of foreign

exchange, and regulator of payment & settlement systems while
continuously working towards the development of Indian financial
markets. The RBI regulates financial markets and systems through
different legislations. It regulates the foreign exchange markets
through the Foreign Exchange Management Act, 1999.
More Information on : www.rbi.gov.in
National Stock Exchange (NSE) Rules and Regulations
In the role of a securities market participant, NSE is required to set
out and implement rules and regulations to govern the securities
market. These rules and regulations extend to member registration,
securities listing, transaction monitoring, compliance by members to
SEBI / RBI regulations, investor protection etc. NSE has a set of Rules
and Regulations specifically applicable to each of its trading
segments. NSE as an entity regulated by SEBI undergoes regular
inspections by them to ensure compliance.