Structure of Financial Institutions Framework – Business Environment (2024)

1. Learning outcomes

After reading this chapter you should be able:

To understand the concept of financial sector and its classification. To understand the salient Features of Indian financial sector.To understand the role played by various financial institutions in the Indian economy. To explain the importance of financial sector for smooth and uninterrupted running of the economy.

Introduction

In the year 1991, the Indian economy has witnessed tremendous reforms in financial sector. The Indian economy was going through severe crisis and was at the verge of collapse. To overcome that crisis the government undertook some major structural reforms in all the major spheres, be it monetary policy reforms, industrial reforms, foreign trade policy, or insurance sector reforms in the name of liberalization, globalization and privatisation (LPG). These reforms provided strong foundation to strengthen the Indian financial sector.

Financial sector plays the Vitol role in the overall development of an economy. It acts as a channel for the transfer of resources from those who have idle funds to those who are in need i.e. from those who have surplus funds to those who are in shortage of funds. Financial sector is the most important transformational engine for the economic development and growth. It bridges the gap between the level of savings and the level of investment for the creation of new wealth (capital formation) by transfer of funds from savers to investors through financial intermediaries that sets the pace for the accomplishment of broader macroeconomics objectives. It acts as the spark in the fire of economic development and growth. Financialsector ensures the adequate supply of funds in the economy to enable full utilisation of national resources while keeping check on price level changes. It is a composition of various markets, institution, laws and regulatory authorities.

The process of saving, finance and investment the enables the user of funds and lender of funds to exchange funds is done through financial sector. Thus financial sector is a sector that enables the smooth flow of funds between lenders and borrowers. Financial sector consist of set of institutions, markets and institutions and it also includes legal and regulatory framework which is the most important component of financial sector. A well-developed financial sector is the foundation for growth and prosperity of any economy. A healthy financial sector is the key element in keeping economy stable. The savings of the one sector becomes source of finance for another sector through the intermediaries which leads to capital formation leading to increased national income for the country.

The financial sector provide financial services to commercial and retail customers; this sector includes banks, insurance companies, investment funds, and real estate. The part of an overall economy that is primarily made up of banking institutions, brokers and money markets. The finance sector is a very important aspect of big and highly developed economies, such as those in the United States, Japan and Switzerland the United Kingdom.

Meaning:-

Indian Financial Sector – The way forward

Financial sector reforms can be categorized in 2 phases. The first phase of reforms that started in 1985 mainly focused on new technology import, increasing productivity, and effective use of human resources. The second phase, start in 1991-92, the government aimed at reducing fiscal deficit by opening the economy to overseas investments. Financial sector reforms during 1991-92 focused on, improvement in financial health of the entities , creation of a competitive environment modification of the policy framework, improvement in financial health of the entities and creation of a competitive environment. The last decade witnessed a significant expansion of financial markets with the introduction of products in banking, insurance, several new instruments and capital markets space. During this phase, the Indian financial sector opened up to new private players including overseas companies.

Financial Sector of India–Eligibility for government autonomy

For acquiring government autonomy in India there are certain criterions that are required to be fulfilled

1. Accessibility of total non-performing wealth of below 9%

2. Availability of sufficient fund of up to 8%

3. Minimum net possessed funds of more than USD 2.5 million and net revenues of minimum past three years.

4. Financial institutions that satisfy the above mentioned will be authorized for functional independence in almost all managerial areas.

3. Features

I.Promotion of liquidity: – the major function of the financial sector is the provision of money at the time when it is required and in the adequate quantity to facilitate the smooth production of goods and services. Financial sector ensures adequate liquidity in the economy which is essential for the proper functioning of any developing economy.

III.Allocation of risk: – though the risk cannot be eliminated altogether but it helps in minimising the risk. It ensures optimum allocation of the risk by bringing it within acceptable limit by spreading it among the large number of people.

IV. Accelerates the pace of economic development:- financial sector accelerates the growth rate of economic development as it finances industrial sector of the economy by way of giving long term, medium term and short term loans. It not only looks after the financial requirements of secondary and tertiary sector but also caters to the requirements of primary sector which is dominant sector of Indian economy.

V.Leads to capital formation: –as financial sector mobilises the idle savings of the household sector and puts it into productive use leading to capital formation in the economy. Therefore leading to capital asset formation which is part and parcel of economic growth.

VI.Size transformation: – they create large volume of credit from small deposits that they receive from their customers. Credit creation is one of the most significant functions performed by financial sector. It helps in maintaining adequate amount of liquidity in the market all the time.

VII.Maturity transformation: –they offer their customers alternative forms of deposits and investment schemes according to their risk taking ability, expected returns and liquidity preference. And at the same time provides borrowers, funds of required maturity

VIII.Inculcates saving habits among people: -it encourages saving habits among people by offering them wide range of financial assets according to their needs and requirements. These investment opportunities have led to increased level of savings and increased level of investments from the same level of monetary income.

IX.Savings mobilisation: -financial sector is highly efficient system for mobilising the savings of household sector. Saving mobilisation takes place when currency, bank deposits and post office savings are put to productive uses.

X.Sectorial allocation of funds: – it ensures the sectorial allocation of funds on the basis of their priority in the national plans for the achievement of various microeconomics and macroeconomics objectives of the nation.

Structure of Indian Financial System

The Indian financial system can be classified into the organized financial system and the unorganized financial system. The organised financial system comes under the purview of the Ministry of Finance (MOF), Securities Exchange Board of India (SEBI) Reserve Bank of India (RBI), and other regulatory bodies.

The unorganised financial system consists of:

(i) Individual money lenders such as relatives, land lords, traders, neighbours, store owners and so on.

(ii) Groups of persons operating as funds or ‘associations’.

(ii) Partnership firms consisting of brokers, and non banking financial intermediaries such as finance, chit fund companies, investment.

Organised financial system

Components of formal financial system

Formal financial system consist of four segments, these are-

1. Financial institutions,

2. Financial markets,

3. Financial instruments

4. Financial services.

Financial institutions

Financial institutions are intermediaries that mobilize the savings and facilitate the allocation of funds in an very efficient manner. Financial institutions are classified as banking and non banking institutions. Banking institutions are creator of credit while non banking financial institutions (NBFI) are purveyors of credit. In India non banking financial institutions (NBFIs) such as Non Banking Financial Companies (NBFCs), Development Financial Institutions (DFIs) and as well as Housing Finance Companies (HFCs) are the major institutional purveyors of credit.

9. National Bank for Agricultural and Rural Development (NABARD) 10.National Housing Bank (NHB)

11.Investment institutions in the business of mutual funds (UTI, Public Sector and

12.Private Sector Mutual Funds)

13.Insurance activity (LIC, GIC and 67 its subsidiaries) .

There are some state level financial institutions such as State Financial Corporation and State Industrial Development Corporation (SIDCs) which are owned, managed and controlled by the State Governments.

Financial markets

Financial market is an instrument enabling participants to deal in financial claims. Money market and capital market are the organized financial markets in India. Money market is for short term securities while capital market is for long term securities.

Capital Market- It is that segment of financial market in which securities having long maturities are traded and is used as the means for borrowing and lending in long term. Capital market securities consist of equity, preference, debentures and bonds. Government or corporate sector raises funds to finance its activities from capital market. Further the capital markets may also be divided into primary markets and secondary markets. Newly formed securities are bought or sold in primary markets, such as during initial public offerings (IPOs).On the other hand Secondary markets allow investors tobuy and sell existing securities. The transactions in primary markets exist between issuers and investors and the transaction in secondary market exists among investors.

Money market:-Money market deals in securities having maturity period of less than one year. It is used as means of short term borrowing and lending. Money market instruments are also as cash investments as they offer high liquidity and are having very short maturity period. Commercial papers, certificate of deposits, treasury bills, bankers’ acceptance, euro dollars, repurchase agreements, municipal notes and federal funds are type’s money market instruments.

Role in the economy

A financial market helps the economy in the following manner.

Saving mobilization: The most important role of financial market is to obtaining funds from the savers or surplus fund from the unit such as household individuals, business firms, public sector units, central government, state governments etc.

Investment: Financial markets play an important role in arranging to invest funds.

National Growth: financial market is that, which helpful to contribute to a nation’s growth by ensuring unfettered flow of surplus funds to deficit units. Flow of funds for productive purposes is also made possible.

Entrepreneurship growth: Financial market also contribute to the development of the entrepreneurial claw by making available the necessary financial resources.

Industrial development: The different components of financial markets help an accelerated growth of industrial and economic development of a country, thus contributing to raising the standard of living of the society.

Function of financial Market

The intermediary functions of financial markets include the following:

Transfer of resources: Financial markets helpful in transfer of real economic resources from lenders to ultimate borrowers.

Enhancing income: Financial markets allow lenders to earn interest or dividend on their surplus invisible funds, which is further helpful in contributing to the enhancement of the individual and the national income.

Productive usage: Financial markets allow for the productive use of the funds borrowed. The enhancing the income and the gross national production.

Capital formation: Financial markets provide a channel through which savings flow to assist capital formation of a country.

Price determination: Financial markets play a very important role in the determination of price of the traded financial assets through the interaction of buyers and sellers.

Sale mechanism: Financial markets is that instrument which helpful in selling of a financial asset through an investor in order to offer the benefit of marketability and liquidity of such assets.

Information: The activities of the participants in the financial market helpful in dissemination of information to the various segments of the market in order to reduce the cost of transaction of financial assets.

Financial instrument

Financial instrument is a claim against a person or an financial institution for the payment at a future date or a periodic payment in the form of dividend and interest. Financial instruments may be primary or secondary securities. Primary securities are issued by the ultimate borrowers of funds to the ultimate savers e.g. Mutual Fund Units, Insurance Policies, Bank Deposits, etc. It help the financial markets and the financial intermediaries to perform the important role of channelizing funds from leaders to borrowers.

Financial instruments can be either cash instruments or derivative instruments:

Cash instruments — Cash instrument are those instruments whose value is determined directly by the markets. These instruments can be securities, which are readily transferable, such as loans and deposits, where both borrower and lender have to agree on a transfer.

Derivative instruments —Derivative instrument are those instruments which derive their value from the value of one or more underlying entities such as an asset, index, or interest rate. They can be over-the-counter (OTC) derivatives and exchange-traded derivatives and [2]

Alternatively, financial instruments may be categorized by “asset class” depending on whether they are equity base or debt based.

Short-term debt-based financial instruments last for one year or less. Cash of this kind can be deposits and and Securities come in the form of T-bills and commercial paper. Exchange-traded derivatives under short-term debt-based financial instruments can be short-term interest rate, futures. OTC (over the counter) derivatives are forward rate agreements.

Long-term debt-based financial instruments last for more than one year. Under cash these are loan and under securities, these are bonds. Exchange-traded derivatives(ETD) are bond futures and option. OTC(over the counter) derivatives are interest rate swaps, interest rate caps and floors, interest rate options, and exotic derivatives.

Under equity-based financial instruments security are stocks. Exchange-traded derivatives (ETD) in this category include stock options and equity futures. The OTC (over the counter) derivatives are stock options and exotic derivatives.

Financial Services

Financial services is the term used to describe the institutions and organisations that deal with the management of the money. They provide expert advice on financial planning, money management, investment management, insurance plans and dealing in foreign exchange and many more. Financial services include hire purchase, credit rating merchant banking, leasing, hire purchase, credit rating etc. Financial services rendered by the financial intermediaries’ bridge the gap between lack of knowledge on the part of the investors and increasing superiority of financial market and instruments.

Financial sector contribution to growing economy

Indian economy is considered as the top growing economies in the world. Financial services sector is one of the most distinguished sectors of Indian economy. Financial sector’s contribution comes across even more strong when we look at total number of employment and tax revenue that it generates. Employment generated by banking and insurance sector every year runs in millions. While employment generation and revenue are two very important contributions to overall economy and is another important contribution of financial sector. Banks and non banks in India have been discharging credit in billions to big or small industries, entrepreneurs etc every financial year. With superior availability of credit, the Indian economy during last two decades has managed to march toward higher economic growth and development.

Recent Indian reforms for the growth of financial sector