Indian Financial System

Indian Financial System is a system in which People, Financial Institutions, Banks, Industrial Companies and the Government demand for fund and the same is supplied to them. There are two parts of Indian Financial System—first demand side and second supply side. The representative of demand side can be Individual investor, Industrial and Business Companies, Government etc. and the representative of supply side will be Banks, Insurance Companies, Mutual Fund and other Financial Institutions.

Indian Financial System

The Indian financial system, which refers to the borrowing and lending of funds or to the demand for and supply of funds, consists of two parts, viz., the Indian money market and the Indian capital market.

The Indian money market is the market in which short-term funds are borrowed and lent. The capital market in India, on the other hand, is the market for medium-term and long-term funds.

Usually, we classify the Indian money market into organised sector and the unorganised sector. The unorganised sector consists of indigenous bankers including the non-banking financial companies (NBFCs). Besides, these two, there are many sub-markets in the Indian money market.

The organised banking system in India can be broadly divided into three categories, viz., the central bank of the country known as the Reserve Bank of India, the commercial banks and the co-operative banks which includes private sector and public sector banks and also foreign banks.

The highest financial institution in organized sector is Reserve Bank of India and in addition to this Banks of Public Sector, Banks of Private Sector, Foreign Banks and other financial institutions is also part of organized sector.

The Reserve Bank of India

The RBI was established under the Reserve Bank of India Act, 1934 on 1st April, 1935 with a capital of Rs. 5 crore. It was nationalised on 1st January, 1949; on the recommendation of Parliamentary Committee 1948. It is the Central Bank of India. Its financial year is 1st July to 30th June.

Structure

RBI is governed by a central board (headed by a governor) appointed by the central government of India. The general superintendence and direction of the bank is entrusted to central board of directors of 20 members, the Governor and four deputy Governors, one Governmental official from the ministry of Finance, ten nominated directors by the government to give representation to important elements in the economic life of the country, and the four nominated director by the Central Government to represent the four local boards with the headquarters at Mumbai, Kolkata, Chennai and New Delhi. Local Board consists of five members each central government appointed for a term of four years. RBI has 22 regional offices across India.

Role and Function

The RBI Act 1934 was commenced on April 1, 1935. The Act, 1934 provides the statutory basis of the functioning of the bank. The bank was constituted for the need of following:

• To regulate the issues of banknotes.
• To maintain reserves with a view to securing monetary stability
• To operate the credit and currency system of the country to its advantage.

Functions of RBI as a central bank of India are explained briefly as follows:

Bank of Issue – The RBI formulates, implements, and monitors the monitory policy. Its main objective is maintaining price stability and ensuring adequate flow of credit to productive sector.

Regulator-Supervisor of the financial system – RBI prescribes broad parameters of banking operations within which the country’s banking and financial system functions. Their main objective is to maintain public confidence in the system, protect depositor’s interest and provide cost effective banking services to the public.

Manager of exchange control – The manager of exchange control department manages the foreign exchange, according to the foreign exchange management act, 1999. The manager’s main objective is to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.

Issuer of currency – A person who works as an issuer, issues and exchanges or destroys the currency and coins that are not fit for circulation. His main objective is to give the public adequate quantity of supplies of currency notes and coins and in good quality. The Finance Ministry issues Currency Notes and Coins of rupee one, all other Currency Notes are issued by the Reserve Bank of India.

Developmental role – The RBI performs the wide range of promotional functions to support national objectives such as contests, coupons maintaining good public relations and many more.

Related functions – There are also some of the related functions to the above mentioned main functions. They are such as; banker to the government, banker to banks etc….

Banker to government performs merchant banking function for the central and the state governments; also acts as their banker.

Banker to banks maintains banking accounts to all scheduled banks.

Controller of Credit – RBI performs the following tasks:

• It holds the cash reserves of all the scheduled banks.
• It controls the credit operations of banks through quantitative and qualitative controls.
• It controls the banking system through the system of licensing, inspection and calling for information.
• It acts as the lender of the last resort by providing rediscount facilities to scheduled banks.

Supervisory Functions – In addition to its traditional central banking functions, the Reserve Bank performs certain non-monetary functions of the nature of supervision of banks and promotion of sound banking in India. The Reserve Bank Act 1934 and the banking regulation act 1949 have given the RBI wide powers of supervision and control over commercial and co-operative banks, relating to licensing and establishments, branch expansion, liquidity of their assets, management and methods of working, amalgamation, reconstruction and liquidation.

Promotional Functions – With economic growth assuming a new urgency since independence, the range of the Reserve Bank’s functions has steadily widened. The bank now performs a variety of developmental and promotional functions, which, at one time, were regarded as outside the normal scope of central banking. The Reserve bank was asked to promote banking habit, extend banking facilities to rural and semi-urban areas, and establish and promote new specialized financing agencies.

Monetary Policy – Monetary policy is govern by RBI to control the amount of liquidity and avability of credit in economy through following instrument

Cash Reserve Ratio – CRR is the amount of funds that the banks have to keep with the RBI. If the central bank decides to increase the CRR, the available amount with the banks comes down. The RBI uses the CRR to drain out excessive money from the system. Commercial banks are required to maintain with the RBI an average cash balance, the amount of which shall not be less than 3% of the total of the Net Demand and Time Liabilities (NDTL), on a fortnightly basis and the RBI is empowered to increase the rate of CRR to such higher rate not exceeding 20% of the NDTL.

Repo Rate – The rate at which the RBI lends money to commercial banks is called repo rate. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the RBI.

A reduction in the repo rate helps banks get money at a cheaper rate and vice versa. The repo rate in India is similar to the discount rate in the US.

Reverse Repo Rate – It is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money are in safe hands with a good interest.

An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system.

Bank Rate – Bank rate is also called as the discount rate. It is the rate of interest which a central bank charges on the loans and advances provided to commercial banks. In other word Bank rate is a rate at which RBI lends money to the Commercial banks. Bank rate serves as a basic parameter to the commercial banks to fix interest on long term loan to the individuals and corporate.

Statutory Liquidity Ratio (SLR) – Every bank is required to maintain at the close of business every day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold and unencumbered approved securities. The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR). RBI is empowered to increase this ratio up to 40%. An increase in SLR also restricts the bank’s leverage position to pump more money into the economy.

Marginal Standing Facility Rate – RBI announced that MSF scheme has become effective from 09th May, 2011. Under this scheme, Banks will be able to borrow up to 1% of their respective Net Demand and Time Liabilities. The rate of interest on the amount accessed from this facility will be 100(i.e. 1%) basis point above the repo rate. This scheme is likely to reduce volatility in the overnight rates and improve monetary transmission Overnight.

Banking in India

• The first bank of limited liability managed by Indians was Oudh Commercial Bank founded in 1881. Subsequently, Punjab National Bank was established in 1894.
• Swadeshi movement; which began in 1906, encouraged the formation of a number of commercial banks.
• The Banking Companies Act was passed in February 1949, which was subsequently amended to read as Banking Regulation Act, 1949.
• Commercial banks mobilise savings in urban areas and make them available to large and small industrial and trading units mainly for working capital requirements.
• Commercial Banking System in India consisted of 298 scheduled commercial banks (including foreign banks).
• Of the scheduled commercial banks, 224 are in public sector of which 196 are regional rural banks (RRBs) and these account for about 77.9% of the deposits of all scheduled commercial banks.
• Commercial banks are broadly classified into nationalised or public sector banks and private sector banks, with a few foreign banks. The public sector banks account for more than 92% of the entire banking business in India-occupying a dominant position in the commercial banking. The State Bank of India and its 7 associate banks along with another 20 banks are the public sector banks.
• Oudh Commercial Bank was the first complete Commercial Bank of India.
• The Imperial Bank was established in the year 1921 by merging three main Presidency Banks.
• The largest bank-Imperial Bank was nationalised in 1955 on recommendation of Gorewala Committee and rechristened as State Bank of India.
• In 1959, 7 regional banks were nationalised and given the status of Associate Banks of State Bank of India.
• On 19th July, 1969, 14 big commercial banks with deposits worth Rs. 50 crores or more and on 15th April, 1980, six other scheduled banks were nationalised, bringing total number of nationalised banks to 27 (19 + SBI + 7 SBI Associates).
• Before the merger of New Bank of India in Punjab National Bank (in 1993) the total number of nationalised banks was 28(8 SBI & Associates + 14 + 6).

Lead Bank Scheme

• After the nationalisation of 14 banks the Lead Bank Scheme of the RBI was adopted in 1969 for branch expansion programme of banks.
• Under the scheme, all the nationalised banks and private banks were allotted specific distracts where they were asked to take the lead in surveying the scope of banking development particularly expansion of credit facilities.

Banking Reforms

• On the recommendation of Narsimhan Committee, a number of steps taken to improve functioning of banking sector. SLR and CRR were reduced.
• Banks were given freedom to open new branches. Rapid computerisation of banks was undertaken.
• Banking “Ombudsmen Scheme” started functioning to expedite inexpensive resolution of customer’s complaints.

Scheduled and Non-scheduled Banks

• The scheduled banks are those which are entered in the second schedule of the RBI Act, 1934. These banks have a paid-up capital and reserves of an aggregate value of not less than Rs. 5 lakhs and satisfy the RBI that their affairs are carried out in the interest of their depositors.
• All commercial banks (Indian and foreign), regional rural banks and state co-operative banks are scheduled banks. Non scheduled banks are those which are not included in the second schedule of the RBI Act 1934. At present there is only one such bank in the country.

Regional Rural Banks

• The Regional Rural Banks (RRBs), the newest form of banks, have come into existence since middle of 1970s (sponsored by individual nationalised commercial banks) with the objective of developing rural economy by providing credit and deposit facilities for agriculture and other productive activities of all kinds in rural areas.
• The emphasis is on providing such facilities to small and marginal farmers, agricultural labourers, rural artisans and other small entrepreneurs in rural areas.

Co-operative Banks

• Co-operative banks are so called because they are organised under the provisions of the Co-operative Credit Societies law of the states. The major beneficiary of the Co-operative Banking is the agricultural sector in particular and the rural sector in general. The first such bank was established in 1904.
• The Co-operative credit institutions operating in the country are mainly of two kinds: agricultural (dominant) and non-agricultural.
• At the apex is the State Co-operative Bank (SCB) (co-operation being a state subject in India), at the intermediate (district) level are the Central Co-operative Banks (CCBs), and at the village level are Primary Agricultural Credit Societies (PACs); Long-term agricultural credit is provided by the Land Development Banks.
• Approximately 91% of total credit of banks is controlled by the banks of public sectors.
• In public sector banks, the State Bank of India group is the biggest, which controls 29% of total credit.
• First Regional Rural Bank was established on 2’ October, 1975.
• In the year 1991, Narsimhan Committee was constituted to advice on the issue of reconstruction of banking system.

Development Banks

• Industrial Development Bank of India (IDBI), established in 1964. Main functions : Providing finance to large and medium scale industrial units.
• Industrial Finance Corporation of India (IFCI), established in 1948. Main functions : (a) Project finance (b) Promotional services.
• Industrial Credit and Investment Corporation of India Limited (ICICI), established in 1991.
• Main functions : Providing term loans in Indian and foreign currencies; Underwriting of issues of shares and debentures.
• Small Industries Development Bank of India (SIDBI), established in 1989. Main functions : Providing assistance to small scale industries through state finance corporations, state industrial development corporations, commercial banks etc.
• Export-Import Bank of India (Exim. Bank) was established in 1982. Main functions : Coordinating the working of institutions engaged in financing export and import trade, Financing exports and imports.
• National Housing Bank (NHB) started operations in 1988.
• Main functions : Development of housing finance in the country. ‘- NABARD was established in 1982.
• Main functions : to serve as an apex refinancing agency for institutions engaged in providing agricultural finance to develop credit delivery system to coordinate rural financing activities.

Insurance

• The basic concept of insurance is of spreading the loss of a few over many. Insurance industry includes two sectors-Life Insurance and General Insurance. Life Insurance in India was introduced by Britishers. A British firm in 1818 established the Oriental Life Insurance Company at Calcutta now Kolkata.
• Life Insurance Corporation (LIC) was established in September 1956. General Insurance Corporation (GIC) was established in November 1972.
• Indian Insurance sector has low penetration particularly in rural areas. It also has low turnover and profitability despite high premium rate. The committee on Insurance Sector Reforms was set up in 1993 under the chairmanship of R.N. Malhotra which submitted its report in 1994.
• Malhotra Committee recommended entry of the private sector in insurance sector. It also suggested entry of foreign insurance companies on selective basis. All the four associate companies of GIC should be granted permission to perform their business independently. Insurance Regulatory Authority (IRA) should be established on the lines of SEBI and IRA should be granted complete functional autonomy.

Capital Market

The Capital Market in India includes following institutions (i) Commercial Banks (ii) Insurance companies (iii) Development Banks or specialised financial institutions like IFCI, IDBI, ICICI, EXIM, NHB, NABARD, UTI etc. (iv) Merchant banking agencies.

Individuals who invest directly on their own in securities are also supplier of fund to capital market. The trend in the capital market is basically affected by two important factors (i) operations of the institutional investors in the market and (ii) the excellent results flowing in from the corporate sector.

Capital market is divided in to two part (i) Primary Capital Market (ii) Secondary Market. If shares or debentures of private corporations, primary sureties of government companies or new sureties and issue of bonds of public sector are sold or purchased in the capital market, then the market is called Primary Capital Market. Secondary Market includes transactions in the stock-exchange and guilt aged market.

The sources of capital in the Indian Capital market are — Share capital, acceptance letter etc. Merchant Bank, Mutual Fund, Leasing Companies, Risk Capital Companies etc. collect and invest public money into the capital market.

Stock Exchange

The stock exchange is the market for buying and selling of stocks, shares, securities, bonds & debentures etc. It increases the market ability of existing securities by providing simple method for public & others to buy and sell securities.

Some Important Share Price Index of India

BSE SENSEX — This is the most sensitive share index of the Mumbai Stock Exchange. This is the representative index of 30 main shares. Its base year is 1978-79. BSE is the oldest stock exchange of India, founded in 1875.

BSE 200 — This represents 200 shares of Mumbai Stock Exchange. Its base year is 1989-90.

DOLLEX — Index of 200 BSE Dollar Value Index is called DOLLEX. Its base year is 1989-90.

NSE-50 — From 28th July, 1998, its name is S & P CNX Nifty. National Stock Exchange has launched a new share Price Index, NSE-50 in place of NSE-100 in April 1996. NSE-50 includes 50 companies shares. This stock exchange was founded on Ferwani Committee’s recommendation in 1994.

CRISIL 500 — is the new share Price Index introduced by Credit Rating Agency CRISIL on January 18, 1996. It has 1994 as the base year.

The National Stock Exchange (NSE) has launched a new version of its online trading software called ‘National Exchange for Automatic Trading’ (NEAT).

Types of Shares

A company may have many different types of shares that come with different conditions and rights.

Equity shares – These shares are also known as ordinary shares. They have the potential to give the highest financial gains, but also have the highest risk. Ordinary shareholders are the last to be paid if the company is wound up. They are the shares which do not enjoy any preference regarding payment of dividend and repayment of capital. They are given dividend at a fluctuating rate. The dividend on equity shares depends on the profits made by a company. Higher the profits, higher will be the dividend, where as lower the profits, lower will be the dividend.

Preference shares – These shares are those shares which are given preference as regards to payment of dividend and repayment of capital.Shares in this category receive a fixed dividend, which means that a shareholder would not benefit from an increase in the business’ profits.They do not enjoy normal voting rights. Preference shareholders have some preference over the equity shareholders, as in the case of winding up of the company, they are paid their capital first. They can vote only on the matters affecting their own interest. These shares are best suited to investors who want to have security of fixed rate of dividend and refund of capital in case of winding up of the company.

Deferred shares – These shares are those shares which are held by the founders or pioneer or beginners of the company. They are also called as Founder shares or Management shares.In deferred shares, the right to share profits of the company is deferred, i.e. postponed till all the other shareholders receive their normal dividends. Being the last claimants of the profits, they have a considerable element of speculation or uncertainty and they have to bear the greatest risk of loss. The market price of such shares shows a very wide fluctuation on account of wide dividend fluctuations. Deferred shares have disproportionate voting rights. These shares have a small denomination or face value.

Cumulative preference shares give holders the right that, if a dividend cannot be paid one year, it will be carried forward to successive years. Dividends on cumulative preference shares must be paid, despite the earning levels of the business, provided the company has distributable profits.

Redeemable shares come with an agreement that the company can buy them back at a future date – this can be at a fixed date or at the choice of the business. A company cannot issue only redeemable shares.

Bonus shares – The word bonus means a gift given free of charge. Bonus shares are those shares which are issued by the company free of charge as bonus to the shareholders. They are issued to the existing shareholders in proportion to their existing share holdings. It is a kind of gift to the shareholders from the company. It is bonus in the form of shares instead of cash.

It is given out of accumulated profits and reserves. These shares have all types of preferences which are available to the existing shares. For example two bonus shares for five equity shares. The issue of bonus shares is also termed as capitalization of undistributed profits. Bonus shares are a type of windfall gain to the equity shareholders. They are advantageous to the equity shareholders as they get additional shares free of cost and also they earn dividend on them in future.

Some Other Important Terms

• Devaluation means lowering the official value of the local money in terms of foreign currency or gold.
• Balance of Payments (BOP) is a systematic record of all the economic transactions between one country and the rest of the world in a given period.
• Balance of Trade (BOT) is the difference between the value of goods exported and the value of goods imported per annum. Services not included in BOT.
• BOP is divided in current account and capital account.
• EXIM Policy 2000-01 introduced Special Economic Zones Scheme (SEZ)
• 1994-95, Indian Rupee was made fully convertible on current account.

Important Questions on Indian Financial System

Questions 1
Consider the following statements.

1. Sensex is based on 50 of the most important stocks available on the Bombay Stock Exchange (BSE).
2. For calculating the Sensex, all the stock are assigned proportional weightage.
3. New York Stock Exchange is the oldest Stock Exchange in the World.

Which of the statement(s) given above is/are correct? [UPSC (Pre) 2005]
(A) Only 2
(B) 1 and 3
(C) 2 and 3
(D) None of these

Questions 2
Which of the following is correctly matched? [UPPCS (Pre) 2004]
(A) Bombay Stock Exchange – SENSEX
(B) National Stock Exchange – NYSE
(C) New York Stock Exchange – NIFTY
(D) London Stock Exchange – NIKKEI

Questions 3
Capital Market means [UPPCS (Pre) 2008]
(A) Share Market
(B) Commodity Market
(C) Money Market
(D) All of the above

Questions 4
For regulation of the Insurance Trade in the country the Government has formed [UPPCS (Pre) 2002]
(A) SEBI
(B) Reserve Bank of India
(C) Insurance Regulatory and Development Authority
(D) General Insurance Corporation

Questions 5
Which is the first Private Sector Bank in India to use Software Robotics? [HCS (Pre) 2014]
(A) ICICI Bank
(B) HDFC Bank
(C) SBI
(D) UTI Bank

FAQs on Indian Financial System