INDIAN FINANCIAL SYSTEM - I

Module 1: Unit 1

The Financial System: An Introduction

Sub-topics

A] Meaning of Financial System

B] Evolution of Financial System
C] Components of a Financial System
D] Key Elements of a Well-functioning Financial System
E] Bank-based and Market-based Financial Systems
F]Financial Institutions- Functions
G] Financial Markets: Role and Linkages
- Role and characteristics
- Link between money and capital markets
-Link between primary and secondary markets

FINANCIAL SYSTEM: AN INTRODUCTION

A] Meaning of Financial System

A financial system consists of institutional units and markets that interact in a

complex manner for the purpose of mobilizing funds for investment, and providing
facilities, including payments systems, for the financing of commercial activity. The
term “system” in financial system indicates a group of complex and closely linked
institutions, agents, procedures, markets, transactions, claims and liabilities within
an economy.

The role of financial institutions within the system is primarily to intermediate

between those that provide funds and those that need funds, and typically involves
transforming and managing risk.

Financial markets provide a forum within which financial claims can be traded
under established rules of conduct, and can facilitate the management and
transformation of risk. They also play an important role in identifying market prices
(“price discovery”) of financial instruments. Financial institutions and markets
provide financial services that facilitate the sourcing and deployment of funds.

Financial system is a composite of: Financial institutions, financial markets,

financial instruments, financial services and money.
 B] Evolution of Financial System

Please read the following chapter from the link given:

https://openknowledge.worldbank.org/bitstream/handle/10986/5972/9780195207880_ch0
3.pdf
Source: World Bank
C] Components of a Financial System

The four basic components of a financial system are:

I] Financial Institutions
II] Financial Markets
III] Financial Instruments (Assets or Securities)
IV] Financial Services
V] Financial Sector Regulators

I] Financial Institutions
Financial institutions facilitate smooth working of the financial system by making investors
and borrowers meet. They mobilize the savings of investors either directly or indirectly via
financial markets, by making use of different financial instruments as well as in the process
using the services of numerous financial services providers.
They could be categorized into Regulatory, Intermediaries, Non-intermediaries and
Others. They offer services to organizations looking for advices on different problems
including restructuring to diversification strategies. They offer complete array of services to
the organizations who want to raise funds from the markets and take care of financial assets for
example deposits, securities, loans, etc.

II] Financial Markets

A financial market is the place where financial assets are created or transferred. They can be
broadly categorized into money markets and capital markets. Money market handles short-
term financial assets (less than a year) whereas capital markets take care of those financial
assets that have maturity period of more than a year.
The key functions of financial markets are:
1. Assist in creation and allocation of credit and liquidity.
2. Serve as intermediaries for mobilization of savings.
3. Help achieve balanced economic growth.
4. Offer financial convenience.
Another way in which financial markets can be classified is primary markets and secondary
markets. Primary markets are markets for new issue of securities in contrast secondary
markets take care of securities that are presently available in the stock market.
Money markets make it possible for businesses to gain access to funds on a short term basis,
while capital markets allow businesses to gain long-term funding to aid expansion. Without
financial markets, borrowers would have problems finding lenders. Intermediaries like banks
assist in this procedure. Banks take deposits from investors and lend money from this pool of
deposited money to people who need loan. Banks commonly provide money in the form of
loans.

III] Financial Instruments

These are an important component of the financial system. The products which are traded in a
financial market are financial assets, securities or other type of financial instruments. There
is a wide range of securities in the markets since the needs of investors and credit seekers are
different. They indicate a claim on the settlement of principal down the road or payment of a
regular amount by means of interest or dividend. Equity shares, debentures, bonds, etc are some
examples.
Debt funds are borrowed through these instruments like bonds, debentures, commercial papers,
T-Bills, certificates of deposits, bank deposits. Equity funds are raised by issuing shares/part
ownership of a businesses, examples: Ordinary shares, preference shares.

Financial instruments can also be classified as:

A] Marketable Securities - that can be easily traded in the money and capital markets,
for example, stocks, T-bills, bonds, commercial papers etc.
• B] Non-Marketable Securities- are financial assets like bank deposits, post office
deposits company deposits, and provident fund deposits. They represent personal
 transactions between the investor and the issuer. They cannot be traded in the secondary
market.
Another classification of financial instruments can be done as follows:
A] Indirect Finance/Securities
Indirect finance is where borrowers borrow funds from the financial market
through indirect means, such as through a financial intermediary.
• This is different from direct financing where there is a direct connection to the
financial markets as indicated by the borrower issuing securities directly on the market
• This type of funds are raised through indirect securities
• Such securities are liabilities of private and public sector banks, insurance and mutual
funds trusts.
Examples:
• Bank deposits
• Mutual fund units
• Insurance products

Indirect securities can issued by either:

Depository banks that pay interest on deposits from the interest earned from loans

Non-depository insurance companies, mutual funds and pension funds that collect
money from selling policies or unit shares
Benefits of indirect finance are
- Better suited for the requirement of investors
- Pooling in of resources by financial intermediaries
- Help achieve efficiency of size and scale

B] Direct finance/Securities- funds are directly raised from the financial market without
using a third party services, such as a financial intermediary
• This type of finance is raised through direct or primary securities.
• These securities are issued by a non-financial unit such as a business firm, NBFCs
(they are companies registered under Company’s Act 1956) government, a financial
institution. They include
• Equity shares- non-voting rights shares/voting rights shares
• Preference shares- cumulative convertible preference shares
• Fixed-income securities- Bonds and Debentures, Treasury Bills
• Floating rate bonds
Global Depository Receipts and American Depository Receipts

IV] Financial Services

Financial services consist of services provided by Asset Management and Liability
Management Companies. They help to get the necessary funds and also make sure that they
are efficiently deployed. They assist to determine the financing combination and extend their
professional services upto the stage of servicing of lenders. They help with borrowing, selling
and purchasing securities, lending and investing, making and allowing payments and
settlements and taking care of risk exposures in financial markets. These range from the leasing
companies, mutual fund houses, merchant bankers, portfolio managers, bill discounting and
acceptance houses. The financial services sector offers a number of professional services like
credit rating, venture capital financing, mutual funds, merchant banking, depository services,
book building, etc. Financial institutions and financial markets help in the working of the
financial system by means of financial instruments. To be able to carry out the jobs given, they
need several services of financial nature.

V] Financial Sector Regulators:

Financial sector need regulation and monitoring through regulatory bodies set by the
government. This is an essential aspect of a financial market in order to protect the interest of
lenders and borrowers as well as to ensure that the financial institutions do not indulge in illegal
and risky businesses. The following are the regulators in different segments of the Indian
financial system.
i) Banking Sector Regulation- The Reserve Bank of India (RBI) [RBI Act, 1934]
ii) Insurance Sector Regulation Insurance Regulatory and Development Authority
(IRDA) [IRDA Act, 1999]
iii) Capital Market Regulation Securities and Exchange Board of India (SEBI) [SEBI
Act, 1988]
iv) Pension Fund Regulation- Pension Fund Regulatory and Development Authority
(PFRDA) [PFRDA Act, 2013] pension funds like
Housing Finance Regulation- National Housing Bank [National Housing Bank Act, 1987]
regulates the housing finance sector

D] Key Elements of a Well-functioning Financial System

A well-functioning financial system is a prerequisite for channeling of savings into productive

investment that is essential for economic growth and development. If the financial system of a
country is not efficient then the surplus money capital in the form of savings will remain idle
or will be inefficiently used resulting in huge cost to the economy.

A well-functioning financial systems are characterized by financial instruments that help

people solve financial problems, liquid markets with low trading costs (operationally efficient),
timely financial disclosures resulting in market prices that reflect available information
(informationally efficient), and therefore prices that move primarily with changes in
fundamental value instead of liquidity demands. Well-functioning markets ultimately lead to
efficient allocations, which use resources where they are most valuable.

The following are some of the important prerequisites of a well-functioning financial system:
 1. A strong regulatory mechanism and appropriate legal framework for the functioning
of the financial system.
2. Stable monetary management by the central bank.
3. Sound fiscal policy
4. Efficient management of public debt
5. A sound banking system effectively regulated by the central bank.
6. A well-functioning securities market, both debt and equity
7. Efficient and advanced information system supported by upgraded technology.

Key elements of a well functioning financial system are:

1. Operational efficiency:An efficient payment system is a key element of a well-

functioning financial system. This implies a payment system, which would enable easy
and speedy exchange of goods and services. This is done through commercial banks
and other non-banking financial intermediaries. The operational efficiency of these
agencies saves the financial system from any break down. of the payment system results
in low transaction costs as a percentage of the value of the trade, include the cost of
reaching the market, the actual brokerage costs, and the cost of transferring the asset.
This attribute is often referred to as internal efficiency of the financial system.
2. Liquidity. An efficient financial market should ensure easy liquidity. One of the
important considerations for investment is the ability to convert investment into cash in
case of extingencies. Financial markets provide a platform for buyers and sellers to
meet together and buy and sell securities. This process enables an investor to get back
investment as and when he/she requires it.
3. Fungibility: Financial markets convert cash into securities and back to cash without
any hurdles. Intermediaries operating in the market pool funds from savers and issue
different forms of securities which are offered for investment in the market. Therefore,
the form of funds is changed and this can be brought back to the original form as and
when required.
4. Marketability and Price Continuity: A well functioning financial system will ensure
that a financial asset can be bought and sold quickly, at a price close to the prices for
previous transactions, assuming no new information has been received. This is known
as price continuityIn turn, price continuity requires depth, which means that numerous
potential buyers and sellers must be willing to trade at prices above and below the
current market price.
5. Informational Efficiency: Informational efficiency measures
the degree to which market
prices correctly and quickly reflect information and thus the true value of an underlyin
g asset.Timely and accurate information should be easily available on the price and
volume of past transactions and the prevailing bid-price and ask-price. Prices rapidly
adjust to new information. Therefore, the prevailing price reflects all available
information regarding the asset. This is a pre-requisite for a well-functioning financial
market.
 6. Complete Markets: A complete market is a market with two conditions:

(i) Negligible transaction costs. This also implies perfect information.

(ii) There is price for every asset in every possible state of the world (a state of the
world is a complete specification of the values of all relevant variables over the
relevant time horizon)
For a financial system to work efficiently, the market segments, like money
market, government debt market, corporate bonds market, equity market,
should fulfill the conditions of complete markets.

E] Bank-based and Market-based Financial Systems

Debate: Is there a relationship between economic performance of a country and

financial structure- the degree to which a country’s financial system is market-
based or bank-based Bank based and market based financial system?

Economists have debated the role of financial structure—the advantages and disadvantages
of bank-based financial systems relative to market-based systems—for more than a century.
This debate was earlier confined to developed economies, but in recent years have also become
important in connection with developing and emerging economies. The debate is centered
around the question- in order to achieve economic growth and development, should
policymakers concentrate on developing the banking system or equity and bond markets?
In other words, what should get more importance- the banking system or the capital market for
providing finance for economic activities?

In a bank-based financial system banks play a leading role in mobilizing savings, allocating
capital, overseeing the investment decisions of the industrial sector and other sectors. In a bank-
based economy, the capital market is generally underdeveloped and only a small portion of
corporate financing needs are met through the issuance of securities while bank financing
predominates. Companies borrow heavily from banks, whose refinancing needs are in turn
covered by the central bank. A bank-based economy is also called a credit-based economyor
indirect finance-based economy.
In a market-based financial system securities markets (stock market and corporate and
government debt markets) play an important role in getting people’s savings channeled to firms
and other businesses. A market-based economy can be referred to as a securities-based
economy or direct finance-based economy.

In reality, most economies end up having financial systems that are a balance of the above
two types.
In the early stages of development of a country’s economy, the need for financial services are
largely for the purpose of funding agricultural activities, trade and small businesses as well as
personal consumption. A large part of the demand for finance is met by the informal sources
like money lenders and indigenous bankers as well as family and friends.

As an economy grows and develops, needs of the users and the providers of financial services
change. Informal finance becomes less important and bank-based debtfinance become more
important. For example, in case of India, after independence, the informal sector played a major
role in financing economic activities, in spite of the fact that there was an active and well spread
out banking system. The scope of bank credit was limited to urban areas and to larger
businesses. This was sought to be corrected through nationalization of private sector banks,
first in 1969 and then in 1980. This resulted in significant branch expansion in rural areas. This
established the bank-based financial system in India. As the Indian economy grew and
particularly after the structural reforms of 1990s, there was a shift towards market-based
financial system with tremendous growth of capital market. Though, Indian banking system
continues to provide the larger part of finance for all kinds of economic activities, including
industrial finance, a very significant part of people’s savings are now going into the equity
market and mutual funds.

Many developing economies establish bank-based financial system in their early

developmental stage. During such period, industrial finance is largely met through bank credit
and the capital market as a source of industrial finance has limited scope. Although banks
dominate most formal financial systems, the relative importance of the stock market tends
to increase with the level of development. Far more finance is raised from bank loans,
however, than from selling equity, even in industrial countries.

The argument in favour of a bank-based system is that banks have advantages over market-
based system when legal institutions and accounting systems are weak in an economy. Even in
countries with weak legal and accounting systems and poor contract enforcement, powerful
banks can force firms to reveal information and pay their debts, thus facilitating industrial
expansion. On the other hand, well-developed stock markets quickly reveal information, which
reduces the incentives for individual investors to acquire information. This can reduce
incentives for identifying innovative projects and new businesses with potential. This results
in inefficient allocation of resources. Furthermore, since investors can sell their shares easily
and with little cost, their incentives to monitor companies in which they have invested are
diminshed, which hinders corporate control and national productivity.

Those in favour of market-based financial system argue that stock markets provide the
ability to diversify risk and customize risk management devices. Such markets help several
options to savers to diversify their savings into. This increases flow of funds into the financial
system, at lower risks to the lenders, as compared to the bank-based system. Such flow of funds
help the growth of economic activities, resulting in economic growth.

However, the above mentioned debate remains inconclusive till date. There has been
extensive research done to explain the link between structure of financial system and GDP
growth. But country, industry, and firm-level data all show that for a given level of
development, comparing countries by their financial structure does not help to explain cross-
country differences in long-run GDP growth, industrial performance, new firm formation, firm
use of external funds, or firm growth. Most research show the following:

a) Both banks and the capital market tend to all grow and become more active and
efficient as a country’s GDP grows and it becomes richer.
b) In higher income countries, stock markets become more active and efficient than
banks. Thus, financial systems tend to be more market based.
c) Countries with strong protection for shareholder rights, good accounting standards,
low levels of corruption tend to be more market-based.
d) Poor accounting standards, heavily restricted banking systems, and high inflation
generally tend to have underdeveloped financial systems.

Distinguishing countries by their overall level of financial development helps to explain

cross-country difference in economic growth. Countries with greater degrees of
financial development, as measured by aggregate measures of bank development
and market development – enjoy substantially greater economic growth rates.

F] Financial Institutions- Functions

A financial institution acts primarily as an intermediary in channelling funds from lenders to
borrowers or from savers to investors.
Any institution that collects money and puts it into assets such as stocks, bonds, bank deposit
s, or loans is considered a financial institution.
There are two types of financial institutions: depository institutions and nondepository institut
ions.

Depository institutions: Banks and credit societies accept deposits, pay interest on
deposits and use the deposits to create loans.
Non-depository institutions:
Insurance companies, brokerage firms, and mutual fund companies, sell financial products.
Many financial institutions provide both depository and nondepository services.
FIs include commercial banks, co-operative banks, non-banking financial companies
(NBFCs), mutual funds, insurance companies and pension funds.

Following are the functions of a financial institutions (FIs):

1. Convenience to savers: FIs convert securities into more convenient vehicles for
mobilistaion of savings. This provides great utility to small savers.Convenience
to savers comes from divisibility of securities into small denominations to suit
the requirements of the savers. The minimum investments in mutual funds or
 pension funds are very low in most cases. FIs help to bring about equilibrium
between savings fund and investment funds and provide stability in the financial
markets.

2. Capital formation: By channelizing savings into investment, FIs make capital

formation possible. Capital formation refers to net capital asset accumulation during
a given time period or additions of capital stock that includes tools, equipments,
machinery, transportation, energy. Capital formation is essential for economic
growth.
3. Transmutation effect: While converting savings into investments, FIs convert
contracts with a given set of characteristics into contracts with very different sets of
characteristics. They make one type of contracts with ultimate lenders and another
type with ultimate borrowers. This is referred to as transmutation effect.
4. Purchase of primary securities: FIs purchase primary securities from ultimate
borrower and issue indirect securities for the portfolio of the ultimate lenders.
Primary securities are issued by non-finance economic units, such as, business firms
and even government. They include issue of new stocks of companies, new bonds,
debentures, treasury bills etc. These primary securities are offered in the form of
IPOs or issuance of new debt instruments (bonds and debentures) or auctioning of
treasury bills. The issuers of primary securities raise funds from money and capital
markets. The funds raised are used for investment and capital formation. FIs
subscribe to primary securities or in other words they provide funds to non-financial
units by purchasing primary securities issued by the non-financial units.
5. Satisfaction of simultaneous portfolio preference: Borrowers are non-financial
units whose main function is to produce and purchase output. They finance their
spending by issuing primary securities. On the other side are the lenders who have
surplus funds with the help of which they hold assets like bank deposits, bonds,
stocks, pensions, mutual funds units. They convert their liquid asset (cash) into
financial assets in order to earn interest income and increase their wealth. FIs satisfy
simultaneously the portfolio preferences of two types of individuals and firms.
6. Act as dealers: FIs purchase primary securities from non-finance units. Therefore,
they function as dealers by buying funds from ultimate lenders in exchange for their
own indirect securities and selling funds to ultimate borrowers in exchange for the
latter’s primary securities. The purchase of primary securities by surplus income
units (savers) is called Direct Finance and by FIs as Indirect Finance.Indirect
securities, on the other hand, are financial assets issued by FIs to mobilize the
savings of those who have excess funds. These include demand and time deposits
of commercial banks, deposits of NBFCs, insurance policies, mutual fund units,
pension funds.
7. Reduce hoarding of cash: FIs reduce hoarding of cash by economic units by
providing a channel for idle cash to be converted into income earning financial
assets. This helps in increasing funds availability for capital formation resulting in
economic growth.
 8. Promote savings and income: FIs play an important role in promoting saving habit
among households by offering them earnings from their savings. This helps
improve income generation and standard of living as well as help households create
wealth. Higher household incomes result in higher aggregate expenditure and
higher national output.
9. Spreading of risk: Since FIs possess greater collective resources than individual
units, they can spread the risk of financial investment in wide-ranging assets. They
diversify their funds and spread the risk to borrowing. For example, holding of
government securities will expose them to low risk as compared to holding non-
secured securities issued by NBFCs. The riskier the securities, higher are the
returns. A FI is able to arrange its assets and balance the risk and earning capacity.
This is not usually possible for an individual unit to do.
10. Provision of liquidity: FIs provide liquidity by helping convert financial assets into
cash whenever required. This is done at low cost and without loss of value of
money. This ability of converting assets into liquidity encourages people to acquire
financial assets. FIs manufacture liquidity. They create claims which are more
liquid than the securities they buy, and issue them to savers. The redemption facility
available to unit holders of open ended mutual funds is an example. Mutual funds
offer to buy back their own units, providing an exit option to the unit holders.
11. Promote economic growth: FIs provide capital finance to the business sector to
carry out production activities.FIs help local, state and central governments raise
funds for welfare schemes and infrastructure building.FIs create a range of financial
assets which helps deepen and expand money and capital markets. This is essential
for economic growth.
12. Lower cost of funds: While acting as intermediaries, competition among FIs leads
to lowering of interest rates. Low interest rates benefits borrowers as their cost of
borrowing goes down. This leads to more investments by businesses, production of
more output and higher employment. Higher employment will increase income and
also ability to save.
13. Specialised management of funds: Funds of FIs are managed by experts.
Securities issued by FIs give both large and small investors the benefits of
experienced and specialized management together with continuous supervision.
This is not possible for individual units to do.

G] Financial Markets: Role and Linkages

Financial markets are markets where financial assets are bought and sold. These markets
include intermediaries that bring savers and investors together. In any economy there exist
organized and unorganized financial markets. Unorganised markets have been in existence
since ancient times providing funds on the basis of well established traditions and conventions
evolved over centuries. Organised or modern financial markets came into existence with the
development of modern business and banking. However, both types of markets co-exist in most
economies.
Here we will discuss the organized financial markets.

The following are the types of financial markets:

1. Capital Market

Capital market is a market for long-term debt and equity shares. In this market, the capital
funds comprising of both equity and debt are issued and traded. This also includes private
placement sources of debt and equity as well as organized markets like stock exchanges.
Capital market can be further divided into primary and secondary markets.

Primary Market
The primary market is the part of the capital market that deals with issuing of new securities.
Primary markets create long term instruments through which corporate entities raise funds from
the capital market. In a primary market, companies, governments or public sector institutions
can raise funds through bond issues and corporations can raise capital through the sale of
new stock through an initial public offering (IPO). The process of selling new shares to
investors is called underwriting. Dealers earn a commission that is built into the price of the
security offering, though it can be found in the prospectus.

The following issues are made in the primary market in India:

Initial Public Offering (IPO) – Fresh issue of shares or selling existing securities by an
unlisted company for the first time is known as IPO. Listing and trading of securities of a
company takes place in IPO.

Rights Issue – Rights issue is when the listed company issues new securities and provides
special rights to its existing shareholders for buying the securities before issuing it to public.
The rights are issued on particular ratio based on the number of securities currently held by the
share holder.

Preferential Issue – It is the fresh issue of securities and shares by listed company. It is called
as preferential as the shareholders with preferential shares get the preference when it comes to
dividend disbursement.
 Secondary Market

Secondary Market refers to a market where securities are traded after being initially offered
to the public in the primary market and/or listed on the Stock Exchange. Majority of the
trading is done in the secondary market. Secondary market comprises of equity markets and
the debt markets. Secondary market is a trading avenue in which already existing/pre- issued
securities are traded amongst investors. Secondary market could be either auction or dealer
market. While stock exchange is the part of an auction market, Over-the-Counter (OTC)
is a part of the dealer market.

DEALER MARKET AUCTION MARKEET

1. A financial market 1. A market in which buyers
mechanism wherein multiple enter competitive bids and
dealers post prices at which they sellers enter competitive offers
will buy or sell a specific at the same time.
security of instrument.

2. In a dealer market, a dealer –

who is designated as a “market
maker” – provides liquidity and 2. On an auction market, the
transparency by electronically current price for a share in a
displaying the prices at which it security is the highest price a
is willing to make a market in a buyer is willing to pay and the
security, indicating both the lowest price a seller is willing to
accept. Matching bids and
price at which it will buy the
security (the “bid” price) and the offers are then paired together
price at which it will sell the and the orders are executed.
security (the “offer” price).

3. The government securities

market and all OTC markets are 3. All future markets are
dealer market. auction market.

4. Auction market are Order-

4. Dealer market are Quote driven
driven.

For the general investor, the secondary market provides an efficient platform for trading of
securities. For the management of the company, secondary equity markets serve as a
monitoring and control mechanism. If a company wants the value of its traded stock to
remain high, it will adopt measures to improve its profit performance.
 The SEBI is the regulatory authority of the secondary market.

The products traded in the secondary market in India are:

(i) Equity Shares:

(ii) Rights Issue / Rights Shares
(iii) Bonus Shares
(iv) Preferred Stock / Preference shares
(v) Government securities (G-Secs)
(vi) Debentures
(vii) Bonds

Brokers and sub-brokers play a very important role in the secondary market. A broker is a
member of a recognized stock exchange, who is permitted to do trades on the screen-based
trading system of different stock exchanges. He is enrolled as a member with the concerned
exchange and is registered with SEBI. A sub broker is a person who is registered with SEBI
as such and is affiliated to a member of a recognized stock exchange.

Link between primary and secondary markets:

The money and capital markets are complementary to each other. Their functioning is
interlinked as follows:

1. The primary/new issue market cannot function without the secondary market. The
secondary market or the stock-market provides liquidity for the newly issued securities. The
newly issued securities are traded in the secondary exchanges offering liquidity to the stocks
at a fair price.
2. The new issue market provides a direct link between the prospective investors and the
company. By providing liquidity and safety, the stock markets encourage the public to
subscribe to the new issues. The marketability and the capital appreciation provided in the
stock exchanges are the major factors that attract the investing public towards the stock
market. Thus, it provides an indirect link between the savers and the company.
3. The stock exchanges through their listing requirements, exercise control over the primary
market. The company seeking for listing on the respective stock exchange has to comply
with all the rules and regulations given by the stock exchange.
4. Though the primary and secondary markets are complementary to each other, their functions
and the organizational set up are different from each other. The health of the primary market
depends on the secondary market and vice versa.

2. Money Market

The Money market in India is a market for short-term funds with maturity ranging
from overnight to one year in India including financial instruments that are deemed to
be close substitutes of money. Similar to developed economies the Indian money
 market is diversified and has evolved through many stages. The Indian money market
consists of diverse sub-markets, each dealing in a particular type of short-term credit.
The money market fulfills the borrowing and investment requirements of providers and
users of short-term funds, and balances the demand for and supply of short-term funds
by providing an equilibrium mechanism. It also serves as a focal point for the central
bank's intervention in the market.
The Indian money market consists of
A] Unorganised sector: moneylenders, indigenous bankers, and unregulated Non-
Bank Financial Intermediaries (e.g. Finance companies, Chit funds, Nidhis)
B] Organised sector: Reserve Bank of India, private banks, public sector banks,
development banks and other International Finance Corporation, IDBI, and the co-
operative sector.

It includes segments like :

a) Treasury bills market from where the government borrows for short term.
b) The call money market where banks and financial institutions borrow and lend for
short term.
c) Commercial papers are short term instruments issued by companies.
d) Certificates of deposit are issued by commercial banks
e) Repos , forward rate agreements and interest rate swaps
f) Money Market Mutual Funds

Comparison between money and capital markets

BASIS FOR
MONEY MARKET CAPITAL MARKET
COMPARISON

Meaning A segment of the financial market A section of financial market where

where lending and borrowing of short long term securities are issued and
term securities are done. traded.
BASIS FOR
MONEY MARKET CAPITAL MARKET
COMPARISON

Financial instruments Treasury Bills, Commercial Papers, Shares, Debentures, Bonds, Retained
Certificate of Deposit, Trade Credit etc. Earnings, Asset Securitization, Euro
Issues etc.

Institutions Central bank, Commercial bank, non- Commercial banks, Stock exchange,
financial institutions, bill brokers, non-banking institutions like
acceptance houses, and so on. insurance companies etc.

Risk Factor Low Comparatively High

Liquidity High Low

Purpose To fulfill short term credit needs of the To fulfill long term credit needs of the
business. business.

Time Horizon Within a year More than a year

Merit Increases liquidity of funds in the Mobilization of Savings in the

economy. economy.

Return on Investment Less Comparatively High

Link between money and capital markets:

The money market and capital market are closely interrelated because most corporations and
financial institutions are active in both. Firms may borrow funds from the money market for a
short period or for a loan period from the capital market.A number of factors may prompt
borrowers and lenders to resort to either the money market or the capital market which reflect
the interdependence of the two markets. They are discussed below.

1. Lenders may choose to direct their funds to either or both markets depending on the
availability of funds, the rates of return, and their investment policies.

2. Borrowers may obtain their funds from either or both markets according to their
requirements. A firm may borrow short-term funds by selling commercial paper or it may float
additional shares or bonds.
3. Some corporations and financial institutions serve both markets by buying and selling short-
term and long-term securities.

4. All long-term securities become short-term instruments at the time of maturity. So some
capital market instruments also become money market instruments.

5. Funds flow back and forth between the two markets whenever the treasury finances maturing
bills with treasury securities or whenever a bank lends the proceeds of a maturing loan to a
firm on a short-term basis.

6. Yields in the money market are related to those of the capital market. A fall in the short-term
interest rates in the money market shows a condition of essay credit which is likely to be
followed or accompanied by a more moderate fall in the long-term interest rates in the capital
market. However, money market interest rates are more sensitive than are long-term interest
rates in the capital market.

Questions
1. What do you understand by the term financial system? Discuss the components of a
financial system.
2. Explain how financial instruments/securities are classified.
3. What are the key elements of a well functioning financial system.
4. Explain the features of bank-based and market based financial systems.
5. Discuss the functions of financial institutions.
6. Explain the role of the primary and the secondary segments of the capital market. In
what way are the two markets linked?
7. Explain the role of the money market. What is the linkage between capital and money
markets?
8. Make comparative analysis of each of the following:
(i) Direct and indirect securities
(ii) Equity and debt securities
(iii) Market based and bank based financial systems
(iv) Dealer market and auction markets
(v) Primary and secondary markets
(vi) Money and capital markets
5.
 Module 1: Unit 2

Financial System and the Economy

A] Types of Economic Units

B] Macroeconomic framework analysis for exploring the role of a financial system

- National Income Accounts

- Flow of Funds analysis

- Trends in savings & investment

C] Relationship between Financial system & Economic growth

A] Types of Economic Units

The following types of economic units in an economy are relevant to understand the
macroeconomic framework in which the financial system operates:

1. Surplus-spending Economic Units

These are units whose consumption and planned investment are less than their
income. The surplus savings that they have is held in the form of cash balances or
financial assets. The acquisition of financial assets or making of loans is, in fact,
lending for productive investment. Such lending by the surplus-spending sector can
be termed as demanding financial assets or supplying loanable funds. In India, the
household sector is a net-surplus spending economic unit.

2. Deficit-spending Economic Units

These are units whose consumption and planned investment exceeds income. The
deficit-spending economic units have negative savings. They finance their needs by
borrowing or by decreasing their stock of financial assets. Borrowing by deficit-
spending units creates a supply of financial securities or demand for loanable
funds. In India, the government and the corporate sector are deficit-spending
economic units.

The surplus savings of the surplus-spending household units have to be transferred to

the deficit-spending economic units. A link in the form of a financial system is
necessary to transfer surplus savings to deficit units. The surplus and deficit units can
be brought together either directly through external financing (direct financing
through bonds, equity, debentures, T-bill, commercial papers) or indirectly through
intermediation (banks and other financial institutions).
A MACRO-ECONOMIC FRAMEWORK ANALYSIS FOR EXPLORING
THE ROLE OF THE FINANCIAL SYSTEM IN THE ECONOMY

The main tools of analysis are as follows.

• National Income Accounts

• Flow of Funds Accounts

• Trends in Savings and Investment

NATIONAL INCOME ACCOUNTS

National income accounts are the best-known system of macro-economic flow

statistics. They are used to measure production in the economy and earnings derived
from production. National income and national product are flow concepts and are
measured over a given or specified period of time. National product refers to the flow
of goods and services produced by the residents of a country during any given period
of time. National income represents the flow of total factor earnings available for
purchasing the net flow of goods and services in the economy during any given period
of time. The annual series on the economy’s national income classified by industry-
of-origin provides useful information about the structure of the economy. National
income accounts classified by sector-of-origin show what kind of income has been
generated in each sector of the economy and the total value of the goods and services
produced.

Classification of the Indian Economy

• Primary sector: agriculture, forestry and logging, fishing, and mining and quarrying

• Secondary sector: manufacturing, (registered and unregistered), construction,

electricity, gas, and water supply

• Transport, communication, and trade: transport, storage and communication, trade,

hotels, and restaurants

• Finance and real estate: banking and insurance, real estate ownership of dwellings,
and business services

• Community and personal services: public administration and defence, other

services

• Foreign sector: foreign sector

FLOW OF FUNDS ACCOUNTS

The flow of funds accounts reflects the diversified savings and investment flows from
the broad sectors of an economy through various credit and capital market
instruments. The accounts bring out the pattern of financing economic activities and
 the financial inter-relationship among various sectors of the economy. They help
identify the role of finance in the generation of income, savings, and expenditure.

The following ratios are used to study the depth and significance of financial system
in an economy.

1. Finance Ratio (FR):

This ratio depicts the process of financial deepening in the economy. It is an indicator of the
rate of financial development in relation to economic growth. It is a ratio of the total issues
consisting of primary and secondary claims in relation to the national income.

FR = Total financial claims/ Net income

= Total Issues/ Net national product at factor cost

2. Financial Inter-relation Ratio (FIR)

FIR reflects the proportion of financial issues with respect to net capital formation in
the economy. It reflects the relationship between the financial structure and the real
asset structure of the economy.

FIR = Financial assets/Physical assets

= Total issues/ Net domestic capital formation

3. New Issue Ratio (NIR)

This is a ratio of primary issues to net domestic capital formation. It measures the
proportion of primary claims issued by non-financial institutions to net capital
formation. It indicates how far direct issues to the savers have financed the investment
by the investing sectors.

NIR= Primary issues/ Net physical investments

= Primary issues/ Net domestic capital formation

4. Intermediation Ratio (IR)

It is the ratio of secondary issues to primary issues. In other words, it is the ratio
between the financial claims issued by the financial institutions and the financial
instruments issued by non-financial institutions. It indicates the importance of
financial intermediaries in channelising financial resources.

IR = Total secondary issues/total primary issues

Trends in Savings and Investment

Economic objectives like price stability, maintaining high levels of income and employment,
and high rates of economic growth have a close relationship with the concepts of saving and
investment.

Saving is income minus expenditure and Investment involves sacrifice of current

consumption and the production of investment goods which are used to produce
commodities. It includes the accumulation of inventories and investment in real assets and
includes investment in expenditure for plant and equipment, residential and other
construction, and additions to inventories.

Investment results in capital formation. Capital formation is the net investment in fixed
assets. In the national accounts, investment is the sum of Gross Fixed Capital Formation and
the physical change in stocks and work in progress. Gross Fixed Capital Formation includes
depreciation while Net Capital Formation excludes it.

Both saving and investment are flow concepts and refer to the addition of the stock of capital
(wealth) that occurs over a period of time. The stock concept ‘savings’ refers to the holding
of wealth in some form, usually financial claims. Savings refers to financial capital at a point
of time and saving refers to addition to the capital over a period of time. The concepts of
saving and investment help analyse some important aspects of macro-economics such as
fluctuations in economic activity between prosperity and recession, the process of economic
growth, and the method of financing Gross Domestic Capital Formation.

The household sector saves in the form of currency, bank deposits, non-banking deposits, life
insurance, funds, provident and pension fund claims on government, shares and debentures
including units mutual funds. For economic growth, it is necessary that saving is held in
financial assets such as deposits, shares and debentures, and in the form of contractual
savings rather than in currency. If savings are held in the form of currency, it is probable that
they might be invested in unproductive assets like gold.

RELATIONSHIP BETWEEN THE FINANCIAL SYSTEM AND ECONOMIC

GROWTH

• An efficient financial system facilitates economic activity and growth.

• The growth of financial structure is a precondition to economic growth

• Markets, institutions, and instruments are the prime movers of economic growth

• The financial system of a country diverts its savings towards more productive uses
and so it helps to increase the output of the economy.

• Mobilises savings

• Helps accelerate the volume and rate of savings by providing a diversified range of
financial instruments and services through intermediaries.
 • This results in an increased competition in the financial system which channelises
resources towards the highest-return investment for a given degree of risk.

• This lowers financial intermediation costs and stimulates economic growth.

• Well-developed money and government securities market helps the central bank to
conduct monetary policy effectively with the use of market-based instruments.

• Well-developed financial markets are also required for creating a balanced financial
system

• Financial system plays an important role in disciplining and guiding management of

companies, leading to sound corporate governance practices.

• The domestic financial system when linked to the international financial system
increases capital flow with the help of financial markets.

• This link reduces risk through portfolio diversification and helps in accelerating
economic growth.

Module 1: Unit 3

Reforms in the Indian Financial System

Sub-topics

• Background of Indian financial system

• Reforms in the Indian financial system
- Phases of Financial Sector Reforms
- Objectives of reforms in the Indian financial system
- Banking Sector Reforms
- Capital Market Reforms
- Evaluation of financial system reforms

A] Background of Indian Financial System

Indian financial is a composite of financial intermediaries, financial markets, financial

instruments, financial services and financial regulators. Financial markets are segmented
into money and capital markets. Financial services markets are segmented as insurance,
pension and mutual funds markets. Further classifications can be made as: debt and equity
markets, primary and secondary markets, markets for direct and indirect securities and
so on.

It should be noted that in India, like in most other countries, the financial system has a formal
and an informal segment. In our study we will analyse the formal segment of the financial
system. The financial system in India has regulators that oversee the functioning of each area
of the system. These are the RBI, SEBI, IRDA and the PFRDA.

The financial system prior to 1990s was characterised by the following:

After independence, India adopted the planned economy model to attain goals like employment
generation, reduction of inequalities and poverty reduction. The policy makers created many
regulatory mechanisms to ensure that the resources are utilised in a desired manner to achieve
the predetermined objectives. Like other parts of the economy, such regulations were put in
place in the financial sector too. These regulations began to show their drawbacks in the 1980s
in the form of shortage of funds for investments, high cost of borrowing, public sector
monopoly in banking, inefficient financial services, underdeveloped money and capital
markets. All these problems affected the real economy and ultimately resulted in sluggish
growth on the GDP.

1. Lack of independence of monetary policy: Monetary policy is the key policy

determining the functioning of the banking system and the money market. It is
implemented by the central bank, which is an autonomous institution, to control credit
creation and money supply. During inflation, monetary policy is used to reduce money
supply and during recession it is used to increase money supply. Prior to 1990s, the RBI
was not free to independently follow monetary policy. Monetary policy was dictated
by government’s fiscal policy (policy related to taxation, public borrowing and public
debt). The government had to spend heavily for developmental purposes leading to
expansion of fiscal deficit. The government borrowed extensively from the RBI to
finance its fiscal deficit. This led to increased money supply and caused inflation. The
RBI’s measures to control inflation did not work well due to huge government spending
causing inflation.
2. Excessive government regulations: The financial system was characterised by
extensive government regulations. The interest rates were administered and not market
determined. The capital market was under the control of the Controller of Capital
 Issues which was the regulatory authority before SEBI came into existence; it derived
authority from the Capital Issues (Control) Act, 1947. The CCI controlled the amount
as well the pricing of new issues. This was an obstacle to raising funds from the capital
market by industries.
3. Weak banking structure: In 1969 and 1980 major banks were nationalized and they
were made to focus on priority sector lending. In spite of massive branch expansion
that followed nationalization, the banking sector was inadequate in providing credit to
the growing needs of the economy. Public sector banks dominated the sector and this
resulted in lack of competition making the banking sector inefficient and restricted.
Banks had compulsorily lend to the government through SLR. SLR and CRR were very
high thereby restricting banks’ capacity to lend.
4. Lack of transparency:There was lack of proper accounting and risk management
systems and lack of transparency in operations of major financial market participants.
Such a system hindered efficient allocation of resources.
5. Underdevelopment capital market: The capitalmarket lacked transparency and was
underdeveloped. Due to this not many retail investors participated in the market. Flow
of saving to the primary and secondary segments of the capital market was not
significant.
Financial sector reforms initiated in the early 1990s have attempted to overcome these
weaknesses in order to enhance efficiency of resource allocation in the economy.

B] Reforms in the Indian Financial System

Financial sector reforms refer to steps taken to bring in changes in the banking system, capital
market, government debt market, foreign exchange market etc. with the objective to improve
efficiency in their functioning. An efficient financial sector is necessary for the mobilization of
household savings and to ensure their proper utilisation in productive sectors.India’s financial
sector has undergone drastic changes over the last few decades beginning 1991.

Phases of Financial Sector Reforms

In early 1990s India underwent major structural reforms in order to address the above
mentioned problems. As a part of the new economic policy, the industrial sector and foreign
trade were significantly liberalised. The public sector underwent a major change with
privatisation and disinvestment. These were the first phase of reforms, known as first
generation reforms that reduced government regulations over physical resources. These
reforms were followed by the second generation reforms which were aimed at reducing
government regulations in the financial sector of the economy. The main objective of these
reforms was to make the Indian financial system more responsive to the growing need of
finance and capital that followed the first generation reforms.

A] The First Phase or First Generation Reforms: These reforms measures were undertaken
in early 1990s. By this time, the government had already announced the structural reforms like
industrial sector reforms, foreign trade reforms and public sector reforms (LPG reforms). Soon
after India began to experience higher rate of growth as a result of these reforms, the first phase
of financial sector reforms were introduced. The objective was to liberalise the banking sector
and money market to increase availability of credit for the growing need of the business sector.
These reforms were designed essentially to promote greater efficiency in the economy. In this
phase the health of financial sector has recorded very significant improvement. The main
objective of the financial sector reforms in India was to create an efficient, productive and
profitable financial services industry. The Narasimham Committee I recommendations were
implemented in this phase to strengthen the banking system.

B] Second Phase or Second Generation Reforms: Second generation financial sector

reforms or the second phase of the reforms commenced in the mid-1990s and laid greater
emphasis on the strengthening the financial system on the introduction of the structural
improvements. Narasimham Committee II was to look into the extent of the effectiveness of
the implementation of reforms suggested by Narasimham committee I and was entrusted with
the responsibility to lay down a course of future reforms for the growth and integration of the
banking sector by adopting international standards. Many money market instruments were
introduced. Several very important capital market reforms were introduced like setting up of
SEBI and NSE, move to screen-based trading, dematerialisation of financial assets etc.

Both the phases of reforms changed the nature and characteristics of the financial sector
completely.

Objective of Financial Sector Reforms

1. To allocate the resources efficiently, increasing the return on investment and accelerate the
growth of the real sector in the economy.
2. ToCreate an efficient, competitive and stable financial markets that could contribute to
stimulate economic growth.
3. Relaxation of the external constraints in the operation of banking sector. Restructuring the
sector by encouraging new banks to enter and make the sector more competitive.
4. Reduce government control over the banking sector by deregulating interest rate and
giving greater functional autonomy to public sector banks.
5. Increase transparency in the banking system through the introduction of prudential norms
and adopting Basel standards.
6. Introduce new money market instruments to increase the depth of the market so that short
term funds are easily available.
7. Bring in transparency in the functioning of the stock exchanges.
8. Enabling the process of price discovery by the market determination of interest rates that
improves allocative efficiency of resources.
9. To prepare the financial sector to face international competition.
10. To empower financial market regulators to regulate and facilitate development of financial
markets and to ensure financial stability.

Banking Sector Reforms

The main aim of banking sector reforms was to promote a diversified, efficient and
competitive financial system with ultimate goal of improving the efficiency of
banking services.Some of the important banking sector reforms are:

1. Changes in CRR and SLR: One of the most important reforms includes the reduction
in cash reserve ratio (CRR) and statutory liquidity ratio (SLR). The SLR has been
reduced from 39% in 1990 to the current value (July 2020) of 18%. The cash reserve
ratio has been reduced from around 15 % in 1990 to 3% (July 2020) . This reduction in
the SLR and CRR has given banks more financial resources for lending to the
agriculture, industry and other sectors of the economy.

2. Changes in administered interest rates: Earlier, the system of administered interest

rate structure was prevalent in which RBI decided the interest rate charged by the
 banks. The main purpose was to provide credit to the government and certain priority
sectors at concessional rates of interest. The system has been done away and RBI no
longer decides interest rates on deposits paid by the banks. However, RBI regulates
interest on smaller loans up to Rs 2 lakhs on which the interest rate should not be more
than the prime lending rates.

3. Capital Adequacy Ratio: The capital adequacy ratio is the ratio of paid-up capital and
the reserves to the deposits of banks. The capital adequacy ratio of Indian banks had
not been as per the international standards. The capital adequacy of 8% on the risk-
weighted asset ratio system was introduced in India. Basel 3 norms are introduced in
India.

4. Allowing private sector banks: After the financial reforms were introduced, private
sector banks were encouraged to operate. Some of the new private sector banks like
HDFC Bank, ICICI Bank, IDBI Bank came into existence. This has brought much
needed competition in the Indian banking sector which was earlier dominated by public
sector banks. Foreign banks have also been allowed to open branches in India. Foreign
banks were allowed to operate in India using the following three channels:

o As foreign bank branches,

o As a subsidiary of a foreign bank which is wholly owned by the foreign Bank,

o A subsidiary of a foreign bank within maximum foreign investment of 74%

5. Reforms related to non-performing assets (NPA): NPAs are those loans on which
the loan instalments have not been paid up for 90 days. RBI introduced the income
recognition norms for NPAs. According to this norm, if the income on the assets of the
bank is not received in two quarters after the last date, the income is not recognised.
Recovery of bad debt was ensured through Lok Adalats, civil courts, tribunals etc. The
Securitisation and Reconstruction of Financial Assets and Enforcement of Security
Interest (SARFAESI) Act was brought to handle the problem of bad debts. In 2016,
the Insolvency and Bankruptcy Code was passed. It is the bankruptcy law which
seeks to consolidate the existing framework by creating a single law for insolvency and
bankruptcy. This is expected to go a long way in dealing with the problem of NPAs.
6. Elimination of direct or selective credit controls: Earlier, under the system of
selective or direct credit control, RBI controlled the credit supply using the system of
 changes in the margin for providing a loan to traders against the stocks of sensitive
commodities and to the stockbrokers against the shares. This system of direct credit
control was abolished and now the banks have greater freedom in providing credit to
their customers.
7. Promotion of microfinance for financial inclusion: for the promotion of financial
inclusion, microfinance scheme was introduced by the government, and RBI and
NABARD provided guidelines for it. The most important model for microfinance has
been the Self Help Group Bank linkage programme. It is being implemented by the
regional rural banks, cooperative banks, and scheduled commercial banks.

8. 10 Public Sector Banks Merged into 4

In a bid to strengthen the role of the public sector banks in the economy, the
Government of India rolled out the third round of bank merger plan under which merger
of ten public sector banks into four banks took place. As per the merger, selected
acquirer banks were to take over the allotted banks. Punjab National Bank was decided
to merge with Oriental Bank of Commerce, and the United Bank of India; Indian Bank
with Allahabad Bank, Canara Bank with Syndicate Bank, and Union Bank of India with
Andhra Bank and Corporation Bank.
By merging the PSBs, the Government aimed to reduce the number of PSBs, which can
help fulfill the vision of creating 3-4 global sized banks.
9. MCLR: The Reserve Bank of India introduced the MCLR methodology for fixing
interest rates from 1 April 2016. It replaced the base rate structure, which had been in
place since July 2010. The MCLR is the minimum interest rate that a bank can lend
at. MCLR is a tenor-linked internal benchmark, which means the rate is determined
internally by the bank depending on the period left for the repayment of a loan.
MCLR is closely linked to the actual deposit rates and is calculated based on four
components: the marginal cost of funds, negative carry on account of cash reserve
ratio, operating costs and tenor premium. Under the MCLR regime, banks are free to
offer all categories of loans on fixed or floating interest rates. Banks cannot lend at a
rate lower than MCLR.
10. Technology in banking: Initially, technology upgrade in banking took place with
introduction of ATMs and other computerised management system. Toady banking
technology has taken a new dimension with digital banking. A majority of banks have
 started offering almost all of their offline services on online platforms. Many Banks,
including the popular ones like SBI, Kotak Mahindra, and Axis Bank, planned to go
onboard with digital services by incorporating artificial intelligence and analytics in
their banking mechanism. Digital moves by the banks to shift towards the cashless
Economy, have uplifted the financial sector well, by providing access to easier
payments. E-commerce, mobile commerce, and online payments have been
successful. The development of UPI (Unified Payments Interface) in the year 2019 is
evident in the ease and convenience that digital payments provide users with.

Capital Market Reforms

Capital market is the market for borrowing and lending medium and long term funds. It is
market that is tapped primarily by industries for capital expenditure and restructuring and by
the government for infrastructure building. It is this segment of the financial system that
determines the level of investment and capital formation which in turn determines the rate of
GDP growth. Capital market reforms can be discussed as follows:

A] Government Securities Market Reforms

The market for government securities is the oldest and most dominant in terms of
market capitalisation, outstanding securities, trading volume and number of
participants. It not only provides resources to the government for meeting its short term
and long term needs, but also sets benchmark for pricing corporate paper of varying
maturities and is used by RBI as an instrument of monetary policy. Prior to the nineties,
G-sec market was virtually not visible as it used to operate under severe controls on
pricing of assets, segmentation of markets and barriers to entry, low levels of liquidity,
limited number of players, near lack of transparency, and high transactions cost.Major
reforms have been carried out in the government securities market. Before 1990s, the
government largely borrowed from the RBI in the form of deficit financing and from
banks at low rates of interest by making it statutory for banks to purchase government
securities under SLR. The high SLR reserve requirement led to the creation of a captive
market for government securities which were issued at low administrated interest rate.
 The following reforms were introduced to shift from a captive market for government
securities to a more open market.

Major reforms in the government debt market are:

1. The instruments in this segment are fixed coupon bonds, commonly referred to as dated
securities, treasury bills, floating rate bonds, zero coupon bonds and inflation index
bonds. Both Central and State government securities comprise this segment of the debt
market. All these instruments have undergone changes in the 1990s

2. The policy of automatic monetization of the fiscal deficit of government was phased
out in 1997 through an agreement between the government and RBI. Now the
government borrows money from the market through the auction of government
securities.

3. The government borrows the money at market determined interest rates which have
made the government cautious about its fiscal deficits.

4. The late nineties have seen the emergence of market based liquidity arrangement
through the Liquidity Adjustment Facility (LAF); expansion of the repo markets;
growth in the number and volume of secondary market transactions in G-sec

5. 182 days T-bills were introduced in November, 1986 on auction basis. The 182 days T-
bills were replaced by introduction of 364 days T-bills on fortnightly auction basis
since April, 1992. Subsequently, 91 days T-bills were introduced on auction basis in
January, 1993.Currently, 91 days T-Bills, 182 days T-Bills and 364 days T-Bills are
sold on auction basis.

6. Administrated interest rates on government securities were replaced by an auction

system for price discovery. T-Bills are auctioned by the RBI on behalf of the
government.

7. Foreign institutional investors were now allowed to invest their funds in the
government securities.

8. The government introduced the system of delivery versus payment settlement for
ensuring transparency in the system.
 9. The system of repo was introduced for dealing with short term liquidity adjustments.
10. Primary dealers were introduced as market makers in the government securities
market.

B] Equity and Corporate Debt Markets Reforms

1. Setting of Securities and Exchange Board of India (SEBI)Establishment of

Securities and Exchange Board of India (SEBI) SEBI became operational since 1992.
It was set with necessary powers to regulate the activities connected with marketing of
securities and investments in the stock exchanges, merchant banking, portfolio
management, stock brokers and others in India. The objective of SEBI is to protect the
interest of investors in primary and secondary stock markets in the country.
2. Dematerialisation of Shares:Dematerialisation of shares has been introduced in all the
shares traded on the secondary stock markets as well as those issued to the public in the
primary markets. Even bonds and debentures are now in demat form. The advantage of
demat trade is that it involves paperless trading.
3. Screen Based Trading: The Indian stock exchanges were modernised in 90s, with
computerised Screen Based Trading System (SBTS) which helps to down trading time,
cost, risk of error and fraud and there by leads to improved operational efficiency as
well increase volume of trade. The trading system also provides complete online market
information through various inquiry facilities. This has increased investor participation.
4. Establishment of National Stock Exchange (NSE): The setting up to NSE is a
landmark in Indian capital markets. At present, NSE is the largest stock market in the
country. Trading on NSE can be done throughout the country through the network of
satellite terminals. NSE has introduced inter-regional clearing facilities.
5. Investor Protection: The central government has notified the establishment of
Investor Education and Protection Fund (IEPF)with effect from 1st Oct. 2001. The
IEPF is utilised for promotion of awareness amongst investors and protection of their
interests. The sources of funds for IEPF are amounts in unpaid dividend accounts of
companies, application moneys received by companies for allotment of any securities
and due for refund, matured deposits and debentures with companies and interest
accrued there on, if they have remained unclaimed and unpaid for a period of seven
years from the due date of payment.
6. The National Securities Clearing Corporation Limited (NSCL): The NSCL was set
up in 1996. It guarantees all trades in NSE since July 1996. The NSCL is responsible
for post-trade activities of NSE. It has put in place a comprehensive risk management
system, which is constantly monitored and upgraded.
7. Trading in Central Government Securities: In order to encourage wider participation
of all classes of investors, including retail investors, across the country, trading in
government securities has been introduced from January 2003. Trading in government
securities can be carried out through a nationwide, anonymous, order-driver, screen-
based trading system of stock exchanges in the same way in which trading takes place
in equities
8. Credit Rating Agencies: Various credit rating agencies such as Credit Rating
Information services of India Ltd. (CRISIL– 1988), Investment Information and credit
Rating Agency of India Ltd. (ICRA – 1991), etc. were set up to meet the emerging
needs of capital market. They also help merchant bankers, brokers, regulatory
authorities, etc. in discharging their functions related to debt issues.
9. Buy Back Of Shares: Since 1999, companies are allowed to buy back their shares.
Through buy back, promoters reduce the floating equity stock in market. Buy back of
shares help companies to overcome the problem of hostile takeover by rival firms and
others.
10. Derivatives Trading: Derivatives trading in equities started in June 2000. At present,
there are four equity derivative products in India stock futures, stock pptions, index
futures and index options. Derivatives trading is permitted on two stock exchanges in
India i.e. NSE and BSE. At present in India, derivatives market turnover is more than
cash market
11. PAN Made Mandatory: In order to strengthen the KYC norms and to have sound audit
trail of transactions in securities market, PAN has been made mandatory with effect
from January 1, 2007.
12. Access to Global Funds Market: Indian companies are allowed to access global
financial markets and benefit from the lower cost of funds. They have been permitted
to raise resources through issue of American Depository Receipts (ADRs), Global
Depository Receipts (GDRs), Foreign Currency Convertible Bonds (FCCBs) and
External Commercial Borrowings (ECBs). Further Indian financial system is opened
up for investments of foreign funds through Non-Resident Indians (NRIs), Foreign
Institutional investors (FIls), and Overseas Corporate Bodies (OCBs)
 13. Mutual Funds: Mutual Funds are an important avenue through which millions of retail
investors participate in the securities market. As an investment intermediary, mutual
funds offer a variety of services andadvantages to small investors. SEBI has the
authority to lay down guidelines and supervise and regulate the working of mutual
funds.
14. Development of Venture Capital Funds: Venture capital represents financial
investment in highly risky projects with a hope of earning high returns. After 1991,
economic liberalisation has made possible to provide medium and long term funds to
those firms, which find it difficult to raise funds from primary markets and by way of
loans from FIs and banks.
15. Multi Commodity Exchange of India Ltd (MCX): MCX is an
independent commodity exchange based in India. It was established in 2003 and is
based in Mumbai. It is India's largest commodity derivatives exchange where the
clearance and settlements of the exchange takes place. MCX offers options trading in
gold and futures trading in non-ferrous metals, bullion, energy, and a number of
agricultural commodities (mentha oil, cardamom, crude palm oil, cotton, and others).

Evaluation of Financial Sector Reforms

Since the initiation of reforms in the early 1990s, the Indian economy has achieved high GDP
growth rate in an environment of macroeconomic and financial stability. India has achieved
this acceleration in growth while maintaining price and financial stability. Some of the major
outcomes of the financial sector reforms are:

1. After the financial sector reforms, the resilience and stability of Indian economy have
increased. The GDP growth rate has increased from below 5% per annum, before 1990s
to more than 6% per annum.

2. The banking sector and insurance sector have grown considerably. The entry of private
sector banks and foreign banks brought much-needed competition in the banking
sector which has improved its efficiency and capability. All these have benefited the
customer with diversified options.

3. The stock exchanges of the country have seen growth and stability, and they
haveadopted international best practices.
 4. RBI has effectively regulated and managed the growth and operations of the non-
banking financial companies of India. The SEBI has played a significant role in
providing depth and breadth to the capital market and regulating it effectively. There
have a reduction in capital market scams in recent years.

5. The budget management, fiscal deficit, and public debt condition have improved after
the financial sector reforms.

6. As a result of the growing openness, India was not insulated from exogenous shocks
since the second half of the 1990s. These shocks, global as well as domestic, included
a series of financial crises in Asia, Brazil and Russia, 9/11 terrorist attacks in the US,
border tensions, sanctions imposed in the aftermath of nuclear tests, political
uncertainties, changes in the Government, and the current oil shock. Through these
shocks, stability could be maintained in financial markets.

7. The growth and development of the capital market has resulted in significant
mobilisation of households’ savings into the market through mutual funds and stocks.
Greater transparency and availability of market information has increased confidence
of the small investors. This has gone a long way in channelizing savings into
productive investments.

8. However, all the issues of Indian economy have not been resolved. The social sector
indicators such as the provision of health facilities, quality of education,
empowerment of women etc. have not been at par with the economic growth.

9. Further, the new issues like the recent rise in non-performing assets of banks, slow
growth of investments in the economy, the issues of jobless growth, high poverty rate,
a much lower growth rate in the agriculture sector etc. need to be resolved with more
concrete efforts.

The process of financial sector reforms is an ongoing one. While India’s financial system needs
are growing both quantitatively and qualitatively, the current regulatory mechanism still cause
problems to smooth flow on funds required to achieve the full growth potential of the economy.