What is Financial Institution (FI)?

Financial institutions are organizations that provide financial services to their clients. These
include banks, credit unions, insurance companies, brokerage firms, and asset management
companies. They play a crucial economic role by facilitating monetary transactions, lending,
investment, and risk management. Financial institutions act as intermediaries between savers and
borrowers, mobilize savings, and channel them into productive investments, thereby fostering
economic growth and financial stability.

Types of Financial Institutions

Financial institutions come in various forms, each serving distinct functions to support economic
activities and financial stability. Here are the main types of financial institutions:

Commercial Banks
A commercial bank is a financial institution that accepts money from individuals and businesses
and provides loans to those in need. It offers services such as loans, savings, certificates of
deposits, bank accounts, bank overdrafts, etc., to its customers. These organizations earn money
by granting loans to individuals and gaining interest on loans. Business loans, house loans,
personal loans, car loans, and education loans are the different types of loans offered by
commercial banks.
Investment Banks
Investment banking helps individuals, organizations, governments, and other institutions raise
capital and provides financial consultancy advice. It doesn’t deal with customer deposits but
rather assists with financing through securities such as bonds and stocks.
They are a type of financial institution that provides services that specialize in facilitating
business operations, such as financing and offerings of capital expenditure and equity, mergers
and acquisitions, and new issues of initial public offerings (IPOs). They also commonly act as
market makers for trading exchanges, provide brokerage services for investors, and other
corporate restructurings.
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Credit Unions
A credit union is a financial institution similar to a commercial bank. However, it is a non-profit
institution created, owned, and operated by its members. Credit unions provide
traditional banking services only to their members, such as account opening, issuing credit cards,
loans, etc. Credit unions charge interest and account fees just like a bank, but they reinvest those
profits into the products they offer; however, banks provide these profits to their shareholders.
Historically, credit unions only served a particular demographic according to their field of
membership, such as military members, teachers, etc. Nowadays, they have liberated the
restrictions on membership and provide their services to the general public.

Insurance Companies
Insurance companies are familiar kinds of non-bank financial institutions. They offer insurance
services to both individuals and organizations. The insurance can be related to the protection
against financial risk, life insurance, health, home, shop, company, products, vehicles, etc. These
institutions put the money from insurance premiums into a pool to fund the policy coverage.
Insurance companies can be necessary for the stability of financial systems mainly because they
are significant investors in financial markets. As a result of the growing links between insurers
and banks, insurers are insuring the risks of households and firms to guarantee their financial
stability.

Brokerage Firms
A brokerage firm or company is a middleman who facilitates the transaction by connecting the
buying and selling parties. Brokers assist in the dealing of securities such as stocks, mutual
funds, shares, bonds, options, and other financial instruments. Once the transaction is completed,
brokers receive both parties’ brokerage (commission). Some brokerage companies also provide
financial advice and act as consultants.

Role of Financial Institutions

Financial institutions form the backbone of a nation's economic development, playing a

multifaceted role in fostering growth, stability, and prosperity. These institutions, ranging from
banks and credit unions to central banks and investment firms, serve as intermediaries that
facilitate the efficient allocation of resources in the economy. In this comprehensive exploration,
researcher delves into the intricate ways in which financial institutions contribute to economic
development.

1. Capital Mobilization and Formation:

One of the primary functions of financial institutions is to mobilize savings from individuals,
businesses, and other entities within the economy. By encouraging savings, these institutions
accumulate a pool of funds that can be channeled into productive investments. This capital
formation is instrumental in providing the financial resources necessary for economic expansion,
innovation, and infrastructure development.

2. Investment Facilitation:

Financial institutions are pivotal in channeling funds towards productive investments. Whether
through loans, equity investments, or other financial instruments, these institutions provide the
necessary capital for businesses and entrepreneurs to undertake projects, expand operations, and
drive economic growth. By efficiently matching savers with borrowers, financial institutions
contribute to the vitality of various sectors within the economy.

3. Risk Management and Diversification:

The management of financial risks is inherent to the operations of financial institutions. Through
diversification of their portfolios and the use of risk management tools, these institutions mitigate
the impact of potential financial losses. This risk-bearing function is crucial as it encourages a
broader spectrum of investors and entrepreneurs to participate in economic activities, fostering a
climate conducive to development.

4. Payment Systems and Financial Infrastructure:

Efficient payment systems are essential for the smooth functioning of economic transactions.
Financial institutions, particularly banks, provide the necessary infrastructure for electronic funds
transfer, credit cards, and other payment mechanisms. This not only facilitates day-to-day
transactions but also contributes to the overall efficiency of business operations, thereby
positively impacting economic development.
5. Financial Intermediation and Efficiency:

Financial intermediation is a core function of banks and financial institutions. By acting as

intermediaries between savers and borrowers, they ensure that funds are allocated to their most
productive uses. This process enhances the efficiency of capital allocation in the economy,
directing resources toward activities that contribute significantly to economic development.

6. Credit Creation and Monetary Policy Transmission:

Financial institutions, particularly commercial banks, have the ability to create credit through the
fractional reserve banking system. This credit creation, when managed prudently, contributes to
the expansion of the money supply, stimulating economic activities. Moreover, financial
institutions, including central banks, play a crucial role in transmitting monetary policies that
influence interest rates, inflation, and overall economic stability.

7. Long-Term Investments and Infrastructure Financing:

Economic development often requires substantial investments in long-term projects and

infrastructure. Financial institutions, such as development banks, specialize in providing
financing for large scale infrastructure projects. By facilitating these investments, financial
institutions contribute to the creation of essential foundations for sustained economic growth.

8. Financial Inclusion and Social Impact:

Financial institutions play a pivotal role in promoting financial inclusion by expanding access to
banking and financial services. This is particularly important in developing economies, where a
significant portion of the population may be unbanked or under banked. Through innovative
financial products and services, financial institutions contribute to poverty reduction and
inclusive economic growth.

9. Technology and Innovation:

The rapid advancement of technology has transformed the financial sector. Financial institutions
are embracing fintech innovations, such as digital banking, block chain, and artificial
intelligence, to enhance efficiency, reduce costs, and improve customer experiences. These
technological advancements not only benefit the institutions themselves but also contribute to the
overall productivity and competitiveness of the economy.

10. Global Financial Integration:

Financial institutions facilitate global economic integration by connecting domestic markets with
the international financial system. Cross-border investments, foreign direct investment, and
international trade rely on the services provided by financial institutions. This integration opens
up opportunities for economic growth through access to international capital, markets, and
expertise.

11. Hedging and Risk Management:

Financial institutions provide essential tools for hedging and managing various types of risks in
the financial markets. Businesses are exposed to risks such as currency fluctuations, interest rate
changes, and commodity price volatility. Financial institutions offer derivative products,
insurance, and other risk management instruments to help businesses mitigate these risks. By
providing these services, financial institutions contribute to the stability of businesses and the
broader economy, encouraging investment and expansion.

12. Facilitating Small and Medium-sized Enterprises (SMEs):

Small and medium-sized enterprises (SMEs) are often considered the backbone of many
economies. Financial institutions play a crucial role in providing financing and support to SMEs.
They offer loans, credit lines, and other financial products tailored to the needs of these
businesses, enabling them to grow, create jobs, and contribute significantly to economic
development. Moreover, financial institutions may provide advisory services to help SMEs
improve their financial management and operational efficiency.

13. Wealth Management and Asset Allocation:

Financial institutions, including asset management firms and private banks, assist individuals and
institutions in managing their wealth. They offer a range of investment products, such as mutual
funds, pension funds, and private equity, allowing clients to diversify their portfolios and
optimize their asset allocation. Effective wealth management not only preserves and grows
individual wealth but also directs investments towards productive sectors, contributing to overall
economic development.

14. Education and Financial Literacy:

Financial institutions play a pivotal role in promoting financial education and literacy. They offer
educational programs, workshops, and materials to help individuals and businesses understand
financial concepts, investment strategies, and risk management. By enhancing financial literacy,
these institutions empower individuals to make informed decisions about savings, investments,
and debt management. A financially literate population is better equipped to participate in the
economy, make sound financial choices, and contribute to economic growth.

15. Liquidity Provision and Central Bank Functions:

Central banks, as key financial institutions, play a critical role in maintaining monetary stability
and providing liquidity to the financial system. They control the money supply, set interest rates,
and act as lenders of last resort during financial crises. By ensuring the stability of the banking
system and providing liquidity when needed, central banks contribute to overall economic
stability and confidence. This, in turn, encourages investment, consumption, and economic
development.

16. Corporate Governance and Ethical Practices:

Financial institutions influence corporate governance and ethical practices within the business
community. Banks and other financial intermediaries often impose certain standards and
requirements on the companies they finance. This includes criteria related to transparency,
ethical behavior, and adherence to environmental and social responsibility. By promoting good
governance and ethical business practices, financial institutions contribute to sustainable
development, reduce the risk of financial scandals, and foster a positive economic environment.

Functions of Financial Institution

Financial institutions perform several key functions essential to the economy and financial
system. Here are the primary functions of financial institutions:

Intermediation
Financial institutions act as intermediaries between savers and borrowers. They collect funds
from individuals and businesses as deposits and then lend them to borrowers who need capital
for various purposes, such as starting a business or purchasing a home.

Depository Services
Financial institutions provide depository services by accepting deposits from individuals and
businesses. They offer checking accounts, savings accounts, and other deposit products where
customers can securely store their money. These deposits may also earn interest.

Credit Provision
Financial institutions extend credit to individuals and businesses through loans and credit lines.
They evaluate the creditworthiness of borrowers, determine interest rates, and provide financial
support for various needs, such as personal loans, mortgages, business loans, and working
capital.

Investment Services
Financial institutions offer investment services to help individuals and businesses manage and
grow wealth. They provide access to investment products such as stocks, bonds, mutual funds,
and other securities. They also offer advisory services to guide clients in making informed
investment decisions.

Risk Management
Financial institutions assist individuals and businesses in managing financial risks. They provide
insurance products, such as life insurance, health insurance, property insurance, and liability
insurance, to protect against potential losses and unforeseen events.

Payment and Settlement Services

Financial institutions facilitate payment transactions between individuals and businesses. They
provide payment and settlement services such as processing electronic fund transfers, issuing
credit and debit cards, and managing payment systems to enable smooth and secure transactions.
Asset Management
Financial institutions offer asset management services, where they manage investment portfolios
on behalf of clients. They provide expertise in selecting investment options, diversifying
portfolios, and monitoring market conditions to optimize returns and meet clients’ financial
goals.

Financial Advisory
Financial institutions provide financial advisory services to individuals and businesses. They
offer guidance on financial planning, retirement planning, tax planning, estate planning, and
overall wealth management. They assist clients in making informed financial decisions based on
their goals and risk tolerance.

What is Commercial Bank?

A commercial bank is a kind of financial institution that carries all the operations related to
deposit and withdrawal of money for the general public, providing loans for investment, and
other such activities. These banks are profit-making institutions and do business only to make a
profit.

The two primary characteristics of a commercial bank are lending and borrowing. The bank
receives the deposits and gives money to various projects to earn interest (profit). The rate of
interest that a bank offers to the depositors is known as the borrowing rate, while the rate at
which a bank lends money is known as the lending rate.

Function of Commercial Bank:

The functions of commercial banks are classified into two main divisions.

(a) Primary functions

Accepts deposit : The bank takes deposits in the form of saving, current, and fixed deposits.
The surplus balances collected from the firm and individuals are lent to the temporary
requirements of the commercial transactions.
Provides loan and advances : Another critical function of this bank is to offer loans and
advances to the entrepreneurs and business people, and collect interest. For every bank, it is the
primary source of making profits. In this process, a bank retains a small number of deposits as a
reserve and offers (lends) the remaining amount to the borrowers in demand loans, overdraft,
cash credit, short-run loans, and more such banks.

Credit cash: When a customer is provided with credit or loan, they are not provided with liquid
cash. First, a bank account is opened for the customer and then the money is transferred to the
account. This process allows the bank to create money.

(b) Secondary functions

Discounting bills of exchange: It is a written agreement acknowledging the amount of money

to be paid against the goods purchased at a given point of time in the future. The amount can also
be cleared before the quoted time through a discounting method of a commercial bank.

Overdraft facility: It is an advance given to a customer by keeping the current account to

overdraw up to the given limit.

Purchasing and selling of the securities: The bank offers you with the facility of selling and
buying the securities.

Locker facilities: A bank provides locker facilities to the customers to keep their valuables or
documents safely. The banks charge a minimum of an annual fee for this service.

Paying and gathering the credit : It uses different instruments like a promissory note, cheques,
and bill of exchange.

Types of Commercial Banks:

There are three different types of commercial banks.

Private bank –: It is a type of commercial banks where private individuals and businesses own
a majority of the share capital. All private banks are recorded as companies with limited liability.
Such as Housing Development Finance Corporation (HDFC) Bank, Industrial Credit and
Investment Corporation of India (ICICI) Bank, Yes Bank, and more such banks.

Public bank –: It is a type of bank that is nationalised, and the government holds a significant
stake. For example, Bank of Baroda, State Bank of India (SBI), Dena Bank, Corporation Bank,
and Punjab National Bank.

Foreign bank –: These banks are established in foreign countries and have branches in other
countries. For instance, American Express Bank, Hong Kong and Shanghai Banking Corporation
(HSBC), Standard & Chartered Bank, Citibank, and more such banks.

Examples of Commercial Banks

Few examples of commercial banks in India are as follows:

1. State Bank of India (SBI)

2. Housing Development Finance Corporation (HDFC) Bank

3. Industrial Credit and Investment Corporation of India (ICICI) Bank

4. Dena Bank

5. Corporation Bank

Meaning of Banking Sector Reforms in India

 Banking Sector Reforms in India refer to the series of changes implemented

to modernize and strengthen the Indian banking system.

 These reforms were initiated in the early 1990s as part of India’s overall
economic liberalization and has been ongoing since then.

 Most of these reforms have been carried out in the Public Sector Banks (PSBs),
though some of them have also been applicable for Private Sector Banks.
Need for Reforms in Public Sector Banks

Banking Sector Reforms in India were needed for the following reasons:

 Public Sector Banks (PSBs) account for 80% of the overall NPAs of the
Banking sector.

 PSBs also suffer from slower credit Growth of hardly around 4% in comparison
to 15-30% registered by New private Banks (NPBs).

 The PSBs also face higher losses of around ₹66,000 crores.

 PSBs account for 93% of total frauds, leading to loss of Taxpayers’ money.

Challenges of PSBs

The challenges faced by the Public Sector Banks (PSBs) that necessitated the Banking
Sector Reforms in India can be seen as follows:

 PSBs enjoy less strategic and operating freedom because of majority

government ownership.

 Government exercises significant control over all aspects of PSBs operations

ranging from recruitment policies, pay to investments, financing and bank
governance including board and top management appointments.

 Implicit promise of bailout of bank liabilities which is an implicit cost to the

taxpayer.

 PSB Officers are wary of taking risks in lending or renegotiating bad debt,
because of fears of harassment under the guise of vigilance investigations.

 High operating costs.

  Recruitment processes of PSBs hinder them from campus hiring.

Banking Sector Reforms in India: Key Measures

Taken

Some of the key measures taken towards Banking Sector Reforms in India have been
explained in the sections that follow.

Privatisation of Public Sector Banks (PSBs)

 Privatisation of Public Sector Banks (PSBs) in India has been in consideration

as a potential solution to enhancing efficiency in the Indian Banking System.

 Privatization of PSBs simply means less active and direct participation of the
Central Government in the day-to-day activities of the Public Sector Banks
(PSBs).

Merger of Public Sector Banks (PSBs)

 Merger of Public Sector Banks (PSBs) is being done in order to create a more
robust, efficient and competitive Banking System in India.

 Also known as the Consolidation of Public Sector Banks, it refers to the

process of combining smaller and weaker banks with larger and stronger ones
to create more robust, efficient, and competitive banking entities.

Governance Reforms in Banks

  Governance Reforms in Banks in India have been an important part of Banking
Sector Reforms in India.

 Over the years, the Indian banking sector has witnessed significant changes in
its governance structure in order to ensure the stability, efficiency, and integrity
of the financial system.

 Some of the key initiatives taken for Governance Reforms in Banks in

India include:
o Establishment of a Bank Board Bureau (BBB).

o EASE Reform Agenda, etc.

Technological Upgradation of Banks

 In order to ensure survival and efficient functioning in the era of digital

banking, banks and financial institutions in India are being upgraded
technologically.

 The following initiatives have been taken for making rapid strides in adoption
of digital technology:

Society for Worldwide Interbank Financial Telecommunication

(SWIFT)

 The Society for Worldwide Interbank Financial Telecommunication (SWIFT)

provides a network to enable financial institutions all over the world receive
and send information about financial transactions in a standardized, secure, and
reliable environment.

 It was established in 1973.

  It makes use of a standardized proprietary communications platform to
facilitate the transmission of information.

 It neither manages external client accounts nor holds funds on its own.

 The headquarter of SWIFT is in Belgium.

 Prior to SWIFT, Telex was the only reliable means of communication

regarding transfer of international funds. However, Telex was discontinued due
to various issues such as security concerns, low speed, and a free message
format.

E-Kuber

 e-Kuber was introduced as part of Banking Sector Reforms in India in 2012 as

the Core Banking Solution (CBS) of the Reserve Bank of India (RBI).

 Core Banking Solutions (CBS) means a solution that enables banks to offer a
multiple customer-centric services from a single location on a 24×7 basis, thus
enabling support to corporate as well as retail banking activities.

 Using a Core Banking Solution (CBS), customers can access their accounts
from anywhere and from any branch (irrespective of branch where their
accounts was opened).

 Thus, it aims to create a “one-stop” solution for financial services.

 Almost all the branches of Commercial Banks, including the Regional Rural
Banks, are brought into the fold of core-banking.

 The e-kuber system can be accessed either through Internet or INFINET.

Conclusion
Banking Sector Reforms in India have played a crucial role in shaping an efficient and
robust banking system. While significant progress has been made, continuous efforts are
required to address new emerging challenges. The journey of banking sector reforms in
India must persist to build a resilient banking sector that can support India’s ambitious
economic growth aspirations.

INTRODUCTION TO NBFC

A non-banking financial company (NBFC) is a company registered under the Companies Act 2013, and
its operations are regulated by the Reserve Bank of India (RBI) under the framework of Chapter III -B
(Provisions Relating to Non-Banking Institutions Receiving Deposits and Financial Institutions).
Although Chapter III exclusively dealt with NBFCs, the word NBFC was not defined until The RBI
(Amendment) Act, 1997, by inserting clause (f) under Section 45-I, which defined Non-Banking
Financial Company as –

1. “a financial institution which is a company

2. a non-banking institution which is a company and which has as its principal business the
receiving of deposits, under any scheme or arrangement or in any other manner, or lending in
any manner;

 such other non-banking institution or class of such institutions, as the Bank may, with the
previous approval of the Central Government and by notification in the Official Gazette,
specify;”

so, in this definition “financial institution” includes Section 45 I (c) of RBI Act, which sites that a
company is also considered as NBFC if it carry on any of the activities listed below –

 “The financing, by way of making loans or advances or otherwise, of any activity other than its
own,

 the acquisition of shares, stock, bonds, debentures or securities issued by a government or local
authority or other marketable securities of a like nature:
  letting or delivering of any goods to a hirer under a hire-purchase agreement as defined in clause
(c) of section 2 of the Hire-Purchase Act, 1972:

 the carrying on of any class of insurance business;

 managing, conducting or supervising, as foreman, agent or in any other capacity, of chits or

kuries as defined in any law which is for the time being in force in any State, or any business,
which is similar thereto;

 collecting, for any purpose or under any scheme or arrangement, monies in lumpsum or by way
of subscriptions or by sale of units, or other instruments or in any other manner and awarding
prizes or gifts, whether in cash or kind, or disbursing monies in any other way, to persons from
whom monies are collected or to any other person,

but does not include any institution, which carries on as its principal business, –

 agricultural operations; or

(aa) industrial activity; or

(b) the purchase or sale of any goods (other than securities) or the providing of any services; or

(c) the purchase, construction or sale of immovable property, so however, that no portion of the
income of the institution is derived from the financing of purchases, constructions or sales of immovable
property by other persons;”

In a nutshell a Non-Banking Financial Company means and includes any business of financial institution
referred under Section 45 I(c) and Section 45 I (f).In addition to RBI guidelines, NBFCs are regulated by
NHB, SEBI, MCA IRDAI and State Government.

REGULATORS OF NON-BANKING COMPANIES

BACKGROUND OF NBFC’s

 Since the 1960s, non-banking financial companies (NBFCs) have emerged in India to cater to
consumers and investors whose needs weren’t met by traditional banks. These NBFCs offer
diverse financial services, including equipment leasing, loans, investment options, and even chit-
fund operations.

 Initially, the Companies Act governed the financial sector. However, the unique and complex
nature of financial operations and their role as financial intermediaries necessitated a distinct
regulatory framework.

 In the 1970s, the Indian government tasked the Banking Commission, under the leadership of
Bhabatosh Datta, with investigating the operations of chit funds and non-banking financial
intermediaries.
 Besides the Banking Commission (1972), the James Raj Committee (1975) also examined the
functioning of NBFCs. Both committees concurred on the inadequacy of the existing legislative
framework and emphasized the need for improvement.

 Building upon the recommendations of the Chakravarty Committee (1985) for a tiered licensing
system to safeguard depositors, the Narasimhan Committee (1991) established a comprehensive
regulatory framework for NBFCs. This framework encompasses capital adequacy, debt-to-equity
ratio limits, credit concentration controls, adherence to sound accounting practices, standardized
disclosure requirements, and asset valuation standards.

 Furthermore, it emphasized the need for a dedicated supervisory agency under the Reserve Bank
of India to oversee and regulate NBFCs.

 Further, the committees advocated for the creation of a supervisory body within the Reserve Bank
of India to regulate NBFCs.

 During the 1980s and 1990s, Non-Banking Financial Institutions (NBFCs) experienced a
significant increase in investor interest due to their reputation for customer-centricity. This
resulted in a rapid expansion of the industry, with the number of NBFCs quadrupling from
approximately 7,000 in 1981 to around 30,000 in 1992. This rapid growth prompted the Reserve
Bank of India (RBI) to consider implementing a regulatory framework for the NBFC sector.

 In recognition of this need, a committee led by Professor Sukhamoy Chakravarty was convened
in December 1982 by Dr. Manmohan Singh, the then-Governor of the Reserve Bank of India. The
committee’s primary objective was to evaluate the functioning of the country’s monetary system.
To achieve this, the committee recommended an analysis of the banking sector, non-banking
financial institutions, and the unorganized sector, with a focus on understanding the impact of
various monetary and credit policy tools.

 The Reserve Bank of India (RBI) took further steps towards regulating the NBFC sector in 1992.
A committee chaired by Mr. A. C. Shah, former Chairman of Bank of Baroda, was established to
propose effective regulatory measures. This committee recommended mandatory registration and
adherence to prudential norms for NBFCs

 Building upon the recommendations of the Shah Committee and the Joint Parliamentary
Committee’s observations from 1992, the RBI formed an Expert Group led by Mr. Khanna in
April 1995. This group focused on designing a comprehensive supervisory framework for
 NBFCs. Their proposed framework included an off-site surveillance system and on-site
examinations tailored to the size and business activities of each NBFC.

 Recognizing the need for a robust legal framework, the government enacted an Ordinance in
January 1997, followed by an Act in March 1997. These legislative measures significantly
amended Chapters III-B and V of the RBI Act, granting the central bank greater powers to
regulate and supervise NBFCs.