Indian Financial System PDF

INDIAN FINANCIAL SYSTEM Ankita. Rohatgi MEANING OF INDIAN FINANCIAL SYSTEM: The Indian financial system is a complex network of financial institutions, markets, instruments, and services that facilitate the flow of funds between savers and investors. It comprises various entities such as ban...

INDIAN FINANCIAL SYSTEM Ankita. Rohatgi MEANING OF INDIAN FINANCIAL SYSTEM: The Indian financial system is a complex network of financial institutions, markets, instruments, and services that facilitate the flow of funds between savers and investors. It comprises various entities such as banks, non- banking financial companies (NBFCs), insurance companies, stock exchanges, mutual funds, pension funds, and other financial intermediaries. Constituents of the Financial System: 1)Financial Institutions: Financial institutions are intermediaries that mobilize savings and efficiently facilitate the allocation of funds. Financial institutions can be classified as banking and non-banking financial institutions. Banking institutions are creators of credit while non- banking financial institutions are sources of credit. In India, non-banking financial institutions, namely, the Developmental Financial Institutions (DFIs) and Non-Banking Financial Companies (NBFCs) as well as housing finance companies (HFCs) are the major institutional sources of credit. Financial institutions can also be classified as term- finance institutions such as the Industrial Development Bank of India (IDBI), Industrial Financial Corporation of India (IFCI), Small Industries Development Bank of India (SIDBI) and Industrial Investment Bank of India (IIBI). 2. Financial Markets: Financial markets are a mechanism enabling participants to deal with financial claims. The markets also provide a facility in which their demands and requirements interact to set a price for such claims. The main organized financial markets in India are the money market and capital market. The first is a market for short-term securities while the second is a market for long-term securities, that is, securities having a maturity period of one year or more 3. Financial Instruments: A financial instrument is a claim against a person or an institution for the payment at a future date of a sum of money and/or a periodic payment in the form of interest or dividend. Financial securities may be primary or secondary securities: i) Primary Securities: Primary securities are also termed direct securities as they are directly issued by the ultimate borrowers of funds to the ultimate savers. For example, primary or direct securities include equity shares and debentures. ii) Secondary Securities: Secondary securities are also referred to as indirect securities, as they are issued by the financial intermediaries to the ultimate 4) Financial Services: Financial intermediaries provide key financial services such as merchant banking, leasing, hire purchase, credit rating, and so on. Financial services rendered by financial intermediaries bridge the gap between lack of knowledge on the part of investors and the increasing sophistication of financial instruments and markets Before investors lend money, they need to be reassured that it is safe to exchange security for funds. This reassurance is provided by the financial regulator who regulates the conduction of the market, and intermediaries to protect the investors‟ interests. The Reserve Bank of India regulates the money market and the Securities and Exchange Board of India (SEBI) regulates the capital market. FUNCTIONS OF INDIAN FINANCIAL SYSTEM: 1.Intermediation Financial systems act as intermediaries between savers and borrowers, channeling funds from those who have excess funds (savers) to those who need funds (borrowers). This intermediation process facilitates the efficient allocation of capital and promotes economic growth. 2. Mobilization of savings Financial systems provide a mechanism for individuals and businesses to save money and earn a return on their savings. Through banks, investment funds, and other financial institutions, savings are pooled together and made available for productive investments. 3. Facilitation of investments Financial systems enable individuals, businesses, and governments to access the capital needed for investment in productive activities. They provide various investment options such as stocks, bonds, and venture capital, allowing entities to raise funds to expand operations, launch new projects, or develop infrastructure. 4. Risk management Financial systems offer a range of risk management tools and instruments, such as insurance, derivatives, and hedging strategies. These mechanisms help individuals and businesses mitigate risks associated with fluctuations in interest rates, exchange rates, commodity prices, and other market uncertainties. 5. Price discovery Financial markets provide a platform for trading financial instruments, allowing buyers and sellers to determine fair prices based on supply and demand dynamics. This price discovery process ensures transparency and efficiency in the valuation of assets and facilitates the efficient allocation of resources. 6. Facilitation of payments Financial systems enable the smooth and secure transfer of funds between individuals, businesses, and institutions. They provide payment systems, such as electronic funds transfer, credit cards, and digital wallets, which facilitate the settlement of transactions and support economic activities. 7. Capital Formation Financial systems play a crucial role in capital accumulation within an economy. By mobilizing savings, facilitating investments, and promoting efficient allocation of capital, they contribute to capital stock growth, which is essential for long-term economic development. 8.Monetary policy implementation Central banks implement monetary policy as part of the financial system by controlling the economy’s money supply, interest rates, and liquidity. They regulate and stabilize the financial system, ensuring price stability and fostering macroeconomic stability. 9. Financial inclusion Financial systems aim to promote financial inclusion by providing access to financial services for individuals and businesses, including those in underserved or marginalized communities. This fosters economic participation, poverty reduction, and social development. 10. Safeguarding financial stability The financial system maintains stability and mitigates systemic risks. Regulatory authorities monitor and supervise financial institutions, set prudential standards, and establish risk management frameworks to safeguard the system’s stability and protect consumers. WEAKNESS OF INDIAN FINANCIAL SYSTEM: 1.Lack of Coordination between different Financial Institutions(FIs): There are a large number of FIs. Most of the vital FIs are owned by the government. At the same time, the government is also the controlling authority of these institutions. In these circumstances, the problem of coordination arises. As there is a multiplicity of institutions in the Indian financial system, there is a lack of coordination in the working of these institutions. 2. Monopolistic Market Structures: In India, some FIs are so large that they have created a monopolistic market structure of the financial system. For instance, almost the entire life insurance business is in the hands of LIC of India. So large structures could delay the development of the financial system of the country itself 3.Dominance of Development Banks in Industrial Financing: The development banks constitute the backbone of the Indian financial system occupying an important place in the capital market. Industrial financing today in India is largely through the FI created by the government, both at the national and regional levels. As such, they fail to mobilize the savings of the public. However, in recent times attempts have been made to raise funds from the public through the issue of bonds, units, debentures, and so on 4. Imprudent Financial Practices: The dominance of development banks has developed imprudent financial practices among corporate customers. The development banks provide most of the funds in the form of term loans. So the predominance of debt capital has made the capital structure of the borrowing concerns uneven and lopsided. However, in recent times, all efforts have been made to activate the capital market Impact of Liberalization on Financial Institutions and Markets: Liberalisation is the process or means of the elimination of control of the state over economic activities. It provides a greater autonomy to the business enterprises in decision-making and eliminates government interference. Liberalisation in India Since the adoption of the New Economic Strategy in 1991, there has been a drastic change in the Indian economy. With the arrival of liberalisation, the government has regulated the private sector organisations to conduct business transactions with fewer restrictions. For the developing countries, liberalisation has opened economic borders to foreign companies and investments. Earlier, the investors had to encounter difficulties to enter countries with many barriers. These barriers included tax laws, foreign investment restrictions, accounting regulations, and legal issues. Economic liberalisation reduced all these obstacles and waived a few restrictions over the control of the economy to the private sector. Objectives: To boost competition between domestic businesses. To promote foreign trade and regulate imports and exports. To improve the technology and foreign capital. To develop a global market of a country. To reduce the debt burden of a country. To unlock the economic potential of the country by encouraging the private sector and multinational corporations to invest and expand. To encourage the private sector to take an active part in the development process. To reduce the role of the public sector in future industrial development. To introduce more competition into the economy with Impact of Liberalisation Positive Impact of Liberalisation in India Free flow of capital: Liberalisation has enhanced the flow of capital by making it affordable for the businesses to reach the capital from investors and take a profitable project. Diversity for investors: The investors will be benefitted by investing a portion of their business into a diversifying asset class. Impact on agriculture: In this area, the cropping designs have experienced a huge change, but the impact of liberalisation cannot be accurately measured. Government’s restrictions and interventions can be seen from the production to the Negative Impact of Liberalisation in India The weakening of the economy: An enormous restoration of the political power and economic power will lead to weakening the entire Indian economy. Technological impact: Fast development in technology allows many small scale industries and other businesses in India to either adjust to changes or shut their businesses. Mergers and acquisitions: Here, the small businesses merge with the big companies. Therefore, the employees of the small companies may need to enhance their skills and become technologically advanced. This enhancing of skills and the time it