Indian Financial System – Component and Structure

The Indian Financial System is one of the most significant aspects of the economic growth of our country. This system controls the flow of funds between the people (household savings) of the country and the ones who may invest it wisely (investors/businessmen) for the progress of both parties.

Indian Financial System

Indian Financial System – An Overview

The financial system is composed of the products and services given by financial institutions, that comprise banks, pension funds, organized exchanges, insurance companies, and many other companies that work to facilitate economic transactions. Practically, all economic transactions are affected by one or more of these financial institutions. They build financial instruments, such as stocks and bonds, pay interest on deposits, lend money to creditworthy borrowers, and form and manage the payment systems of modern economies.

Features of the Indian Financial System

  •     It performs a vital function in the economic growth of the country as it helps both savings and investment.
  •     It assists in mobilizing and allocating one’s savings.
  •     It promotes the development of financial institutions and markets.
  •     Performs an important role in capital formation.
  •     It helps links the investor and the one saving.
  •     It is also involved with the Provision of funds.
  •     The financial system meets the requirements of funds for business sectors.
  •     It makes economic growth by allocating the money to those who can properly utilize it.
  •     It commences to capital formation.
  •     Allows investment by business sectors.
  •     It assists saving and hence takes back money into circulation.

Financial Products and Services are Based on the Basic Purposes of any Modern Financial System

  • To give a payment system.
  • To provide time value to money.
  • To give products and services to lower financial risk or to compensate for risk-taking for desirable targets.
  • To assemble and disperse information that enables the most productive allocation of economic resources.
  • To form and control financial markets that provide prices, that shows how well investments are operating, defines the subsequent allocation of resources, and to support economic stability in the markets.

Objectives of Financial System

The main objectives of financial system are:

  1. Raises Fund: Financial services work as an effective tool for increasing funds in an economy.  It gives numerous financial instruments to individuals, investors, corporations, and institutions where they can invest their money thereby raising funds from them.
  2. Encourages Savings: These services give different types of convenient investment opportunities that can grow people’s savings. A mutual fund is one such good alternative where people can invest and earn reasonable returns without much risk.
  3. Deployment of Funds: Financial services allow the proper deployment of financial resources into fruitful means. There are various investment avenues and instruments available in the financial market where people can invest their funds for earning income.
  4. Reduces Risk: Risk minimization is an important role played by financial services. These services assist in increasing the risk and protect people against damages by providing insurance policies.
  5. Economic Growth: Financial services help the government in achieving the overall extension of the economy. The government can easily grow both short-term and long term funds for its many needs. It aids in increasing overall infrastructural facilities and employment opportunities in a country.

Significance of Financial System

  • The Financial System helps the economy to grow.
  • The Financial System brings investment.
  • The Financial System forms a bridge between investors and companies.
  • Financial system aids in fiscal regulation and control of the economy.
  • The Financial System brings accountability for investors.

Limitations of the Indian Financial System

Below are the limitations of the Indian Financial System:

  1. Indian Financial system holds a monopoly in their industry.
  2. India’s Financial system has an inactive capital market.
  3. India’s Financial system has a lack of coordination with Financial Institutions.
  4. India’s Financial system has a Dominance of Development Banks in Industrial Financing.
  5. Indian households are not aware of the investment.
  6. Characteristics of the Indian Financial System
  7. To the growth of the economy, the Financial system helps to grow the economy of the country. it improves the lifestyle and standard of living of the host country.
  8. To bring investment, When the financial institutions work properly, it brings investment to the host country. Because it gives trust to the investors to invest in the country.
  9. To encourage savings, When people started earning, they started saving and investing.
  10. To Allocation of Funds, When the saving and investments start in the economy. it gives opportunities to banks to allocate the funds properly.

Structure of Indian Financial System and Components of Indian Financial System

There are five main components of the Indian Financial System. This includes:

  1. Financial Institutions
  2. Financial Regulators
  3. Financial Markets
  4. Financial Instruments
  5. Financial Services

Financial Institutions

The Financial Institutions act as a mediator between the borrower and the investor. The investor’s savings are mobilized either directly or indirectly through the Financial Markets.

The main functions of the Financial Institutions are mentioned below:

  • A short-term liability can be transformed into a long-term investment
  • It aids in the conversion of a risky investment into a risk-free investment
  • Also serves as a medium of service denomination, which means, it can meet a small deposit with large loans and a large deposit which small loans
  • One of the best examples of a Financial Institution is the Bank. People with excess amounts of money make savings in their accounts, and people in dire need of money take loans.

The Financial Institutions Divided into Two Types

Banking Institutions or Depository Institutions – This comprises banks and other credit unions that collect money from the public against interest given on the deposits made and lend that money to the ones in need.

Non-Banking Institutions or Non-Depository Institutions – Insurance, mutual funds, and brokerage companies come under this category. They cannot demand financial deposits but sell financial products to their customers.

Moreover, Financial Institutions can be divided into three categories:

  • Regulatory – Institutes that regulate the fiscal markets like RBI, SEBI, IRDA, etc.
  • Intermediates – Commercial banks that give loans and other financial aid such as SBI,  PNB, BOB, etc.
  • Non-Intermediates – Institutions that provide financial support to corporate customers. It comprises NABARD, SIBDI, etc.

Financial Regulators

Financial Regulators belong to the government bodies which are liable for regulating, inspecting, controlling the functions of several financial institutions like banks, insurance companies, business entities, Non-banking financial companies (NBFCs), etc.

Financial Regulators are the apex bodies of financial institutions of respective sectors that register and function under these financial regulatory institutions.

Some examples of financial regulators in India are mentioned below.

  • RBI (Reserve Bank of India)
  • IRDA (Insurance Regulatory and Development Authority)
  • SEBI (Securities Exchange Board of India)
  • PFRDA (Pension Fund Regulatory and Development Authority)
  • FMC ( Forward Market Commission)

Financial Markets

The marketplace where buyers and sellers communicate with each other and engage in the trading of money, bonds, shares, and other assets is called a financial market.

The Financial Market can be Divided into Four Types

1. Capital Market – Designed to finance long-term investment, the Capital market deals with transactions that are taking place in the market for over a year. The capital market can be divided into three types:

  • Corporate Securities Market
  • Government Securities Market
  • Long Term Loan Market

2. Money Market – Mostly controlled by the Government, Banks, and other Large Institutions, the type of market is approved for small-term investments only. It is a wholesale debt market that works on low-risk and highly liquid instruments. The money market can be divided into two types:

  • Organized Money Market
  • Unorganized Money Market

3. Foreign exchange Market – One of the most developed markets across the world, the Foreign exchange market, deals with the provisions associated with multi-currency. The transfer of funds in the market is held based on the foreign currency rate.

4. Credit Market – A market where short-term and long-term loans are granted to individuals or Organizations by various banks and Financial & Non-Financial Institutions is called the Credit Market.

Financial Instruments

A financial instrument refers to a monetary document/ contract between two parties that are traded in the financial markets (Money market, capital market, or derivative market). It describes an asset of one party and at the same time, the liability of another party.

The Financial Instruments can be Classified as follows:

Money Market Instruments:

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The money market instrument in the short term debt financing instrument to enhance nice liquidity of businesses typically traded over the counter.

  • Certificate of Deposit: It is the dematerialized form of funds lent to the corporation fora stipulated time period against interest earned. The working procedures are the same as fixed deposits (FDs) given any special negotiation.
  • Commercial Papers: It is unsecured short term debt instruments usually having a maturity period (7days to year) typically issued by large-cap fundraising companies.
  • Treasury Bills: It is also a short-term debt instrument issued by the central government of India only having a maturity period of up to a year.
  • Repurchase Agreement (Repo): The commercial banks and other financial institutions borrow funds from the Reserve Bank of India for a shorter time through Repurchase Agreement by selling government-approved securities with a guarantee to repurchase in a future date.
  • Call Money: Whenever a loan is given for one day and has to be repaid the next day, it is known as call money.
  • Commercial Bills: The commercial Bills are also traded in the money market and utilized to raise funds against receivables (Due payments). Such the practice of raising funds at a discount is called bill/ invoice discounting.
  • Bankers Acceptance: It is another money market instrument that is widely used in the financial market. A banker’s acceptance refers to the extension of a loan to the stipulated banks against a signed guarantee of repayment in the future.

Capital Market Instruments:

The capital market instrument refers to the long term capital financing instrument (debt and equity) traded on the recognized stock exchanges. The corporations arise such financial instruments to promote long term funds from the general public.

  • Equity Shares
  • Preference Shares
  • Debentures
  • Corporate Bonds

Derivative Instruments:

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The derivatives are those financial instruments that don’t have their own value. Instead, its value is derived from underlying assets. It is utilized to hedge the risk associated with price fluctuations of the securities.

  • Forward
  • Futures
  • Options
  • Swaps
  • Exchange-traded Funds

Financial Services

The financial services are provided by Asset management and Liability Management Companies. These companies help to get the required funds and also make sure that they are efficiently invested.

The four categories of financial services that are offered in India.

a. General Banking Services: The services offered by the commercial banks or other banking institutions like a deposit of money, granting loans/ advances, Bill discounting, credit/ debit card, account opening, etc.

b. Insurance Services: Under these kinds of services various insurance policies like life insurance, health insurance, car insurance, etc. comes under it.

c. Investment Services: The different financial institutions such as stockbrokers, merchant and investment bankers, primary dealers provide investment and asset management services to businesses and corporations.

  • Loan syndication
  • Underwriting of securities
  • Trading of stocks and other securities
  • Mergers and acquisitions
  • Fundraising services
  • Depository services
  • Online share trading
  • Credit rating services

d. Foreign Exchange Services: These are the specific services that deal in exchange for foreign currencies.

Functions of Financial System

The main functions of financial system are:

Approves payment system:  Financial services play an important role in the proper movement of funds among peoples. As it enables people to successfully make their payments without any hassle. Thus, financial instruments which facilitate financial transactions are Credit cards, debit cards, bill of exchange, and cheque.

Proper Utilization of Funds: Financial services help the inefficient allocation of funds. These serve as a means through which peoples invest their ideal lying resources into better investment plans for generating incomes.

Maintains Liquidity: Sufficient funds in the economy are maintained with the help of Financial Services. As it links the one who needs funds to those who can supply funds because of sufficient savings. Many services like loans and credit cards enable people to procure needed funds easily.

Raises Standard of living: These services play a vital role in improving the living standards of people. On hire purchase system availing these services, Customers are easily ready to purchase costly goods. People can have the benefits of quality and luxury items.

Promotes trade:  Both domestic and foreign trade in a country is promoted by financial services. Forfaiting and factoring companies in the financial market promote the export of goods to foreign markets and further the sales of products in the domestic market. In addition to this insurance and banking offices also support trade activities in-country.

Improve Employment Opportunities: The formation of employment opportunities is another important function of financial services. Many financial institutions employ a large number of people for selling these services. They pay commissions to their employees out of the profit earned by selling these financial services.

Balanced Regional Development: Financial services help in the balanced regional development of the country. All the essential sectors of the economy such as the primary sector, secondary sector, and tertiary sector can procure the required funds through these services. This results in regional inequalities and brings balanced development in a country.

Advantages of Financial System

Below are the main advantages of financial system are:

  • Provides Payment System: The financial system gives a payment mechanism for the smooth flow of funds between peoples in an economy. Buyers and sellers of goods or services can perform transactions with each other due to the presence of a financial system.
  • Links Savers and Investors: The financial system works as a means of bridging the gap between savings and investment. It takes money from those with whom it is lying idle and transfers it to those who want it for investing in productive ventures.
  • Reduces Risk: It aims at reducing the risk by increasing it among a large number of individuals. The financial system issues funds among a large number of peoples due to which risk is given by many peoples.
  • Helps in Capital Formation: The financial system has an efficient role in the capital formation of the country. It allows big corporations and industries to get the needed funds for performing or expanding their operations thereby leading to capital formation in the nation.
  • Raises Standard of Living: It increases the standard of living of peoples by supporting regional and rural development of the country. The financial system encourages the development of weaker sections of society in cooperative societies and rural development banks.
  • Enhance Liquidity: Managing optimum liquidity in an economy is another important role played by the financial system. It means free movement of funds from households (savers) to corporate (investors) which assures sufficient availability of funds in the economy.
  • Promotes Economic Development: The fiscal system influences the step of economic growth or development of an economy. It aims at maximum utilization of all financial resources by investing all idle lying resources into helpful means which leads to the creation of wealth.

Disadvantages of Financial System

Check below the disadvantages of financial system are:

  • Lack of Coordination among Financial Institutions: The financial system allows a lack of coordination among numerous financial institutions. The presence of a large number of financial institutions and government roles in managing authorities of these institutions leads to a lack of coordination.
  • Monopolistic Market Structure: Many institutions in the Indian financial system hold a monopolistic state in the market. LIC and UTI are two institutions that have taken a large part of the life insurance business and the mutual fund industry. These large structures could commence to mismanagement or inefficiency of funds.
  • High Rate of Interest: There is a possibility of the high-interest rate required by several financial institutions in the fiscal system of our country. Many institutions due to their monopolistic structure in the market may charge high or unreasonable interest rates. 
  • Inactive Capital Market: Our country’s fiscal system meets the problem of the inactive capital market. All corporations in India are mostly able to acquire funds through development banks and do not need to go to the capital market.
  • Imprudent Financial Practice: The financial system of India has grown imprudent financial systems due to the dominance of development banks. Development banks provide funds to corporations in the form of term loans which makes the capital structure of borrowed concerns uneven. These banks even allow the use of unfair debts which is against the capital structure.

Conclusion

 Hence for the mutual benefit of Lenders and Borrowers, finance provides a platform to interact with each other. Therefore, through this interaction, the ultimate profits come in the form of capital accumulation (which is very essential for developing countries like India, which faces the obstacle of capital crisis) and economic growth of the country.

Frequently Asked Questions

Q1. What is the financial system?
Ans. Financial institutions, financial markets, financial securities, and services are the composition of the financial system. It facilitates a country’s flow of funds from surplus to deficit so that the available funds can be better utilized for economic growth.

Q2. What are the functions of the Indian financial system?
Ans. The basic functions of the Indian financial system are accumulation and economic growth by:

  • Promotes Savings
  • Mobilization of Savings
  • Allocation of funds to those requiring

Q3. What are the types of financial systems?
Ans. The financial system can be divided into two parts.

Informal: Moneylenders, local bankers, landlords & traders come under informal types.
Formal: Public and Private Sector Banks or other financial institutions are part of formal types.

Q4. What are the objectives of the financial system?
Ans. The main objective of the financial system is to assure the safety of investment, promote the capital accumulation and economic growth of the country as it fills the gap between lenders and borrowers.

Q5. What are the major components of the financial system?
Ans. The five significant components of the financial system are:

  • Financial Institutions
  • Financial Regulators
  • Financial Markets
  • Financial Instruments
  • Financial Services
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