UNIT – 1

Meaning of the Indian Financial System

The Indian Financial System (IFS) refers to a network of institutions, markets,

instruments, and services that facilitate the smooth flow of funds between lenders
(savers) and borrowers (investors). It comprises financial institutions, markets,
instruments, and regulations that ensure economic stability and development.

The financial system plays a crucial role in mobilizing savings and allocating
them efficiently for productive purposes, fostering economic growth.

Indian Financial System – An Overview

The services that are provided to a person by the various Financial
Institutions including banks, insurance companies, pensions, funds, etc.
constitute the financial system.
Given below are the features of the Indian Financial system:
• It plays a vital role in the economic development of the country as it
encourages both savings and investment
• It helps in mobilising and allocating one’s savings
• It facilitates the expansion of financial institutions and markets
• Plays a key role in capital formation
• It helps form a link between the investor and the one saving

• It is also concerned with the Provision of funds

Components of Indian Financial System
There are four main components of the Indian Financial System. This
includes:
1. Financial Institutions
2. Financial Assets

3. Financial Services
4. Financial Markets
Let’s discuss each component of the system in detail.
1. Financial Institutions
The Financial Institutions act as a mediator between the investor and the
borrower. The investor’s savings are mobilised either directly or indirectly via
the Financial Markets.
The main functions of the Financial Institutions are as follows:
• A short term liability can be converted into a long term investment
• It helps in conversion of a risky investment into a risk-free investment
• Also acts as a medium of convenience denomination, which means,
it can match a small deposit with large loans and a large deposit with
small loans
The best example of a Financial Institution is a Bank. People with surplus
amounts of money make savings in their accounts, and people in dire need
of money take loans. The bank acts as an intermediate between the two.

The financial institutions can further be divided into two types:

• Banking Institutions or Depository Institutions – This includes
banks and other credit unions which collect money from the public
against interest provided 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 fall under this
category. They cannot ask for monetary deposits but sell financial
products to their customers.
Further, Financial Institutions can be classified into three categories:
• Regulatory – Institutes that regulate the financial markets like RBI,
IRDA, SEBI, etc.
• Intermediates – Commercial banks which provide loans and other
financial assistance such as SBI, BOB, PNB, etc.
 • Non Intermediates – Institutions that provide financial aid to
corporate customers. It includes NABARD, SIBDI, etc.
2. Financial Assets

The products which are traded in the Financial Markets are called Financial
Assets. Based on the different requirements and needs of the credit seeker,
the securities in the market also differ from each other.
Some important Financial Assets have been discussed briefly below:
• Call Money – When a loan is granted for one day and is repaid on the
second day, it is called call money. No collateral securities are
required for this kind of transaction.
• Notice Money – When a loan is granted for more than a day and for
less than 14 days, it is called notice money. No collateral securities are
required for this kind of transaction.
• Term Money – When the maturity period of a deposit is beyond 14
days, it is called term money.
• Treasury Bills – Also known as T-Bills, these are Government bonds or
debt securities with maturity of less than a year. Buying a T-Bill means
lending money to the Government.
• Certificate of Deposits – It is a dematerialised form (Electronically
generated) for funds deposited in the bank for a specific period of time.

• Commercial Paper – It is an unsecured short-term debt instrument

issued by corporations.
3. Financial Services
Services provided by Asset Management and Liability Management
Companies. They help to get the required funds and also make sure that they
are efficiently invested.
The financial services in India include:
• Banking Services – Any small or big service provided by banks like
granting a loan, depositing money, issuing debit/credit cards, opening
accounts, etc.
 • Insurance Services – Services like issuing of insurance, selling
policies, insurance undertaking and brokerages, etc. are all a part of
the Insurance services

• Investment Services – It mostly includes asset management

• Foreign Exchange Services – Exchange of currency, foreign
exchange, etc. are a part of the Foreign exchange services
The main aim of the financial services is to assist a person with selling,
borrowing or purchasing securities, allowing payments and settlements and
lending and investing.

4. Financial Markets
The marketplace where buyers and sellers interact with each other and
participate in the trading of money, bonds, shares and other assets is called
a financial market.
The financial market can be further divided into four types:

• Capital Market – Designed to finance the long term investment, the

Capital market deals with transactions which are taking place in the
market for over a year. The capital market can further be divided into
three types:
(a)Corporate Securities Market
(b)Government Securities Market

(c)Long Term Loan Market

• Money Market – Mostly dominated by Government, Banks and other
Large Institutions, the type of market is authorised for small-term
investments only. It is a wholesale debt market which works on low-
risk and highly liquid instruments. The money market can further be
divided into two types:
(a) Organised Money Market
(b) Unorganised Money Market
• Foreign exchange Market – One of the most developed markets
across the world, the Foreign exchange market, deals with the
requirements related to multi-currency. The transfer of funds in this
market takes place based on the foreign currency rate.
• Credit Market – A market where short-term and long-term loans are
granted to individuals or Organisations by various banks and Financial
and Non-Financial Institutions is called Credit Market

Objectives of the Indian Financial System

The primary objectives of the Indian Financial System include:
1. Mobilization of Savings – Encouraging individuals and businesses to
save and invest.
2. Efficient Allocation of Capital – Directing funds towards productive
investments for economic development.
3. Financial Stability – Maintaining economic equilibrium by regulating
money flow and preventing financial crises.

4. Development of Financial Institutions – Strengthening banking,

insurance, and investment institutions.
5. Encouragement of Entrepreneurship – Providing financial
assistance to new businesses and startups.
6. Liquidity Management – Ensuring smooth monetary transactions and
availability of credit.

7. Facilitating Economic Growth – Supporting industrialization,

infrastructure development, and employment generation.
8. Consumer Protection – Safeguarding investors and depositors
against fraud and financial misconduct.
9. Global Integration – Strengthening ties with international financial
systems to attract foreign investments.
 Importance of the Indian Financial System
The Indian Financial System is vital for economic growth and
stability. Its significance can be understood as follows:
1. Economic Growth and Development

• Mobilizes savings and directs them toward productive investments.

• Provides credit to industries, agriculture, and infrastructure projects.
2. Facilitates Capital Formation
• Encourages investments in businesses, increasing employment and
income.

• Promotes entrepreneurship by providing venture capital and loans.

3. Ensures Financial Stability
• Regulates money supply and credit flow through monetary policies.
• Prevents financial fraud and crises through regulatory oversight.
4. Supports Government Policies
• Helps in the implementation of fiscal and monetary policies.

• Funds government projects through bonds and securities.

5. Encourages Foreign Investment
• Attracts Foreign Direct Investment (FDI) and Foreign Institutional
Investment (FII).
• Strengthens India's position in the global economy.

6. Ensures Efficient Payment System

• Facilitates smooth transactions through banking, digital payments,
and stock exchanges.
• Reduces reliance on cash and promotes financial inclusion.
7. Protects Investors and Consumers

• Ensures transparent financial dealings through regulatory bodies.

• Provides legal frameworks for dispute resolution in financial
transactions.

Functions of the Indian Financial System

The financial system performs several crucial functions, including:
A. Mobilization of Savings
• Encourages individuals and institutions to save.
• Converts savings into productive investments.

B. Facilitating Capital Formation

• Helps in raising capital for businesses and infrastructure projects.
• Channels funds from surplus sectors (savers) to deficit sectors
(borrowers).
C. Providing Credit and Liquidity
• Banks and financial institutions offer loans for personal, industrial,
and agricultural needs.
• Ensures liquidity for short-term and long-term financial requirements.
D. Risk Management and Insurance
• Financial institutions provide insurance services to mitigate risks.
• Hedging and derivatives help in minimizing financial risks.

E. Regulating Financial Markets

• SEBI regulates the stock market to ensure transparency and investor
protection.
• RBI controls monetary policy to manage inflation and interest rates.
F. Facilitating Payments and Settlements

• Provides a robust banking infrastructure for smooth transactions.

 • Digital payments, NEFT, RTGS, UPI, and mobile banking promote
cashless transactions.
G. Foreign Exchange Management

• Manages exchange rates and foreign currency reserves.

• Facilitates international trade and foreign investments.

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1. Financial Institutions
These are intermediaries that provide services like savings, credit, and
investments. They are classified into:
• Banking Institutions: Include public sector banks, private sector
banks, cooperative banks, and regional rural banks.
• Non-Banking Financial Companies (NBFCs): Offer credit, leasing,
and investment services but cannot accept demand deposits.

• Development Financial Institutions (DFIs): Provide long-term

finance for infrastructure and industrial growth (e.g., NABARD, SIDBI).
2. Financial Markets
Markets that facilitate the exchange of financial assets:
• Money Market: Deals with short-term instruments like Treasury bills,
commercial papers, and certificates of deposit.
• Capital Market: Deals with long-term instruments like stocks and
bonds. It is divided into:
o Primary Market: For new securities issuance.
o Secondary Market: For trading existing securities, e.g., through
stock exchanges like NSE and BSE.

3. Financial Instruments
Include various products that help channelize funds:
 • Equity Instruments: Shares.
• Debt Instruments: Bonds, debentures.
• Hybrid Instruments: Convertible debentures.

• Derivative Instruments: Futures, options.

4. Financial Services
Supportive activities provided by institutions and markets, such as:
• Asset management
• Insurance
• Payment systems

• Wealth management
5. Regulatory Framework
Governed by key regulatory bodies to ensure stability and transparency:
• Reserve Bank of India (RBI): Central bank regulating monetary policy
and banking.

• Securities and Exchange Board of India (SEBI): Regulates capital

markets.
• Insurance Regulatory and Development Authority of India (IRDAI):
Regulates insurance.
• Pension Fund Regulatory and Development Authority (PFRDA):
Regulates pensions.
6. Government Role
The government supports the financial system through:
• Formulating fiscal policies.
• Introducing reforms for better efficiency.
• Offering subsidies, grants, and social schemes for inclusive growth.
Financial Intermediaries in India
Financial intermediaries act as a bridge between savers and borrowers,
facilitating financial transactions. They include:
A. Banks and NBFCs

• Accept deposits and provide loans.

• Facilitate fund transfers and payment processing.
B. Stock Exchanges
• Provide platforms for trading securities (BSE, NSE).
C. Investment Companies

• Manage portfolios and mutual funds.

• Example: UTI, SBI Mutual Fund.
D. Insurance Companies
• Provide life, health, and general insurance services.
E. Pension Funds
• Manage retirement savings and pension schemes.

F. Venture Capital and Private Equity Firms

• Provide funding to startups and businesses.

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The evolution of the financial system in India reflects its journey from a
colonial economy to a modern, liberalized market structure. It can be traced
through the following key phases:

The evolution of the financial system in India reflects its journey from a colonial
economy to a modern, liberalized market structure. It can be traced through the
following key phases:
1. Pre-Independence Period (Before 1947)

• Colonial Financial Institutions: The financial system primarily served the

interests of the British Empire, with limited focus on indigenous
development.
• Introduction of Banks:
o The first bank in India, Bank of Hindustan, was established in 1770.
o The Presidency Banks (Bank of Bengal, Bank of Bombay, and Bank
of Madras) were set up in the early 19th century.
o In 1921, these merged to form the Imperial Bank of India (later
transformed into the State Bank of India in 1955).
• Limited Capital Markets: The Bombay Stock Exchange (BSE),
established in 1875, was one of the few institutions catering to trading in
stocks and bonds.
• Non-Banking Activities: Indigenous bankers, moneylenders, and
unorganized finance were prevalent, especially in rural areas.

2. Post-Independence Period (1947–1969)

• State Dominance: The government focused on establishing institutions to

support planned economic development.
• Nationalization and Reorganization:
o The Reserve Bank of India (RBI), established in 1935, became the
central bank of independent India.
o In 1955, the Imperial Bank was nationalized to form the State Bank
of India (SBI).
• Development of Financial Institutions:
o Establishment of Industrial Finance Corporation of India (IFCI) in
1948.
o Creation of development banks like IDBI, NABARD, and LIC to
cater to industrial, agricultural, and insurance needs.
• Capital Market Growth: Early reforms included regulations to develop
the equity and bond markets.

3. Nationalization and Growth Phase (1969–1991)

• Bank Nationalization:
o In 1969, 14 major banks were nationalized, followed by 6 more in
1980.
 o This aimed to increase financial inclusion and mobilize rural
savings.
• Expansion of Banking Services:
o Focus on rural and cooperative banks to promote agricultural
finance.
o Establishment of Regional Rural Banks (RRBs) in 1975.
• Capital Market Development:
o Formation of regulatory bodies like the Securities and Exchange
Board of India (SEBI) in 1988 (formalized in 1992).
• Focus on Priority Sectors: Directed credit policies were introduced to
support agriculture, small-scale industries, and exports.

4. Liberalization and Globalization Era (1991–2000)

• Economic Reforms: The financial sector underwent significant reforms as

part of broader liberalization policies.
• Banking Sector Reforms:
o Introduction of private sector banks and foreign banks.
o Reduction of state ownership in public sector banks.
o Emphasis on Non-Performing Assets (NPAs) management.
• Capital Market Reforms:
o Establishment of the National Stock Exchange (NSE) in 1994.
o Introduction of electronic trading systems.
o Strengthening SEBI’s role as a regulator.
• Foreign Investment: Liberalization of Foreign Direct Investment (FDI)
and portfolio investments.
• Development of NBFCs: Non-Banking Financial Companies gained
prominence.

5. Contemporary Period (2000–Present)

• Technological Advancements:
o Adoption of core banking solutions (CBS) for improved customer
service.
o Introduction of digital payment platforms like UPI, Paytm, and
BHIM.
o E-governance initiatives in financial services.
• Financial Inclusion:
o Launch of schemes like Jan Dhan Yojana and PM Kisan for greater
access to banking and financial services.
 • Regulatory Innovations:
o Insolvency and Bankruptcy Code (IBC) for efficient resolution of
distressed assets.
o Basel III norms for banking stability.
• Focus on FinTech:
o Emergence of startups offering AI-driven financial services,
blockchain-based payments, and peer-to-peer lending.
• Green Finance: Increased focus on sustainable finance and green bonds.

6. Challenges and Opportunities Ahead

The financial system is adapting to address:

• Digital transformation and cybersecurity risks.

• Expanding financial literacy.
• Strengthening infrastructure for economic growth and sustainability.
Recommendations of the Narasimham Committee (1991 &
1998)
Narasimham Committee I (1991) – Banking Sector
Reforms
The committee focused on enhancing efficiency and strengthening the banking system in
India. Key recommendations included:

1. Reduction in Statutory Requirements: Reduce Cash Reserve Ratio (CRR) and

Statutory Liquidity Ratio (SLR) to ensure more funds for lending.
2. Interest Rate Deregulation: Allow banks to determine their own interest rates to
promote competition.
3. Capital Adequacy Norms: Introduce Basel norms to improve the financial health of
banks & Recommended a Capital Adequacy Ratio (CAR) of 8%.
4. Reclassification of Banks: Classify banks into three tiers:
▪ International banks
▪ National banks
▪ Regional rural banks (RRBs)

5. Autonomy for Public Sector Banks

• Grant operational freedom and reduce government interference.
• Improve performance by professionalizing management.
6. NPAs Management: Introduce stricter measures to reduce Non-Performing Assets
(NPAs).
7. Entry of Private and Foreign Banks: Allow entry of new private sector banks and
expand the role of foreign banks.

Narasimham Committee II (1998) – Banking Sector Consolidation

The focus shifted to structural reforms and further strengthening of the financial system.

1. Strengthening Capital Adequacy: Recommended raising the Capital Adequacy Ratio

(CAR) to 10%.
2. Asset Classification and NPAs Management: Tighten norms for asset classification to
reflect true financial conditions. & Recommended setting up Asset Reconstruction
Companies (ARCs).
3. Merger of Banks: Promote mergers between strong banks to create globally competitive
entities.
 4. Focus on Technological Upgradation: Encourage banks to adopt Core Banking
Solutions (CBS) and improve digital infrastructure.
5. Reduction of Government Stake: Lower the government shareholding in public sector
banks to 33% or less.
6. Risk Management Practices: Strengthen internal controls and risk management
mechanisms.
7. Autonomy for Public Sector Banks: Greater operational autonomy to improve
efficiency and decision-making.
8. Supervision by RBI: Strengthen the role of the Reserve Bank of India (RBI) as a
regulatory authority.

These recommendations played a pivotal role in transforming the Indian banking system,
increasing its efficiency, competitiveness, and alignment with global best practices.