08. EEC-19 Indian Financial Systems

IGNOU BA Economics Study Material

Source : Economics – eGyanKosh

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Block-1 The Basics of Financial System

Block-2 Banking System and Money Market

Block-3 Capital Market in India

Block-4 Financial and Investment Institutions in India

Block-1: The Basics of the Financial System

At its core, a financial system is the framework of institutions, markets, instruments, and services that facilitates the transfer of funds from surplus units (savers) to deficit units (borrowers). Its primary functions are the mobilization of savings, the efficient allocation of capital to productive ventures, the management of financial risks, the provision of liquidity, and the facilitation of payments.

The Indian financial system is broadly categorized into the organized and unorganized sectors. The organized sector comprises a web of regulated entities, including banks, financial institutions, and markets. The unorganized sector, on the other hand, consists of informal intermediaries like moneylenders and indigenous bankers.

The key components of the financial system are:

Financial Institutions: These are intermediaries that channel funds between savers and borrowers. They include commercial banks, cooperative banks, and non-banking financial companies (NBFCs).
Financial Markets: These are platforms where financial assets are traded. They are broadly divided into the money market (for short-term funds) and the capital market (for long-term funds).
Financial Instruments: These are the financial assets traded in the markets, such as shares, debentures, bonds, and treasury bills.
Financial Services: These are the services provided by financial institutions, including banking, insurance, and investment management.

The smooth functioning of the financial system is crucial for a country’s economic development, as it promotes capital formation, encourages investment, and contributes to overall economic stability.

Block-2: The Banking System and Money Market in India

The banking system forms the bedrock of the Indian financial system, with the Reserve Bank of India (RBI) at its apex as the central banking authority. The RBI is responsible for monetary policy, regulation and supervision of the banking sector, and maintaining financial stability.

The Indian banking system is characterized by a mix of public sector banks, private sector banks, foreign banks, and cooperative banks. Commercial banks play a pivotal role in the economy by accepting deposits, providing credit, and facilitating the payments system.

The money market is a crucial segment of the financial system that deals with short-term borrowing and lending of funds, with maturities ranging from overnight to a year. It provides a mechanism for balancing the short-term liquidity needs of banks, financial institutions, and the government.

The key instruments traded in the Indian money market include:

Treasury Bills (T-bills): Short-term debt instruments issued by the Government of India with maturities of 91 days, 182 days, and 364 days.
Commercial Papers (CPs): Unsecured promissory notes issued by highly-rated corporate entities to raise short-term funds.
Certificates of Deposit (CDs): Time deposits issued by banks and financial institutions that can be traded in the secondary market.
Call Money/Notice Money Market: An inter-bank market where banks borrow and lend to each other for very short periods (overnight to 14 days) to manage their daily cash reserve requirements.
Repo (Repurchase Agreement) and Reverse Repo: Instruments used by the RBI to inject or absorb liquidity from the system.

The money market is regulated by the RBI, which uses various tools to influence liquidity and interest rates in the economy.

Block-3: The Capital Market in India

The Indian capital market is the segment of the financial system where long-term funds are raised through the issuance and trading of securities. It plays a vital role in channelizing savings for long-term investments in industry and infrastructure. The Securities and Exchange Board of India (SEBI) is the primary regulator of the Indian capital market, overseeing its functioning and protecting the interests of investors.

The capital market in India is bifurcated into two main segments:

Primary Market: This is where new securities (shares, debentures, bonds) are issued by companies and the government to raise fresh capital. The process of offering shares to the public for the first time is known as an Initial Public Offering (IPO).
Secondary Market: This is where existing securities are traded among investors. The major stock exchanges in India, the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), provide the platform for this trading. The secondary market provides liquidity to investors, allowing them to buy and sell securities.

The key instruments of the Indian capital market include:

Equity Shares: Represent ownership in a company and entitle the holder to a share in the company’s profits (dividends).
Debentures and Bonds: These are debt instruments that represent a loan made by an investor to a borrower (company or government). They carry a fixed rate of interest.
Derivatives: Financial instruments whose value is derived from an underlying asset, such as stocks, indices, or commodities. Options and futures are common types of derivatives.
Mutual Funds: A professionally managed investment fund that pools money from many investors to purchase a diversified portfolio of stocks, bonds, or other securities.

Block-4: Financial and Investment Institutions in India

A diverse array of financial and investment institutions underpins the Indian financial system, each with a specific mandate to cater to the varied needs of the economy. These institutions can be broadly classified as follows:

Regulatory Bodies:

Reserve Bank of India (RBI): The central bank, regulating the banking system and money market.
Securities and Exchange Board of India (SEBI): The apex regulator for the capital market.
Insurance Regulatory and Development Authority of India (IRDAI): Regulates the insurance sector.
Pension Fund Regulatory and Development Authority (PFRDA): Regulates the pension sector.

All-India Financial Institutions (AIFIs): These are specialized institutions established to provide long-term financing to specific sectors of the economy.

National Bank for Agriculture and Rural Development (NABARD): Provides refinance for agriculture and rural development.
Small Industries Development Bank of India (SIDBI): Caters to the financial needs of the micro, small, and medium enterprises (MSME) sector.
Export-Import Bank of India (EXIM Bank): Finances, facilitates, and promotes India’s foreign trade.
National Housing Bank (NHB): The apex institution for housing finance.

Investment Institutions:

Life Insurance Corporation of India (LIC): The largest life insurer and a significant institutional investor in the country.
General Insurance Corporation of India (GIC Re): The national reinsurer.
Unit Trust of India (UTI) and other Mutual Funds: Pool savings from investors and channel them into the capital market.

Other Public Sector Undertakings: A host of public sector banks and non-banking financial companies also play a crucial role in providing financial services across the country.

Together, these institutions form the intricate machinery that drives India’s financial system, facilitating economic growth and providing the necessary financial infrastructure for a developing nation.

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