Module: 27, Structure of Financial Institutions Framework

Paper: 12 BUSINESS ENVIRONMENT

Principal Investigator

Co-Principal Investigator

Paper Coordinator

Content Writer

Prof. S P Bansal Vice Chancellor Maharaja Agrasen University, Baddi

Prof Yoginder Verma

Pro–Vice Chancellor Central University of Himachal Pradesh. Kangra. H.P.

Prof. Manjit Singh Professor, School of Applied Management, Punjabi University, Patiala (Pb)

Prof. Manjit Singh Professor, School of Applied Management, Punjabi University, Patiala (Pb)

Structure of Financial Institutions Framework

1 Objectives

2 Introduction

3 Meaning and overview of financial sector

4 Features

5 Structure of Indian financial sector

6 financial institutions

7 Summary

8 Terminal and model questions

Quadrant 1

Lesson

Structure of financial institutions framework (India)

Structure

1 Objectives

2 Introduction

3 Meaning and overview of financial sector

4 Features

5 Structure of Indian financial sector

6 financial institutions

7 Summary

8 Terminal and model questions

Quadrant- I

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. Financial

sector 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.

Working of financial sector

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:-

savings

intermedaries

investmentseconomic

growth

income generation

Financial sector is the set of institutions, markets, instruments and legal and regulatory

framework that permits the flow of credit in the economy. This segment of economy

encompasses banking services, business, stock and commodity market exchanges, financial

and investment services and mortgage and personal lending.

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.

II. Brings savers and investors to the common platform: -important function of the

financial sector is to bring savers and investors together to facilitate efficient and

effective mobilisation and allocation of resources. It gives savers an opportunity to

invest their idle saving and earn returns on the same while at the same time making

funds available to those who need them for the productive purposes.

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.

Financial institutions are further classified as Term Finance Institutions such as

1.Industrial Development Bank of India (IDBI),

2.Industrial Credit and Investment Corporation of India (ICICI)

3.Industrial Financial Corporation of India (IFCI),

4.Small Industries Development Bank of India (SIDBI)

5.Industrial Investment Bank of India (IIBI). Export Import Bank of India (EXIM)

6.Tourism Finance Corporation of India (TFCI)

7.ICICIVenture

8.Infrastructure Development Finance Company (IDFC)

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 to

buy 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

1) In 2015, RBI set up the much anticipated ‘payment bank’ sector. It awarded payment bank

licenses to eleven entities. Along with redefining consumer experience, these banks are

further helpful to growth of financial sector as well as to overall Indian economy.

2) In order to make banks extra ‘credit friendly’, RBI (Reserve Bank of India) has allowed

banks to raise funds through long-term bonds for financing the infrastructure sector.

3) In 2015 Indian government raised the cap of FDI (Foreign Direct Investment) in insurance

sector by 49%.

4) Recently, Indian government started Mudra Scheme, under which Indian banks will be

providing affordable and cheap credit to new & small entrepreneurs.

Summary

Financial sector 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. It plays crucial role in the economic growth

and development of any economy. It not only extends financial support to the industrial

sector of the economy but also plays greater role in the overall growth and advancement

of all the spheres of the economy. The financial intuition not only brings borrowers and

lenders of money to common place but also ensures the safety of transaction. Regulatory

authorities work as watch dog to supervise, control and coordinate the working of these

institutions. Specialised institutes’ like NABARD ensures the growth and development

of rural economy and primary sector while on the other hand IDBI and IFCI caters to the

financial needs of large scale industries. As these institutes are working at national level,

SFCs and SIDCs/SIICs are performing the same function at state level. So Financial

sector acts as the spark in the fire of economic development and growth.