Indian

Financial
System

Unit 1.1: An Introduction

Financial System
B.Com (Hons) - Semester III

COMPILED BY DHWANI BHATT,

ASSISTANT PROFESSOR, PARUL
UNIVERSITY

COMPILED BY DHWANI BHATT, ASSISTANT PROFESSOR, PARUL UNIVERSITY 0

 PARUL UNIVERSITY
PARUL INSTITUTE OF COMMERCE
FACULTY OF COMMERCE
B.Com (Hons) - Semester III
Indian Financial System - 16010003DS03

Topics:
 Unit 1.1: An Introduction Financial System

 Introduction
 Nature
 Components
 Key elements
 Functions and role of financial system and financial instruments
 Evolution of Financial System in India

 Unit 1.2: Structure of Indian Financial System

 Main functions of these constituents and respective roles.
 Flow of funds matrix.
 Regulatory Bodies: Need and objectives
 Major reforms after 1991 and need of Regulations in Financial System-
RBI, SEBI and IRDA

 Course Learning Objectives

 Explain the structure and significance of the Indian Financial System,

identifying its key components and their roles in driving economic
development
 Analyze the role of financial intermediaries, particularly the Reserve Bank
of India and commercial banks, in mobilizing savings, allocating credit,
and implementing monetary policy in India.
 Distinguish between Money and Capital Markets, evaluating their
functions, instruments, and the role of Stock Exchanges in facilitating
capital mobilization within the Indian Financial System
 Discuss emerging trends and challenges in the Indian Financial System,
analyzing the impact of technological advancements and regulatory
reforms on its future direction.

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 Unit 1.1: An Introduction Financial System

 Introduction

The Indian financial system is a comprehensive framework comprising various

institutions, markets, instruments, services, and mechanisms that facilitate the
transfer of funds between savers and borrowers. It plays a pivotal role in the
economic development of the country by ensuring efficient allocation of resources,
promoting savings and investments, and supporting economic stability.

 Definition:

From an economic standpoint, the Indian financial system can be defined as:

"The Indian financial system is a network of institutions, markets, instruments, and

services that facilitates the flow of funds between savers and investors, thereby
supporting economic growth and development. It ensures efficient allocation of
resources by mobilizing savings and channeling them into productive investments."

Nature of Indian Financial System

The nature of the Indian financial system is multifaceted, reflecting its complexity
and vital role in the economy. Here is a detailed explanation of its nature:

1. Diverse and Multifunctional

The Indian financial system encompasses a wide range of financial institutions,

markets, instruments, and services. These components perform various functions,
including:

 Intermediation: Facilitating the transfer of funds from savers to borrowers.

 Payment Services: Enabling smooth and efficient payment mechanisms.
 Risk Management: Offering tools for managing financial risks (e.g.,
insurance, derivatives).
 Resource Mobilization: Collecting savings and directing them towards
productive investments.

2. Institutional Variety

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The system consists of diverse institutions, each serving different purposes:

 Banks: Including commercial banks, cooperative banks, and regional rural

banks, which provide a range of banking services.
 Non-Banking Financial Companies (NBFCs): Offering financial services
that complement banking activities.
 Insurance Companies: Providing risk management and financial protection.
 Mutual Funds: Pooling resources from investors to invest in diversified
portfolios.
 Development Banks: Catering to specific sectors like agriculture, industry,
and small businesses.

3. Regulated and Supervised

The Indian financial system operates under a robust regulatory framework to ensure
its stability, efficiency, and integrity:

 Reserve Bank of India (RBI): The central bank overseeing monetary policy,
banking regulation, and financial stability.
 Securities and Exchange Board of India (SEBI): Regulating the securities
market and protecting investor interests.
 Insurance Regulatory and Development Authority of India (IRDAI):
Supervising the insurance sector.
 Pension Fund Regulatory and Development Authority (PFRDA):
Regulating pension funds.

4. Market Segmentation

The financial system includes various markets, each catering to different financial
needs:

 Money Market: Short-term borrowing and lending, with instruments like

Treasury Bills and Commercial Papers.
 Capital Market: Long-term funding through equity and debt securities,
including stock exchanges and bond markets.
 Forex Market: Facilitating currency exchange and international trade.
 Derivatives Market: Offering instruments like futures, options, and swaps
for hedging and speculation.

5. Dynamic and Evolving

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The Indian financial system is characterized by its dynamic nature, constantly
evolving to adapt to changing economic conditions and technological advancements:

 Digital Transformation: Rapid adoption of digital banking, mobile

payments, and fintech innovations.
 Financial Inclusion Initiatives: Efforts to bring underserved populations into
the formal financial sector.
 Regulatory Reforms: Continuous updating of regulations to enhance market
efficiency and investor protection.

6. Interconnected and Globalized

The system is interconnected, with various segments and institutions linked through
financial transactions and services. Additionally, it is increasingly integrated with
the global financial system:

 Foreign Investments: Participation of foreign institutional investors (FIIs)

and foreign direct investment (FDI).
 International Trade: Facilitated by a well-developed forex market and
international banking services.

7. Supportive of Economic Development

The Indian financial system plays a crucial role in supporting economic

development:

 Resource Allocation: Efficient allocation of financial resources to productive

sectors.
 Employment Generation: Providing financing for businesses and industries,
leading to job creation.
 Infrastructure Development: Funding large-scale infrastructure projects
crucial for economic growth.

8. Challenges and Opportunities

The system faces several challenges and opportunities:

 Challenges: Financial inclusion gaps, regulatory compliance, cybersecurity

risks, and financial literacy.

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  Opportunities: Growth potential in fintech, deeper penetration of financial
services, and expanding capital markets.

Conclusion

The Indian financial system is a complex, diverse, and dynamic network that plays
a fundamental role in the country's economic stability and growth. Its multifaceted
nature, robust regulatory framework, and continuous evolution make it a cornerstone
of India's economic infrastructure.

Components/Key Elements of Indian Financial System

The Indian financial system is a complex and multifaceted network that

encompasses various institutions, markets, instruments, and services. It plays a
critical role in the economic development of the country by mobilizing savings,
allocating resources, facilitating trade, and supporting investment. The main
components of the Indian financial system can be broadly categorized into the
following:

1. Financial Institutions

Financial institutions in India are responsible for the mobilization and allocation of
resources. They can be broadly divided into banking and non-banking institutions.

a. Banking Institutions

 Commercial Banks: These include public sector banks (like the State Bank
of India), private sector banks (like ICICI Bank), foreign banks, and regional
rural banks. They accept deposits, provide loans, and offer various financial
services.
 Cooperative Banks: These banks operate on a cooperative basis and cater to
the needs of small borrowers in rural and urban areas. They include urban
cooperative banks and rural cooperative banks.
 Development Banks: These are specialized institutions that provide long-
term finance for industrial and agricultural development. Examples include
the Industrial Development Bank of India (IDBI) and the National Bank for
Agriculture and Rural Development (NABARD).

b. Non-Banking Financial Institutions (NBFIs)

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  Non-Banking Financial Companies (NBFCs): These companies provide a
variety of financial services, including loans, credit facilities, acquisition of
shares, and insurance. They do not hold a banking license.
 Insurance Companies: These include both life insurance companies (like
Life Insurance Corporation of India) and general insurance companies (like
New India Assurance Company).
 Mutual Funds: Mutual funds pool resources from investors to invest in
securities like stocks, bonds, and other assets.

2. Financial Markets

Financial markets are venues where financial instruments are bought and sold. They
facilitate the raising of capital, transfer of risk, and provision of liquidity.

a. Capital Market

 Primary Market: This is where new securities are issued. Companies raise
funds by issuing shares, bonds, or debentures.
 Secondary Market: This is where existing securities are traded. The major
stock exchanges in India are the Bombay Stock Exchange (BSE) and the
National Stock Exchange (NSE).

b. Money Market

The money market deals with short-term borrowing and lending, typically for
periods up to one year. It includes instruments like Treasury Bills, Commercial
Paper, and Certificates of Deposit.

c. Foreign Exchange Market

This market facilitates the trading of foreign currencies. It is crucial for international
trade and investment. The Reserve Bank of India (RBI) plays a significant role in
regulating this market.

3. Financial Instruments

Financial instruments are assets that can be traded. They include:

 Equity Instruments: Shares or stocks representing ownership in a company.

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  Debt Instruments: Bonds, debentures, and loans representing a creditor
relationship with the issuer.
 Derivatives: Financial contracts whose value is derived from an underlying
asset, like futures, options, and swaps.

4. Financial Services

Financial services are the services provided by the finance industry, which
encompasses a broad range of businesses managing money. These services include:

 Banking Services: Deposit taking, lending, payment processing, and wealth

management.
 Investment Services: Asset management, brokerage, and financial advisory
services.
 Insurance Services: Risk management through various types of insurance
products.
 Payment and Settlement Services: Systems and services facilitating the
transfer of funds.

5. Regulatory Framework

The Indian financial system is regulated by various authorities to ensure stability,

transparency, and fairness.

 Reserve Bank of India (RBI): The central bank of India, which regulates
monetary policy, issues currency, and oversees banking operations.
 Securities and Exchange Board of India (SEBI): Regulates the securities
market to protect investors and ensure market integrity.
 Insurance Regulatory and Development Authority of India (IRDAI):
Regulates the insurance sector.
 Pension Fund Regulatory and Development Authority (PFRDA):
Regulates and develops the pension sector.
 Ministry of Finance: Governs overall economic policies, including fiscal
policies and public finance.

6. Development Financial Institutions (DFIs)

DFIs are specialized institutions that provide long-term financial assistance to

sectors critical to economic development, such as infrastructure, industry, and

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agriculture. Examples include the Export-Import Bank of India (Exim Bank) and the
Small Industries Development Bank of India (SIDBI).

7. Financial Inclusion Initiatives

The Indian financial system also emphasizes financial inclusion to ensure that
financial services reach the underserved and unbanked segments of the population.
Key initiatives include:

 Pradhan Mantri Jan Dhan Yojana (PMJDY): A national mission for

financial inclusion to ensure access to financial services, particularly for the
poor.
 Microfinance Institutions (MFIs): Provide small loans and other financial
services to low-income individuals or groups.
 Conclusion

The Indian financial system is a dynamic and integral part of the country's economy.
Its efficient functioning is crucial for economic growth, financial stability, and
inclusive development. The interplay between its various components ensures that
savings are channeled into productive investments, risks are managed, and financial
stability is maintained.

Functions and role of financial system and financial instruments

 Introduction

The financial system is the lifeblood of any economy, providing the infrastructure
for the flow of funds between savers, investors, borrowers, and various financial
entities. It plays a crucial role in economic development by ensuring that capital is
allocated efficiently, risks are managed effectively, and the overall stability of the
economy is maintained. This chapter explores the functions and roles of the financial
system in detail.

1. Mobilization of Savings

One of the primary functions of the financial system is to mobilize savings from
individuals, households, and businesses. By providing various financial instruments
and services, the financial system encourages people to save and invest their money,
thus channeling funds into productive uses.

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  Depository Services: Banks and other financial institutions offer savings
accounts, fixed deposits, and other instruments that help accumulate savings.
 Investment Products: Mutual funds, bonds, and stocks provide avenues for
individuals and institutions to invest their savings in a diversified manner.

2. Efficient Allocation of Resources

The financial system allocates resources efficiently by directing funds to their most
productive uses. This ensures that capital is available for businesses and individuals
who can use it to generate economic growth and development.

 Credit Allocation: Banks and financial institutions provide loans and credit
facilities to businesses for expansion, innovation, and operational needs.
 Capital Markets: Stock exchanges and bond markets enable companies to
raise capital for growth by issuing equity and debt securities.

3. Facilitating Payment and Settlement

A well-functioning financial system facilitates the smooth transfer of funds between

parties, ensuring that transactions are settled efficiently and securely.

 Payment Systems: Electronic funds transfer, mobile banking, and payment

gateways enable quick and convenient transactions.
 Clearing and Settlement: Systems like Real-Time Gross Settlement (RTGS)
and National Electronic Funds Transfer (NEFT) ensure that payments are
settled promptly and accurately.

4. Risk Management

The financial system provides mechanisms to manage and mitigate various types of
risks, including credit risk, market risk, and operational risk.

 Insurance Products: Life, health, and general insurance products protect

individuals and businesses from financial losses due to unforeseen events.
 Derivatives Market: Instruments like futures, options, and swaps help
investors and businesses hedge against price fluctuations and other financial
risks.

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5. Price Discovery

Financial markets play a crucial role in the price discovery process, determining the
prices of financial assets based on supply and demand dynamics.

 Stock Exchanges: Prices of stocks and bonds are determined through

continuous trading on stock exchanges, reflecting the collective judgment of
investors about the value of securities.
 Commodity Markets: Prices of commodities like gold, oil, and agricultural
products are discovered through trading in commodity exchanges.

6. Providing Liquidity

Liquidity is essential for the smooth functioning of the financial system, allowing
assets to be quickly bought or sold without significantly affecting their price.

 Money Market Instruments: Treasury bills, commercial paper, and

certificates of deposit provide short-term liquidity for businesses and
governments.
 Secondary Markets: Stock and bond markets offer liquidity by enabling
investors to buy and sell securities easily.

7. Supporting Economic Development

The financial system supports economic development by facilitating investment in

infrastructure, industry, and other critical sectors.

 Development Banks: Institutions like the Industrial Development Bank of

India (IDBI) and the National Bank for Agriculture and Rural Development
(NABARD) provide long-term financing for developmental projects.
 Microfinance: Microfinance institutions offer financial services to low-
income individuals and small businesses, promoting entrepreneurship and
economic inclusion.

8. Implementing Monetary Policy

The financial system plays a key role in the implementation of monetary policy,
helping central banks manage inflation, control money supply, and stabilize the
economy.

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  Open Market Operations: Central banks buy and sell government securities
in the open market to influence liquidity and interest rates.
 Reserve Requirements: Central banks set reserve requirements for
commercial banks to control the amount of money in circulation.

9. Facilitating International Trade and Investment

The financial system enables international trade and investment by providing the
necessary infrastructure for foreign exchange transactions and cross-border capital
flows.

 Foreign Exchange Market: Facilitates the exchange of currencies, essential

for international trade and investment.
 Trade Finance: Financial instruments like letters of credit and trade credit
insurance support international trade by mitigating risks.

10. Promoting Financial Inclusion

Financial inclusion ensures that all segments of society have access to financial
services, promoting equitable economic growth and reducing poverty.

 Banking Services for the Unbanked: Initiatives like Pradhan Mantri Jan
Dhan Yojana (PMJDY) aim to provide banking services to the unbanked
population.
 Microfinance and SHGs: Microfinance institutions and self-help groups
(SHGs) offer credit and financial services to low-income individuals and
communities.

Conclusion

The financial system is integral to the functioning of a modern economy, facilitating

the mobilization of savings, efficient allocation of resources, risk management, and
economic development. By supporting payment and settlement, price discovery,
liquidity provision, and financial inclusion, the financial system ensures stability and
promotes growth. Understanding its functions and roles is essential for appreciating
its impact on the economy and for formulating policies that enhance its
effectiveness.

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Evolution of the Financial System in India

 Introduction

The financial system in India has undergone significant transformation over the
decades, evolving through various phases to become the robust and dynamic
system it is today. This chapter explores the historical development, key
milestones, and reforms that have shaped the Indian financial system.

1. Pre-Independence Era

Before India's independence in 1947, the financial system was rudimentary, with
limited institutions and financial instruments. The colonial government’s focus was
on trade and commerce to benefit the British economy.

 Early Banking: The establishment of the Bank of Hindustan in 1770 marked

the beginning of banking in India. The Presidency Banks—Bank of Bengal,
Bank of Bombay, and Bank of Madras—were established in the early 19th
century.
 Indigenous Banking: Informal financial systems like hundis and indigenous
bankers (shroffs) played a crucial role in trade financing.
 Securities Market: The Bombay Stock Exchange (BSE), established in 1875,
was the primary platform for trading securities.

2. Post-Independence Era (1947-1969)

After independence, India aimed to build a strong and self-reliant economy. The
financial system began to evolve to support industrialization and socio-economic
development.

 Nationalization of RBI: The Reserve Bank of India (RBI), established in

1935, was nationalized in 1949, becoming the central authority to regulate the
banking sector.
 Banking Sector Development: The enactment of the Banking Regulation
Act, 1949, laid the foundation for a regulated banking system. Several
commercial banks were established during this period.
 Development Banks: Institutions like the Industrial Finance Corporation of
India (IFCI) and the Industrial Credit and Investment Corporation of India
(ICICI) were set up to provide long-term financing for industrial projects.

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3. Bank Nationalization and Expansion (1969-1991)

This phase was characterized by the nationalization of major banks and the
expansion of banking services to promote financial inclusion and support economic
development.

 First Wave of Nationalization: In 1969, the Indian government nationalized

14 major commercial banks to extend banking services to rural and semi-
urban areas and to ensure credit availability to priority sectors.
 Second Wave of Nationalization: In 1980, six more banks were nationalized,
further expanding the reach of the banking sector.
 Regional Rural Banks (RRBs): Established in 1975 to provide credit to rural
and agricultural sectors.
 Introduction of Lead Bank Scheme: Aimed at improving the distribution of
banking services in rural areas by designating specific banks to lead the
development efforts in particular districts.

4. Financial Sector Reforms (1991-Present)

The liberalization of the Indian economy in 1991 marked the beginning of

comprehensive financial sector reforms aimed at enhancing efficiency,
competitiveness, and integration with the global economy.

a. Banking Sector Reforms

 Entry of Private and Foreign Banks: New private sector banks and foreign
banks were allowed to operate, increasing competition and improving service
quality.
 Prudential Norms: Introduction of capital adequacy norms, asset
classification, and provisioning requirements to strengthen the financial health
of banks.
 Technological Upgradation: Adoption of core banking solutions, electronic
funds transfer, and internet banking to enhance customer convenience and
operational efficiency.

b. Capital Market Reforms

 Establishment of SEBI: The Securities and Exchange Board of India (SEBI)

was established in 1988 and given statutory powers in 1992 to regulate and
develop the securities market.
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  Dematerialization: Introduction of the Depository Act in 1996 allowed the
conversion of physical shares into electronic form, enhancing the efficiency
and security of transactions.
 Market Infrastructure: Establishment of the National Stock Exchange
(NSE) in 1992, which introduced screen-based trading, and the Central
Depository Services (India) Ltd (CDSL) in 1999.

c. Insurance Sector Reforms

 Liberalization of Insurance Sector: The Insurance Regulatory and

Development Authority of India (IRDAI) was established in 1999, allowing
private and foreign players to enter the insurance market.
 Introduction of New Products: A wider range of insurance products,
including health, motor, and life insurance policies, were introduced.

d. Non-Banking Financial Companies (NBFCs)

 Regulatory Framework: RBI introduced a regulatory framework for

NBFCs, focusing on registration, prudential norms, and corporate
governance.
 Role of NBFCs: NBFCs have emerged as significant players in providing
credit, particularly to underserved segments and sectors.

e. Financial Inclusion Initiatives

 Pradhan Mantri Jan Dhan Yojana (PMJDY): Launched in 2014 to provide

universal access to banking services and promote financial literacy.
 Microfinance and SHGs: Development of microfinance institutions and self-
help groups to provide financial services to low-income individuals and rural
areas.

f. Technological Advancements

 Digital Payments: The advent of the Unified Payments Interface (UPI) and
mobile wallets has revolutionized the payment landscape, promoting digital
transactions.
 Fintech Innovations: Growth of fintech companies offering innovative
financial products and services, such as peer-to-peer lending, robo-advisory,
and blockchain technology.

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5. Current Scenario and Future Prospects

The Indian financial system today is characterized by its diversity, robustness, and
increasing integration with the global economy. Continuous reforms and
technological advancements are expected to drive further growth and development.

 Regulatory Focus: Strengthening regulatory frameworks to ensure stability,

transparency, and consumer protection.
 Sustainable Finance: Promoting green finance and sustainable investment
practices.
 Financial Literacy: Enhancing financial literacy and awareness among the
general public to promote informed financial decision-making.

Conclusion

The evolution of the financial system in India reflects the country’s journey from a
colonial economy to a modern, dynamic, and globally integrated financial market.
Each phase of development has contributed to building a comprehensive financial
infrastructure that supports economic growth, inclusion, and stability.
Understanding this evolution provides valuable insights into the current state of the
financial system and its future trajectory.

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References

https://byjus.com/govt-exams/indian-financial-system/

https://www.imf.org/en/Publications/Books/Issues/2023/07/06/Indias-Financial-
System-Building-the-Foundation-for-Strong-and-Sustainable-Growth-523790

https://www.economist.com/special-report/2024/04/22/indias-financial-system-
has-improved-dramatically-in-the-past-decade

https://www.ibef.org/industry/financial-services-india

https://financialservices.gov.in/beta/en/banking-overview

https://www.elibrary.imf.org/display/book/9798400223525/9798400223525.xml

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