ISSN: 2321-7782 (Online)

e-ISJN: A4372-3114
Impact Factor: 6.047
Volume 5, Issue 2, February 2017
International Journal of Advance Research in
Computer Science and Management Studies
Research Article / Survey Paper / Case Study
Available online at: www.ijarcsms.com

Financial System in India: A Theoretical Aspect

Sushila Jangra
Assistant Professor of Commerce,
Fateh Chand College for Women,
Hisar, Haryana – India

Abstract: During the last decade, the Indian economy has shown a great transformation from a closed, controlled, slow
growing economy to a more open, more liberalised and also one of the fast growing economy among the developing nations.
A financial system functions as an intermediary and facilitates the flow of funds among various other units of the system. It
helps to mobilize and pool savings, promote payment services, produce and process information. In order to make financial
system more effective and efficient, the need of effective management and control among the different components of the
Financial System is required. Also there is a need for proper governance and regulation for the efficient working of the
financial system.

Keywords: India, Financial System, Financial Institutions, Capital Market, Financial Instruments.

I. INTRODUCTION

Money plays an important role in daily life and in every activity of man- individuals, businesses and the government.
Money is necessary for production & distribution and also for the country’s developmental activities and the proper
management of money are called Finance. Thus, Finance is the ‘life blood of every human activity’. According to Webster’s
New Dictionary finance is “the managing or the science of managing money matters”, and financing is “to supply or obtain
money or credit”. Hence, finance refers to funds or monetary resources needed by individuals, business houses and the
government (Gomez, 2013).

But money and finance alone cannot lead to economic development. Here, financial system plays an important role for
economic growth and development of the nation. A financial system functions as an intermediary and facilitates the flow of
funds amongst the various units of the system. The financial system of any country includes its financial markets and supporting
financial institutions. The word ‘system’ in the term “financial system” includes a set of complex and closely interrelated
financial institutions, agents, practices, markets, transactions, claims, assets and liabilities in the economy helping to facilitate
the movement of funds in order to enhance economic development.

The financial system helps to mobilize and pool savings, promote payment services, produce and process information about
investors and investment projects, to enable efficient allocation of funds, monitor investments and help to diversify, transform
and manage risk (Demirguc-kunt, 2006). The Indian economy is one of the fastest growing economies among the developing
countries in the world. It is possible due to the connected or interlined financial system in India. The Indian financial system
consists of financial institutions (like banks etc.), financial markets (like money and capital market etc.), financial instruments
(like bills, shares, debentures etc.) and financial services (like merchant banking etc.).

© 2017, IJARCSMS All Rights Reserved 79 | P a g e

Jangra et al., International Journal of Advance Research in Computer Science and Management Studies
Volume 5, Issue 2, February 2017 pg. 79-86
II. OBJECTIVE OF THE STUDY

This research study revolves on the axis of four objectives which are carefully outlined hereunder:

i) To study the Indian Financial System and its functions.

ii) To study the various constituents of Indian Financial System.

iii) To study the weaknesses of Indian Financial System.

III. RESEARCH METHODOLOGY

The study concentrates basically on the Financial System in India and the components involved in it. For this purpose the
contents related to the study are taken from the articles and books written by the different research scholars and eminent authors.

IV. REVIEW OF LITERATURE

Levine (1997) she defines the effectiveness of financial system in economic growth and also gives a functional approach
which helps to understand the relation between growth and the quality of the functions provided by the financial system.

Hanson and Kathuria (1999) in their study discussed the importance of legal, regulatory and supervisory issues in reform
and provide a brief history of India’s shifts from financial repression to financial liberalization. They have also pointed out some
interrelated challenges that India faces after these financial sector reforms.

Arora and Leach (2005) provide a study of financial service market of South Africa and point out some lessons from them
for the Indian Service Market. Although there are so many differences between the two economies, such as geographical,
population size, per capita income, political and economical etc. the banking sector of the south Africa shows a rapid increase in
the last decade with a vision to reduce the access exclusion, condition exclusion, price exclusion, marketing exclusion and self-
exclusion.

Allen, Chakrabarti and De (2007) in their study pointed out that in recent years India remains a developing country with
all its sheen and dazzling capital market performance, but still the financial system excludes about 40% of the population,
mostly the rural poor. They also highlighted the efficiency and efficacy of financial sector, privatization progress and major
changes of banking sector, valuable norms of corporate governance and the importance of microfinance as a profitable method
of poverty alleviation and development in India.

Khatua and Pradhan (2014) presented an understanding of overreaction effects, which would enable investors to prepare
trading strategies for higher returns and shows strong overreaction and reversal effect. The trading strategy could be used to
make contrarian profit from the overreaction and reversal effects. The study also concluded that overreaction is more prominent
in the case of unspecified events rather than specified events.

Sen and kar (2014) in their study examine the political and institutional causes of India’s growth acceleration and
separated the post-reform growth experience into three distinct growth episodes. They suggested the re-emergence of credible
and repeated personalised relationships between economic and political elites that are neither exclusionary nor politically
illegitimate is essential for economic growth in India.

Narasimhan and Kalra (2014) examined the impact of derivative trading on liquidity in the Indian Stock Market. The
study used the price-impact based liquidity measure. The results of the study showed a shift in the volume from cash market to
derivatives market, decline in the number of trades, increase in liquidity of stocks during the short-run and lower volatility after
the introduction of derivative trading. It was also concluded that the impact of derivative trading on long-term liquidity of the
market depends on the level of liquidity prior to the introduction of derivative trading.

© 2017, IJARCSMS All Rights Reserved ISSN: 2321-7782 (Online) Impact Factor: 6.047 e-ISJN: A4372-3114 80 | P a g e
Jangra et al., International Journal of Advance Research in Computer Science and Management Studies
Volume 5, Issue 2, February 2017 pg. 79-86
V. INDIAN FINANCIAL SYSTEM: AN INTRODUCTION

During the last decade, the Indian economy has shown a great transformation from a closed, controlled, slow economy
growing to a more open, more liberalised and also one of the fast growing economy among the developing nations. Since
economic reforms in 1991, Indian economy has accelerated growth, developed primary market, new financial instruments and a
well functioning and developing secondary market for the economic development of the country. The saving rates in India are
continually rising. The structural change in Indian economy enhance the involvement of genuine investors, Foreign Institutional
Investors (FII), Foreign Direct Investment (FDI) and Financial Intermediaries such as Public Financial Institutions, Non-
Banking Financial Companies (NBFCs), Commercial Banks, housing Banks etc.

VI. FUNCTION OF A FINANCIAL SYSTEM

The financial system of a country performs various valuable functions for the economic growth and development of the
country. The main functions of a financial system are discussed as follows:

i) Function of collection and distribution of savings: A financial system performs a vital role in capital formation. It serves a
link between saver and investor to mobilise savings and channelize them into productive activities for the transformation of
savings into investments.

ii) Function of Liquidity: The important function of a financial system is to provide the money or near money assets for the
production of goods and services. Near money assets are those assets which can be easily converted into cash.

iii) Payment and Settlement function: Payment and settlement system ensure the safely and timely movements of funds.
Generally banks perform this type of functions in a financial system.

iv) Risk Management function: An efficient financial system reduces the risk involved in mobilising savings and allocating
credit for the efficient transformation of savings into investment. It encourages the investors for optimum utilisation of funds.

v) Information Availability functions: An efficient financial system provides necessary information to the operators or
players of the market such as individuals, investors, business houses etc.

vi) Cost Reduction function: The financial system helps in creation of a financial structure that lowers the cost of borrowings
and cost of transactions.

viii) Other Functions: The financial system also performs some other functions. Such as: promote the process of capital
formation, introducing innovative financial instruments, provide necessary services related to finance, offers portfolio
adjustment facilities etc.

VII. CONSTITUENTS OF INDIAN FINANCIAL SYSTEM

A financial System of any economy consists of financial institutions, financial intermediaries, financial market, financial
instruments etc. The Indian financial system consists of financial institutions, financial markets, financial instruments and
financial services. As shown in Graph-1.

© 2017, IJARCSMS All Rights Reserved ISSN: 2321-7782 (Online) Impact Factor: 6.047 e-ISJN: A4372-3114 81 | P a g e
Jangra et al., International Journal of Advance Research in Computer Science and Management Studies
Volume 5, Issue 2, February 2017 pg. 79-86

Indian Financial System

Formal Financial System Informal Financial System

Financial Financial Financial Financial

Institutions Markets Instruments Services

The Indian Financial system can be broadly classified into two systems: one is Formal (Organized) financial system and
other is Informal (Unorganized) financial system.

A) Formal Financial System: This is also known as organized financial system because it comes under the preview of Ministry
of Finance (MOF), Reserve Bank of India (RBI), Securities Exchange Board of India (SEBI) and other regulatory bodies.
Formal financial system consists of four sub-systems. These are: (i) Financial Institutions (ii) Financial Markets (iii) Financial
Instruments and (iv) Financial Services.

I) FINANCIAL INSTITUTIONS

Finance is the prerequisite for the economic development of any country and financial institutions play a vital role in India for
meeting such requirements. Financial institutions act as a facilitator of credits and deposits of the investors and various
stakeholders. These are also known as intermediaries because the duties performed by the financial institutions are just like a
mediator which helps in collection of deposits and distributes credit to the parties. There are two categories of Financial
Institutions i.e., banking institution and non-banking financial institutions (Tiwari, 2012).

i) Banking Institutions: Banking institutions take deposits from the depositors and then distribute the interest on these deposits.
They also provide credit facilities to the individuals and institutions (Tiwari, 2012). The banking industry in India is under the
control of the Central Bank i.e. Reserve Bank of India. RBI organises, supervises, regulates and develops the monetary system
& financial system of the country. The rapid economic growth and development leads the rapid expansion of commercial banks
in India. The nationalisation of banks and the introduction of Lead Bank Schemes provide a momentum to the branch
expansion. At present (as per table 1.1), the national average of population per bank office has reduced from 64000 (1969) to
12,600 (2013).

© 2017, IJARCSMS All Rights Reserved ISSN: 2321-7782 (Online) Impact Factor: 6.047 e-ISJN: A4372-3114 82 | P a g e
Jangra et al., International Journal of Advance Research in Computer Science and Management Studies
Volume 5, Issue 2, February 2017 pg. 79-86
Table 1.1 Branch Expansions of All Commercial Banks
Year Total no. of Rural Branches Percentage of Rural Population per bank
Branches Branches office

1969 8,260 1,860 22% 63,800

1991 60,220 35,206 58.5% 14,150

2011 90,620 33,800 37.3% 13,300

2012 97,111 35,850 36.9% 12,660

2013 98,607 36,452 37% 12,670

Source: Economic Survey 2009-10, RBI Trends and Progress of Banking n India 2009-10, Handbook of Statistics on the Indian Economy 2011-12, Statistical
Table Relating to Banks in India, 2012-13.

The commercial banks in India cover 36,452 villages out of the 6 lakh villages of the county. The Indian banking institutions
can be classified into two categories: Organised and Unorganised sector. The organised banking sector consists of commercial
banks, cooperative bank, regional rural banks (RRBs) and foreign banks etc. The unorganised sector includes the indigenous
bankers, grocery shops, chit fund, landlords, money lenders etc. in India (Gupta, 2012).

ii) Non-Banking Financial Institutions: Non-banking financial institutions consist of development financial institutions which
provide loan to the industries for development and growth. They are responsible for the collection of deposits and invest in
some other forms to get returns and then distribute to the unit holders. NBFIs include LIC, IIBI, SIDBI, IFCI (All India
Financial Institutions), SFCs, SIDCs etc.

II) FINANCIAL MARKETS

A Financial Market can be defined as the situation in which financial assets or financial instruments are created or transferred
from one to another. Financial market performs some important functions for the efficient working of financial system.
Financial markets can be broadly classified into two markets. One is negotiated loan market e.g. a market in which the lender
and the borrower personally negotiate the terms of the loan agreement. The other one is open market where standardised
securities are traded in large volume (Gupta, 2012). The followings are the classification of financial markets on the basis of
different categories:

i) Classification on the basis of Nature of Claim:

a) Debt Market: A debt market is a market where debt instruments are traded. There are two methods to generate funds in a
financial market. One is to issue equities and the other is to issue debt instrument. Nowadays, the debt instruments are more
popular for fund raising. The debt instrument is a contractual agreement by the borrower to pay a fixed amount at regular basis
till the maturity date. These are classified in three categories: i) short term, ii) medium term, iii) long term. If the maturity of the
debt instrument is less than one year, it is a short term debt instrument. If its maturity is more than one year but less than ten
years, then it is a medium term debt instrument. The debt instrument with a maturity more than ten years is said to be a long
term debt instrument.

b) Equity Market: An equity market is a market where equities are bought and sold. The equity shares are also known as
ordinary or common shares. The equity shareholders are the real owner of the company. They gets dividend for their
investment. The rate of dividend varies with the profits of the company and the policies of the board of directors.

© 2017, IJARCSMS All Rights Reserved ISSN: 2321-7782 (Online) Impact Factor: 6.047 e-ISJN: A4372-3114 83 | P a g e
Jangra et al., International Journal of Advance Research in Computer Science and Management Studies
Volume 5, Issue 2, February 2017 pg. 79-86
ii) Classification on the basis of Maturity of Claim:

a) Money Market: The money market can be defined as ‘the place where the demand for and supply of short-term funds meet’.
According to Crowther “the money market is the collective name given to the different firms and institutions that deal in the
different grades of near money” (Gomez, 2013). Thus, money market is a reservoir of short term funds. It is a place where short
term funds are bought and sold via telephone or mail. Funds are borrowed in the market for a short period ranging from one day
to six month or more but less than one year. The assets which are used as credit instruments are well known as “Near Money
Assets” (Gupta et.al, 2012). Money market includes other sub-markets such as Call Money Market, Collateral Loan Market,
Acceptance Market and Bill Market.

b) Capital Market: The capital market is the place where the long-term debt or equities or capital market securities are traded.
Capital market securities, such as stocks and long-term bonds are often traded in the market. In last few years, Indian capital
market has been one of the best performing market in the world. Fuelled with strong economic growth and large inflow of
foreign institutional investors (FIIs) and also the development of the domestic mutual funds industry, the Indian Stock Market
Indices have delivered truly explosive during the last decade. Also, the two major Indian exchanges, the Bombay Stock
Exchange (BSE) and the National Stock Exchange (NSE) ranked 16 th and 17th respectively among the stock exchanges around
the world in terms of Market Capitalisation. The stock market is touching new heights year on year since 2003. The biggest
development in the Indian Capital Markets is the introduction of Derivatives. The derivatives segment becomes a crucial part of
Indian Capital Market nowadays (Allen et. al, 2007).

iii) Classification on the basis of Seasoning of Claim:

a) Primary Market: The new issue market represents the primary market where new financial instruments (such as shares,
bonds) are first time offered. The companies whether new or existing raise their capital through new issue. Primary market
directs the flow of long term funds from the willing investors to corporate enterprises. The new issue market involves
intermediaries for the efficient issue of securities. The primary market cannot be completed without these specialised
intermediaries. These specialised intermediaries are known as merchant bankers, underwriters, brokers, agents, debenture
trustees, portfolio managers etc.

b) Secondary Market: Secondary market is a market where the previously issued securities are traded. A well functioning
secondary market includes specialised security brokers and dealers. The investors desire liquidity for their investments as per
their requirement. Here, they want to sell the securities which they hold. The brokers perform the role of agents of investors for
the buying and selling of the securities. Thus, secondary market provides a place for the buying and selling of securities as well
as fulfils the liquidity requirements of the investors.

c) Derivatives Market: The derivatives segment in India is not so old. The introduction of derivatives makes an incomplete
market more complete and increase the investment opportunities for the traders to invest in the market. Derivatives also provide
convenience when investors desire to hedge the risk or arbitrageur wants additional liquidity for the markets (Narasimhan and
Kalra, 2014). In June 2000, NSE started its operations in derivatives contracts and introduced future contracts on the Nifty
index. The recognition of single- stock futures distinguishes the Indian Derivatives Markets with other markets and due to this
popularity, the NSE of India ranked first (1st) in the single stock future category with 68,911,754 contracts in the year 2005.
Nowadays Derivatives contracts are permitted on both the BSE and NSE (Allen et. al, 2007).

III) FINANCIAL INSTRUMENTS:

The third important component of financial system is financial instruments or assets. They represent claims on income (asset)
and are held for the sake of returns that are expected. Thus, financial instrument or assets represents a claim to the payment of a
sum of money in future in the form of interest or dividend. Financial instruments are different from each other in respect of their
investment features. They are classified in two categories: i) on the basis of term, ii) on the basis of type.
© 2017, IJARCSMS All Rights Reserved ISSN: 2321-7782 (Online) Impact Factor: 6.047 e-ISJN: A4372-3114 84 | P a g e
Jangra et al., International Journal of Advance Research in Computer Science and Management Studies
Volume 5, Issue 2, February 2017 pg. 79-86
i) The classification on the basis of term:

a) Short term: If the maturity of the financial instrument is less than one year, it is a short term financial instrument. b)
Medium term: If the maturity is more than one year but less than ten years, then it is a medium term financial instrument. c)
Long term: If the maturity of financial instrument is more than ten years is said to be a long term financial instrument.

ii) The classification on the basis of type:

a) Primary Securities: The securities which are directly issued by the borrower to the ultimate investor, is known as direct
securities or primary securities. It includes equity shares, preference shares, debentures etc.

b) Secondary Securities: These are also called Indirect Securities, because these are not directly traded by the borrower to the
ultimate investor. These are issued by the financial intermediaries to thee investors.

c) New Innovative Financial Instruments: A new significant change is required for the new investment strategies related with
domestic as well as foreign investors of the market. The new financial instrument has some new features in terms of
agreements, maturity, risk, return, marketability and transaction costs etc. Some new innovative financial instruments are:
American Depository Receipts, Global Depository Receipts, Zero Coupon Convertible note, Secured Premium Notes with
detachable warrants, Fully Convertible Debentures, Floating Rate Bonds, Equity Warrants, Deep Discount Bonds etc.

IV) Financial Services: Efficiency of an emerging financial system essentially depends upon the quality and variety of
financial services provided by financial intermediaries. Financial services refer to the services rendered by the finance industry.
Here, finance industry includes a broad range of organisation that deal with the management of money. These organisations
include banks, credit card companies, insurance companies, consumer finance companies and some government sponsored
enterprises of the country.

B) INFORMAL FINANCIAL SYSTEM

This is also known as unorganized financial system because it does not come under the preview of Ministry of Finance (MOF),
Reserve Bank of India (RBI), Securities Exchange Board of India (SEBI) and other regulatory bodies. An informal financial
system is an unorganised, non-institutional and non-regulated system which deals with the traditional and rural spheres of the
economy.

VIII. WEAKNESS OF INDIAN FINANCIAL SYSTEM

Today Indian financial system is more developed and integrated as compared to what it was 67 years ago. However, there are
certain weaknesses in this system. These are as follows:

i) Lack of co-ordination: Due to the large number of financial institutions, sometimes the problem of co-ordination among the
financial institutions may persist. In Indian economy there are different financial institutions and their large number leads to
difficulty in co-ordination.

ii) Lack of involvement of investors from semi-urban and rural areas: Investors from semi-urban and rural areas are less
aware and more risk averse than the other investors in Indian capital market. Also the expenses for sending the application
forms to these areas increase

iii) Institutional Monopoly: Some of the financial institutions enjoy monopolistic market structure. Some financial institutions
are large; so they enjoy a monopoly market structure. This large structure leads to inefficiency in their working or such type of
mismanagement.

© 2017, IJARCSMS All Rights Reserved ISSN: 2321-7782 (Online) Impact Factor: 6.047 e-ISJN: A4372-3114 85 | P a g e
Jangra et al., International Journal of Advance Research in Computer Science and Management Studies
Volume 5, Issue 2, February 2017 pg. 79-86
iv) Dominance of financial institutions in capital market: The dominance of financial institutions leads the unhealthy
financial practices among corporate customers. Say, when corporate enterprises face financial crisis, the financial institutions
permit a large use of debt than is warranted. This will make the condition worse.

v) Difficult to run an over-regulated financial system: Indian financial system is a combination of various institutions,
markets, service sectors etc. The banking system is also very large. Sometimes this makes irregularities in their work
performance. Even sometimes there is lack of co-ordination among the various banks in money market.

IX. CONCLUSION

Economic growth and development of a nation depends upon the efficiency of a developed financial system. There are two
different viewpoints regarding the relationship between financial development and economic growth. According to first view
point, an efficient financial system effectively mobilises the financial resources and after that invest them in the best possible
manner with the help of market mechanism which leads to economic development. According to other view point, economic
development and financial development are complimentary to each other.

At present, the Indian financial sector has been able to expand its outreach to remote and distant areas through bank
branches, ATMs, financial intermediaries and branchless banking solutions. In order to make financial system more effective
and efficient, there is a need of effective management and control among the different components of the Indian Financial
System. Also there is a need for proper governance and regulation for the efficient working of the financial system. At last , it
can be concluded that a developed financial system leads the economic growth and development of the country. Hence, there is
a positive and direct correlation between the growth in financial system and economic development.

References

1. Allen, F., Chakrabarti, R. and De, S.(2007). India’s Financial System.

2. Arora, S.S. and Leach, J. (2005). Towards Building an Inclusive Financial Sector: Lessons from South Africa. Economic and Political Weekly. Vol.40,
No. 17, pp. 1726-1730.
3. (Demirguc-kunt, A.(2006). Finance and Economic Development: Policy Choices for Developing Countries. World Bank Policy Research Working Paper
3955. WPS3955.
4. Dutt, G. and Mahajan, A. (2016). Dutt & sundram’s Indian Economy. S. Chand & Company Pvt. Ltd. 72nd Revised Edition.
5. Gupta S.K., Aggerwal N. & Gupta N.(2012). Financial Institutions and Markets. Kalyani Publishers.
6. Gomez, C. (2013). Financial Markets, Institutions and Financial Services. PHI.
7. Hanson, J.A. and Kathuria, S.(1999). India’s Financial System: The Challenges of Reform. Oxford University Press, New Delhi.
8. Khatua, S. and Pradhan, H.K. (2014). Indication of Overreaction with or without Stock Specific Public Announcements in Indian Stock market. Vikalpa.
Vol. 39, No.3. pp.35-49.
9. Levine, R.(1997). Financial Development and Economic Growth: Views and Agenda. Journal of Economic Literature. Vol. XXXV. Pp.688-726.
10. Narasimhan M.S. and Kalra, S.(2014). The Impact of Derivative Trading on the Liquidity of Stocks. Vikalpa. Vol. 39.No.3.pp.51-65.
11. Sen, K. and kar, S. (2014) Boom and Bust? A Political Economic Reading of India’s Growth Experience, 1993-2013. Economic and Political weekly. Vol.
XLIX, NO. 50, pp. 40-51.
12. Tiwari, S. (2012). Indian Financial System.

AUTHOR(S) PROFILE

Sushila Jangra, received the Bachelor degree in Commerce from Daya Nand College, Hisar,
Haryana, India and Master degree in Commerce from Government P.G. College, Hisar, Haryana,
India in 2008 and 2011, respectively. Presently she is a working as Assistant Professor in
Commerce at Fateh Chand College for Women, Hisar, Haryana, India.

© 2017, IJARCSMS All Rights Reserved ISSN: 2321-7782 (Online) Impact Factor: 6.047 e-ISJN: A4372-3114 86 | P a g e