Indian Financial System - Introduction And Developments
Financial Market Practice / Education

Indian Financial System – Introduction And Development

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Introduction To The Indian Financial System

The financial system of a country is critical for its development and growth. In the contemporary era of Globalization, it is critical to align the economic structure in line with the developed economies. At the same time, the core objective of the Indian Financial System needs to cater to the growth and development of India. The Indian Financial System has evolved over the past several decades since independence. Before identifying the core developments in the Indian Financial System, let us understand the constitution of a Financial System. In this post, we shall introduce the financial system and its components, as well as their interdependencies.

A system is a collection of components [usually referred to as sub-systems] that interact with each other. A Financial System is a comprehensive integration of many sub systems, comprising of Financial Institutions, Markets, Instruments and Services that facilitate the efficient and effective transfer, allocation and utilization of resources/funds.

The Different Components/Sub-Systems Of A Financial System Are As Follows:

    • Financial Markets
    • Financial Institutions
    • Financial Assets/Instruments
    • Services

The Financial System of any economy provides the foundation for growth and development. Countries that are rich in resources – be it natural, human or any other form – require to plan and strategize the development of their financial systems.

The Government and business entities [including corporate, banks, financial institutions, etc.] require capital for investment and operations. On the other hand, the householders / general public are net savers of capital and hence, deposit their savings in banks and financial institutions. In this process, this capital is channelized [either directly or through the financial intermediaries such as banks and financial institutions] to the entities that require capital.

A robust Financial System ensures that adequate management control systems are in place to ensure that this process of transfer of funds is transparent. The effectiveness of a financial system is in ensuring that there is no misuse of funds, as well as no default by any of the entities in the financial system. This is extremely important, due to the fact that if there is a default by any of the entities, this would result in a lack of confidence among market participants.

Thus, a financial system facilitates transfer of funds from entities that are in surplus to entities that are in deficit. This transfer of funds occurs either directly or through the financial intermediaries.

The entities that are having a deficit of funds can sell “financial claims” in the form of instruments on themselves. These “financial claims” are in form of bonds and treasury bills issued by Government, debentures, shares and commercial papers issued by corporate, fixed deposit receipts and savings bonds issued by banks/financial institutions, mutual funds issued by Asset Management Companies, etc.

These instruments can be bought by those who have surplus funds, either directly or through intermediaries. The reason for buying these instruments may be as follows:

    • Household savings would be safer in the hands of Government Institutions that guarantee repayment of funds – both principal and interest accumulated over a period of time.
    • Returns linked to the risk involved in the investment vehicles depending on the risk appetite of the depositor – this provides supplemental income to the surplus funds holder [Note that idle money has opportunity cost].
    • Opportunity to save on tax by investing in specific instruments applicable for tax exemption / rebate.
    • Need for insurance to mitigate risk – life insurance and general insurance [e.g., motor vehicle insurance, home insurance, etc.]
    • Diversification of asset base for the investor.

 

Benefits Of Direct Transfer Of Funds

An entity requiring funds can sell the instruments directly to the entities that have surplus funds. This method is more cost efficient as it ensures that there are no intermediaries between the investor of funds and the user of funds.

 

Transfer Of Funds Through Financial Intermediaries

Usually large corporate, banks and financial institutions have economies of scale by distributing the financial products through specific channels of distribution, including banks and post offices. This increases the geographical reach for the issuer and hence, minimizes the costs. For example, an investor living in a remote village can deposit his savings in a post office, i.e., more easily accessible.

Another benefit of an investor availing the services of financial intermediaries is the advisory services for wealth management. The layman investor who may require guidance for investing in different markets can avail the services of wealth management experts in financial intermediaries. Such advisory services should be impartial and transparent in providing information to investors.

 

Capital Flow In An Economy

The surplus funds generated as a result of earnings is either invested or saved in either the economy. The funds subsequently flow into business activities for production of goods and services, infrastructure growth and other developmental activities.

Funds are invested in the capital and money markets, foreign exchange markets, commodity futures markets, banks/financial institutions and other intermediaries offering financial services or in the real economy in the form of physical commodity, real estate, etc. Ultimately, the funds are channeled towards production of goods, providing services, developing infrastructure and other economic activities, leading to the overall growth and development of the economy.

 

Financial Markets

“Market” is conventionally defined as a place where buyers and sellers meet to exchange goods, services or even financial products / instruments for a consideration. This consideration is usually money. In an Information Technology enabled environment, buyers and sellers from different locations can transact business in an electronic market place. Hence, the physical market place is not necessary for the exchange of goods or services for a consideration. Electronic trading and settlement of transactions has created a revolution in global financial and commodity markets.

Markets can also be defined as channels through which buyers and sellers exchange goods, services and resources. Markets may be classified as follows:

    • A product market where goods and services are traded.
    • A factor market where labor, capital and land are exchanged.
    • A financial market where financial claims are traded.

A Financial Market is a system of processes and functions that are usually regulated by means of rules and guidelines for enabling participants to transact in financial products and instruments [“Financial Claims”]. In the process of the continuous interaction between the different entities that provide the demand and supply of these financial claims, the “fair value” of the “financial claim” is “discovered“. This is also referred to as price discovery.

Traditionally, transactions used to take place only in unorganized market places. These unorganized market places were not subject to specific rule or regulation. When countries developed and as economies evolved, the need to regulate markets in order to remove distortions and to facilitate free flow of funds gave rise to regulatory bodies. The concept of organized markets evolved in order to entrust confidence among market participants.

The Traditional Organized Financial Markets In India Are:

    • Money Markets
    • Capital Markets
    • Equity Markets
    • Debt Markets

Other emerging organized securities markets in India [that have played a significant role in the last decade] are the organized commodity markets [for exchange traded commodity futures] launched in 2003 and organized currency markets [for exchange traded currency futures] launched in August, 2008.

The capital markets comprise of the equity markets and debt market. New equity stock offering is issued in the primary market. Corporates issue new equity stock for raising capital towards expansion of business activities. The stocks that are issued are subsequently listed on the Indian Equity Exchanges – NSE, BSE and other regional exchanges – which comprises the secondary markets.

The components of the Indian Financial Markets include not only the capital markets and money markets, but also the foreign exchange markets, Insurance / PF / Pension Fund markets, Loan markets and Savings and Investment markets.

 

Developments In The Indian Financial System

Having analyzed the different components of the Indian Financial System and their interdependencies as well as the criticality of capital flows for the overall growth and development of economy, we shall identify the major developments in the Indian Financial System, during the past several decades.

In the pre-independence era, the securities market was devoid of financial institutions that could provide long term financing for the industry. This restricted the access to savings / funds for the industry. Generally, for growth to take place, investments need to be made. Due to the absence of a robust financial system, the lack of capital flows affected growth and development.

In the post independence era from 1947 to middle of 1980’s, planned economic development in the form of the five-year plans [which commenced in 1951] ensured development of infrastructure. The introduction to economic planning led to distribution of economic resources. This had implications for the growth and development of the country.

Nevertheless, the mixed economy followed by the Government of India led to protectionist policies. There were restrictions on imports, exports and manufacturing [based on license quota]. The dominant fear of market failure provided the rationale for active state intervention in the financial system. But until end of 1980’s, the five year plans largely ignored the role of financial system in the development process.

Due to the lack of transparent market mechanism to facilitate price discovery, the financial system in India had a limited role in the overall development. In the ninth 5-year plan, it was widely recognized that the transformation of savings into investments could be largely facilitated by way of financial intermediation.

The Government of India nationalized privately owned banks into Government-owned enterprises. This was aimed at ensuring equitable growth of the entire economy to benefit all sections of the economy. Following are the major events pertaining to restructuring the financial system in the post-independence era:

    • 1948: Reserve Bank of India was nationalized.
    • 1956: State Bank of India was established by takeover of the then Imperial Bank of India.
    • 1956: Over 245 life insurance companies were nationalized to form the Life Insurance Corporation of India [LIC].
    • 1969: Nationalization of 14 major commercial banks.
    • 1972: The General Insurance Corporation was established.
    • 1980: Six more commercial banks were nationalized.

The nationalization of banks resulted in significant changes in the banking system. The need to establish systems and processes based on which lending is permissible towards assisting corporates to access working capital lead to the formation of the Tandon Committee [1974] and Chore Committee [1980]. These committees enabled specifying norms for credit lending.

New Financial Institutions for term lending facilities were established. These institutions were both at Central Government level and State level. This also resulted in the formation of the Unit Trust of India [an investment trust organization]. Also, the pension and provident funds were brought under Government control in terms of regulations governing their investments. Thus, the entire financial system was controlled by the Government.

Establishment of Development Banks / Financial Institutions / Term Lending Institutions ensured availability of credit for industry. The Government intervention also ensured that capital was disbursed in areas of priority – in other words, capital was directed towards development. Following are the major events associated with establishment of Government-owned entities, for the development of the Indian Financial System:

    • 1948: Industrial Finance Corporation of India was established.
    • 1951: Under the State Financial Corporation Act, financial institutions at the state-level [State Financial Corporation or the SFC] were established. These institutions aided the small and medium scale enterprises.
    • 1954: The National Industrial Development Corporation [NlOC] was established for a more dynamic involvement in industrial growth.
    • 1955: The Industrial Credit and Investment Corporation of India [ICICI] Ltd. was established as a development banking institution. This pioneered underwriting of capital issues and channelization of foreign currency loans from the World Bank to private industry.
    • 1958: The Refinance Corporation of India [RCI] was created to provide refinance to banks against term loans granted by them to medium and small enterprises. This entity later merged with the Industrial Development Bank of India [lDBI] in 1964.
    • 1964: Establishment of Industrial Development Bank of India [IDBI] as a subsidiary of RBI. IDBI not only disbursed funds towards planned economic development, but also coordinated the activities of all other financial institutions. IDBI was delinked from RBI in 1976 and was converted into a holding company.
    • 1971: The Industrial Reconstruction Corporation of India [IRCI] was established jointly by IDBI and LIC, to look after rehabilitation of sick mills. This was renamed as the Industrial Reconstruction Bank of India in 1984. This was once again converted into a full-fledged public financial institution [PFI] and was renamed as the Industrial Investment Bank of India in 1997.

The establishment of the State Industrial Development Bank of India [SIDBl], State Industrial Investment Corporations [SIIC] and the Technical Consultancy Organizations [TCO] at the state level ensured percolation of benefits to the grassroots levels of the society. This also aided in reviving growth and development of the Indian economy.

Commercial Banking between 1950 and 1985 saw the utilization of short term deposits to fund trade and commerce. Industrial financing accounted for a small fraction of the total bank credit. RBI attempted to orient the operations of the commercial banking activities towards the growth and development of the Indian economy. Control of the macroeconomic variables under the purview of central bank enabled selective credit controls and moral suasion. This ensured that commercial banking activity supplemented the impact of development banks on industrial growth. Commercial banks were encouraged to underwrite new corporate issues and also provide term-lending facility. Their exposures in these areas were refinanced by the Refinancing Corporation of India. Joint underwriting by a consortium of banks and insurance companies mitigated risk to a large extent. Banks also extended financial assistance by investing in shares / debentures of corporate enterprises. Commercial banks were also encouraged to increase their exposure to small scale industries, exports and agriculture.

Credit Guarantee Corporation [CGO] was established to cover all credit made available to small scale industries as part of the Credit Guarantee Scheme [CGS]. For encouraging credit towards export-oriented units, the Export Credit and Guarantee Corporation [ECGC] was established [this was earlier known as the Export Risk Insurance Corporation]. Agricultural financing was guaranteed by the Agricultural Refinance Corporation [ARC] which was established in 1963. The ARC provided refinance for all Agri-loans made by banks and financial institutions.

In order to protect investors, apart from establishing the financial institutions, a comprehensive legal framework was created, as follows:

    • Companies Act, 1956.
    • Capital Issues [Control] Act, 1947.
    • Securities Contract [Regulation] Act, 1956.
    • Monopolies and Restrictive Trade Practices Act, 1970.
    • Foreign Exchange Regulation Act, 1973

The G.S. Patel Committee on stock exchanges reforms was appointed in 1984. This led to the establishment of the Securities Exchange Board of India [SEBI] in 1988.

 

Components Of Indian Financial Market

    • Capital Markets: Comprises equity markets, debt markets, derivatives. Market participants include Financial Institutions, High Net worth Individuals [HNI] and even Retail Investors.
    • Money Markets: Short-term debt securities issued by Government [Treasury Bills], Commercial Paper, Certificate of Deposits, Repo and Reverse Repo Transactions, etc. Banks, Primary Dealers, HNI, Mutual Funds, Insurance Companies, Pension Funds are the major participants.
    • Foreign Exchange Markets: Dealing in foreign currency by importers and exporters with authorized forex dealers such as banks. This also lately includes currency futures traded on exchange platform. Participants are banks, corporate [Importers/Exporters].
    • Loan Markets: Consists of commercial and retail loans to corporate and non corporate borrowers. Loans are issued by intermediaries such as banks with surplus funds.
    • Insurance/Pension Fund: Business of selling Insurance products / Retirement products and deploying such funds for investment purposes. Institutions include LIC, GIC and other insurance companies, pension funds.
    • Savings, Investments Market: Consists of Commercial and retail savings. Major players are banks, financial institutions and finance companies, mutual funds, chit funds, nidhis, etc.

In this post, we have analyzed the developments in the Indian Financial System in the post-independence era up to the commencement of liberalization of the Indian economy. This is critical for understanding the evolution of the Indian Financial System over several decades of the twentieth century.

 

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