Indian Financial System CBCFB4T06

Syllabus topics (RTMNU)

• Indian Financial System: An overview
• Structure and Functions of the Indian Financial System
• Financial System and Economic Development
• Current Scenario of IFS
• Constituents of IFS: Financial Markets, Financial Instruments, Financial Institutions and Financial Services
• Money Market: Features, Objectives, Reforms and Role
• Money Market Instruments: Treasury Bills, Certificate of Deposits, Commercial Paper, Call Money Market, Commercial Bills

Indian Financial System: An Overview

Definition: The financial system is the set of institutions, markets, instruments and services through which savings of people are collected and given to those who need funds for investment.

In simple words, the financial system is a bridge between savers (households who have surplus money) and investors/borrowers (business firms and government who need money). The Indian Financial System (IFS) works under the control of regulators like the RBI, SEBI, IRDAI and PFRDA.

Structure and Functions of the IFS

The IFS can be divided into two sectors:

1. Organised sector – regulated institutions such as RBI, commercial banks, co-operative banks, regional rural banks, NBFCs, insurance companies, mutual funds and stock exchanges.
2. Unorganised sector – money lenders, indigenous bankers (Shroffs, Multanis, Chettiars), pawn brokers and chit funds that work with little or no regulation.

Functions of the financial system:

1. Mobilisation of savings – collects small savings of people through deposits, insurance, mutual funds, etc.
2. Allocation of funds – gives these funds to productive uses like industry, agriculture and infrastructure.
3. Payment system – provides cheques, NEFT, RTGS, UPI and cards for easy payment.
4. Liquidity – allows people to convert investments into cash quickly (e.g. selling shares on a stock exchange).
5. Risk management – insurance, derivatives and diversification reduce risk.
6. Price discovery – markets decide the price (interest rate, share price) through demand and supply.
7. Information – share prices, credit ratings and reports give information to investors.

Financial System and Economic Development

A strong financial system is necessary for the growth of an economy. Its role:

• Capital formation: It converts savings into investment, which creates new factories, roads and jobs.
• Industrial growth: Banks, development institutions and capital markets provide long-term finance to industries.
• Agriculture and rural growth: NABARD, RRBs and co-operative banks give rural credit.
• Entrepreneurship: Venture capital, MUDRA loans and SIDBI support new and small businesses.
• Balanced regional growth: Bank branches in villages spread credit to backward areas.
• Financial inclusion: Schemes like Pradhan Mantri Jan Dhan Yojana (2014) bring poor people into the banking system.
• Government finance: Government borrows through treasury bills and bonds for development projects.

Current Scenario of IFS

• Digital payments: UPI (launched 2016 by NPCI) has made India a world leader in real-time digital payments.
• Banking reforms: merger of public sector banks, Insolvency and Bankruptcy Code 2016 for recovery of bad loans, new types of banks such as payments banks and small finance banks.
• Capital market growth: rising number of demat accounts and retail investors, T+1 settlement in equity, online IPO applications through ASBA and UPI.
• Growth of NBFCs, fintech and mutual funds (SIP investment is popular).
• Stronger regulation: RBI's Scale Based Regulation for NBFCs, SEBI's investor protection rules.

Constituents of the IFS

The IFS has four main components:

1. Financial Markets – places or systems where financial assets are bought and sold. (a) Money market – short-term funds (up to one year); (b) Capital market – long-term funds (shares, debentures, bonds); also foreign exchange and derivatives markets.
2. Financial Instruments – documents that show a claim on money, e.g. shares, debentures, bonds, treasury bills, commercial paper, deposits, insurance policies, mutual fund units.
3. Financial Institutions – organisations that collect and lend money: banks, NBFCs, insurance companies, development banks (NABARD, SIDBI, EXIM Bank), mutual funds.
4. Financial Services – services that help the flow of funds: merchant banking, leasing, factoring, venture capital, credit rating, depository services, underwriting.

Money Market: Features, Objectives, Reforms and Role

Definition: The money market is the market for short-term funds, where instruments with a maturity of up to one year are traded.

Features:

1. Deals only in short-term funds (overnight to one year).
2. Instruments are highly liquid and close substitutes of money.
3. It is a wholesale market – large amounts are traded.
4. Main participants are RBI, banks, financial institutions, primary dealers, mutual funds and large companies.
5. There is no fixed place; deals are mostly done over phone and electronic platforms.
6. RBI is the regulator and leader of the money market.

Objectives: to provide short-term funds to borrowers; to give an outlet for surplus funds of banks; to help RBI in implementing monetary policy; to meet temporary cash needs of government.

Reforms (after 1987–1991): Chakravarty Committee (1985) and Vaghul Committee (1987) recommendations; setting up of DFHI (Discount and Finance House of India) in 1988; introduction of CDs and CPs (1989–90); 91-day, 182-day and 364-day T-bills; Liquidity Adjustment Facility (LAF) with repo and reverse repo; CCIL (2001) for clearing; market-based interest rates; new instruments like CBLO/TREPS.

Role: balances short-term demand and supply of funds, helps RBI control liquidity and interest rates, finances trade and working capital, and gives safe investment for surplus cash.

Money Market Instruments

Likely exam questions

1. (Long, 8/16 marks) What is the Indian Financial System? Explain its structure and functions, and discuss the role of the financial system in economic development.
2. (Long, 8/16 marks) Define money market. Explain its features, objectives and the reforms introduced in the Indian money market. Describe any three money market instruments.
3. (Short, 4 marks) State the constituents of the Indian Financial System.
4. (Short, 4 marks) Write a short note on Treasury Bills.
5. (Short, 4 marks) Distinguish between Certificate of Deposit and Commercial Paper.

Syllabus topics (RTMNU)

• The Role of: Central Bank (RBI)
• Indigenous Financial Agencies
• Discount Houses
• Acceptance Houses
• Merchant Banks
• Investment Companies
• Asset Management Companies (Mutual Funds)
• Special Financial Institutions: Need, Objectives and Functions of IDBI, IFCI, SFCs, ICICI, EXIM Bank
• Non-Banking Finance Companies: Meaning, Role, Types of NBFCs

Role of the Central Bank (RBI)

Definition: A central bank is the apex bank of a country that issues currency, controls credit and regulates the banking system. In India it is the Reserve Bank of India (RBI), set up on 1 April 1935 under the RBI Act, 1934 and nationalised in 1949.

1. Bank of issue – sole authority to issue currency notes (except ₹1 notes and coins, issued by Government of India).
2. Banker to Government – keeps government accounts, manages public debt.
3. Bankers' bank – banks keep reserves (CRR) with RBI; RBI gives them loans.
4. Lender of last resort – helps banks in a liquidity crisis.
5. Controller of credit – uses repo rate, CRR, SLR and open market operations (monetary policy).
6. Custodian of foreign exchange – manages forex reserves under FEMA, 1999.
7. Developmental role – financial inclusion, payment systems (NEFT, RTGS), rural credit.

Indigenous Financial Agencies

These are traditional, unorganised lenders: indigenous bankers (Shroffs, Multanis, Marwaris, Chettiars) who accept deposits and lend using hundis, and money lenders who only lend from their own funds. They give quick loans without formalities, especially in villages, but charge high interest and are not regulated by RBI. With the growth of banks and microfinance, their role is reducing.

Discount Houses and Acceptance Houses

Discount House: an institution that buys (discounts) bills of exchange and treasury bills before maturity and gives cash. Discount houses are mainly a UK (London money market) concept. In India, the Discount and Finance House of India (DFHI) was set up in 1988 by RBI with public sector banks and financial institutions to develop a market for short-term instruments.

Acceptance House: an institution that "accepts" (guarantees) bills of exchange on behalf of traders, so that the bill becomes more trustworthy and easy to discount. This is also mainly a UK concept (merchant bankers of London). In India, commercial banks do this work through bank acceptances and letters of credit.

Merchant Banks

Definition: A merchant banker is a financial intermediary that manages the issue of securities and gives financial advice to companies. In India they are registered with and regulated by SEBI.

Functions: issue management (IPO/FPO), preparing the offer document, underwriting arrangement, project counselling, loan syndication, portfolio management, advice on mergers and acquisitions. Examples: SBI Capital Markets, Kotak Mahindra Capital, ICICI Securities.

Investment Companies and Asset Management Companies (Mutual Funds)

Investment companies collect money and invest it in shares and securities of other companies, giving investors professional management and diversification.

Mutual Fund: a trust that pools money from many investors and invests it in shares, bonds and money market instruments as per a stated objective. The Asset Management Company (AMC) manages the fund for a fee. UTI (1963) was India's first mutual fund. Mutual funds are regulated by SEBI (Mutual Funds) Regulations, 1996.

• Structure: Sponsor → Trust/Trustees → AMC → Custodian.
• Role: small investors get diversification, expert management, liquidity and the SIP facility; funds are channelled into the capital market.
• Types: equity, debt, hybrid, index funds; open-ended and close-ended schemes.

Special Financial Institutions (Development Banks)

Need: Commercial banks mostly give short-term loans. Industries need long-term finance for machinery and projects. Special Financial Institutions (SFIs) were set up after independence to fill this gap, promote new entrepreneurs, backward regions and exports.

Non-Banking Finance Companies (NBFCs)

Meaning: An NBFC is a company registered under the Companies Act that is engaged in lending, investment in securities, leasing, hire purchase etc., but it is not a bank. It is registered with RBI under Section 45-IA of the RBI Act, 1934.

NBFC vs Bank: an NBFC cannot accept demand deposits, cannot issue cheques drawn on itself, and its depositors do not get DICGC deposit insurance.

Role: credit to people and small businesses that banks do not reach; vehicle, gold, consumer and housing loans; microfinance for the rural poor; infrastructure finance; competition and innovation in finance (fintech).

Types of NBFCs (as per RBI):

1. NBFC-ICC (Investment and Credit Company) – lending and investment (asset finance, loan and investment companies merged into this category in 2019).
2. NBFC-MFI – small loans to low-income households.
3. HFC (Housing Finance Company) – home loans.
4. NBFC-IFC (Infrastructure Finance Company) and IDF-NBFC (Infrastructure Debt Fund).
5. CIC (Core Investment Company) – holds investments in group companies.
6. NBFC-Factors – factoring business.
7. Others: NBFC-P2P (peer-to-peer lending platform), NBFC-AA (Account Aggregator), Mortgage Guarantee Company, NOFHC (Non-Operative Financial Holding Company).

Scale Based Regulation (SBR): From October 2022 RBI regulates NBFCs in four layers by size and risk – Base Layer (small NBFCs), Middle Layer, Upper Layer (large NBFCs named by RBI) and Top Layer (kept empty; for NBFCs with very high risk). The higher the layer, the stricter the rules.

Likely exam questions

1. (Long, 8/16 marks) Explain the need for Special Financial Institutions in India. Describe the objectives and functions of IDBI, IFCI, SFCs, ICICI and EXIM Bank.
2. (Long, 8/16 marks) What is a Non-Banking Finance Company? Explain its role in the Indian financial system and the different types of NBFCs as classified by the RBI.
3. (Short, 4 marks) Explain the role of RBI as a central bank.
4. (Short, 4 marks) Write a short note on discount houses and acceptance houses.
5. (Short, 4 marks) What is an Asset Management Company? State its role in mutual funds.

Syllabus topics (RTMNU)

• History of Indian Capital Markets
• Reforms in capital markets
• Instruments in capital markets
• Primary Markets: Functions, Free Pricing, Book Building, and Intermediaries in the Primary Market
• Secondary Markets: Organization, Membership, Functions and Management of Stock exchanges, concerning the BSE and NSE
• The Concept of Indices, SENSEX, NIFTY, etc.
• Malpractices in the Capital Markets

Capital Market and its History in India

Definition: The capital market is the market for long-term funds (more than one year) where shares, debentures and bonds are issued and traded.

It has two parts: the primary market (new issues) and the secondary market (trading of existing securities on stock exchanges).

History in brief:

• 1875 – The "Native Share and Stock Brokers' Association" was formed in Bombay; it is today's BSE, the oldest stock exchange in Asia.
• 1947 – Capital Issues (Control) Act; the Controller of Capital Issues (CCI) fixed the price of new issues.
• 1956 – Securities Contracts (Regulation) Act for recognition of stock exchanges.
• 1963 – UTI set up; 1988 – SEBI set up (statutory powers in 1992).
• 1992 – CCI abolished and free pricing allowed; Harshad Mehta securities scam exposed.
• 1992 – NSE incorporated; it started trading in 1994 with screen-based trading.
• 1996 – Depositories Act; NSDL (1996) and CDSL (1999) brought demat shares.

Reforms in the Capital Market

1. SEBI as statutory regulator (SEBI Act, 1992).
2. Free pricing of issues after abolition of CCI.
3. Screen-based online trading – NSE (1994) and BSE's BOLT system replaced the open outcry trading ring.
4. Dematerialisation – shares held in electronic form, no bad delivery or forged certificates.
5. Book building method for price discovery in IPOs.
6. Rolling settlement – shortened step by step to T+2 and now T+1 for equity.
7. Derivatives trading (futures and options) from 2000.
8. Clearing corporations that guarantee settlement (NSE Clearing, Indian Clearing Corporation).
9. Demutualisation – ownership and trading rights of stock exchanges separated.
10. Investor protection – ASBA, SCORES complaint system, insider trading rules, foreign portfolio investment allowed.

Instruments in the Capital Market

• Equity shares – ownership capital; dividend not fixed; voting right.
• Preference shares – fixed dividend, priority in repayment.
• Debentures and bonds – borrowed capital with fixed interest; may be convertible or non-convertible.
• Government securities – long-term bonds of central and state governments.
• Others – warrants, mutual fund units, ETFs, REITs and InvITs, derivatives (futures and options).

Primary Market: Functions, Free Pricing, Book Building and Intermediaries

Definition: The primary market (new issue market) is where companies raise fresh capital by issuing new securities to investors for the first time.

Functions: (1) Origination – planning the issue, project study, legal approvals; (2) Underwriting – guarantee that the issue will be fully subscribed; (3) Distribution – selling the securities to investors through brokers and bankers. Methods: public issue (IPO, FPO), rights issue, private placement, bonus issue.

Free pricing: Since 1992 the issuing company and its merchant banker decide the issue price themselves, without government approval. The company must give full disclosures in the offer document as per SEBI (ICDR) Regulations, 2018, so investors can judge the price.

Book building: a process in which the final issue price is found from the bids made by investors within a price band.

1. The company and book running lead manager fix a price band (floor price and cap; the cap cannot be more than 120% of the floor).
2. Investors bid for quantity and price within the band during the bid period.
3. Bids are recorded electronically (the "book").
4. After closing, the cut-off price is decided based on demand.
5. Shares are allotted, and listed on the stock exchange.

Intermediaries in the primary market (all registered with SEBI): merchant bankers/lead managers, underwriters, bankers to the issue (and SCSBs for ASBA), registrars to the issue, brokers and syndicate members, debenture trustees, depositories, credit rating agencies.

Secondary Market: Stock Exchanges (BSE and NSE)

Definition: A stock exchange is an organised and recognised market where existing securities are bought and sold under set rules. In India stock exchanges are recognised under the Securities Contracts (Regulation) Act, 1956 and regulated by SEBI.

Organisation and management: After demutualisation, stock exchanges are companies managed by a Board of Directors with public interest directors and shareholder directors, and a Managing Director/CEO for daily work. Brokers cannot control the board. BSE Ltd is itself listed on NSE.

Membership: Only registered trading members (stock brokers) can trade. Conditions: registration with SEBI, minimum age and education, required net worth and deposits, not bankrupt or convicted of fraud. Investors trade through these brokers.

Functions: liquidity and marketability of securities, fair price discovery, safety of transactions through clearing and settlement guarantee, capital formation, an indicator of the economy, listing and supervision of companies.

Concept of Indices: SENSEX, NIFTY etc.

Stock market index: a number that shows the overall movement of share prices using a group of selected representative shares. If the index rises, the market is rising (bull); if it falls, the market is falling (bear).

• SENSEX (BSE Sensitive Index) – 30 large, actively traded companies; base year 1978-79 = 100; calculated by the free-float market capitalisation method.
• NIFTY 50 (NSE) – 50 large companies from different sectors; base date 3 November 1995 = 1000.
• Other indices: BSE 100, BSE 500, Nifty Next 50, Nifty Bank, sectoral indices (IT, Pharma), India VIX (volatility index).

Uses: shows market mood, benchmark for mutual funds, base for index funds, ETFs and derivatives.

Malpractices in the Capital Market

1. Insider trading – trading on unpublished price sensitive information; banned by SEBI (Prohibition of Insider Trading) Regulations, 2015.
2. Price rigging / manipulation – artificially pushing the price up or down.
3. Circular and synchronised trading – a group trades among itself to create false volume.
4. Front running – a broker trades ahead of a big client order for personal profit.
5. Pump and dump – spreading false tips (now often on social media) and selling at a high price.
6. Vanishing companies – companies raising money in an IPO and then disappearing.
7. Misuse of client funds and securities by brokers.

Major scams like the Harshad Mehta scam (1992) and the Ketan Parekh scam (2001) led to stronger SEBI rules, surveillance and penalties.

Likely exam questions

1. (Long, 8/16 marks) What is a primary market? Explain its functions, the concept of free pricing, the book building process and the intermediaries in the primary market.
2. (Long, 8/16 marks) Explain the organisation, membership, functions and management of stock exchanges in India with reference to BSE and NSE.
3. (Short, 4 marks) Write a note on SENSEX and NIFTY.
4. (Short, 4 marks) State any four reforms in the Indian capital market.
5. (Short, 4 marks) What is insider trading? Mention any three other malpractices in the capital market.

Syllabus topics (RTMNU)

• Venture Capital Financing: Meaning, steps and methods
• Factoring: Meaning, types, costs and benefits, difference between factoring and forfeiting
• Leasing: Meaning, Definition, Types of leases
• Underwriting: Meaning and benefits
• Credit Rating: Meaning and benefits, Role of CRISIL, CARE and ICRA
• Depository Services: Meaning & Benefits
• Regulatory Bodies & Services: SEBI – Organization, Objectives, Powers and Functions
• Investor protection measures and achievements of SEBI
• RBI – Objectives, Organisation and Regulatory Functions

Venture Capital Financing

Meaning: Venture capital is long-term risk capital given to new, innovative and fast-growing businesses (start-ups) in return for an ownership share, with the hope of high returns. In India venture capital funds are registered with SEBI as Category I Alternative Investment Funds.

Steps: (1) Deal origination – finding proposals; (2) Screening – checking the idea, sector and size; (3) Evaluation / due diligence – study of the team, market and finances; (4) Deal structuring – deciding amount, price, share and rights; (5) Monitoring – guidance and board seat; (6) Exit – through IPO, sale to another company or buyback by promoters.

Methods: equity shares, convertible debentures or preference shares, conditional loans (repaid as royalty on sales), and income notes. Many Indian start-ups like Flipkart and Zomato grew with venture capital.

Factoring

Meaning: Factoring is a financial service in which a firm sells its trade receivables (book debts) to a factor (bank or NBFC-Factor) and gets immediate cash. In India it is governed by the Factoring Regulation Act, 2011.

Types: recourse factoring (bad-debt risk stays with the seller) and non-recourse factoring (factor bears the risk); domestic and export factoring; advance and maturity factoring; disclosed and undisclosed factoring; full factoring.

Costs: (1) discount charge – interest on the advance paid; (2) service fee or commission – for collection and sales ledger management.

Benefits: quick cash for working capital, no need to chase debtors, protection from bad debts (non-recourse), saving of administration cost, better credit assessment of buyers.

Leasing

Definition: A lease is a contract in which the owner of an asset (lessor) gives the right to use it to another person (lessee) for a period in return for periodic rent. Ownership remains with the lessor.

Types of leases:

1. Finance lease – long-term, non-cancellable; nearly all risks and rewards pass to the lessee.
2. Operating lease – short-term, cancellable; lessor bears maintenance and risk (e.g. computers, cars).
3. Sale and lease back – a firm sells its asset and takes it back on lease to get cash.
4. Leveraged lease – lessor borrows part of the asset cost from a lender.
5. Direct lease and cross-border (international) lease.

Underwriting

Meaning: Underwriting is an agreement in which an underwriter promises to buy the unsubscribed part of a public issue of securities, for a commission. Underwriters are registered with SEBI.

Benefits: assured minimum subscription and success of the issue, confidence among investors, expert advice on timing and pricing, wider distribution through the underwriter's network.

Credit Rating

Meaning: Credit rating is an opinion given by an independent agency about the ability and willingness of a borrower to repay a debt on time, shown by symbols like AAA (highest safety) to D (default). Agencies are regulated by SEBI (Credit Rating Agencies) Regulations, 1999.

Benefits: to investors – easy, low-cost information on risk; to companies – borrowing at lower interest with a good rating and a wider market; to regulators – better market discipline.

Depository Services

Meaning: A depository is an organisation that holds securities of investors in electronic (demat) form and transfers them by book entry. India has two depositories under the Depositories Act, 1996 – NSDL (1996) and CDSL (1999). Investors deal through Depository Participants (DPs) such as banks and brokers.

Benefits: no risk of loss, theft or forgery of certificates; quick transfer and settlement; no stamp duty on transfer of demat shares; automatic credit of bonus and rights; easy pledge and nomination; lower paperwork.

SEBI – Organisation, Objectives, Powers and Functions

The Securities and Exchange Board of India (SEBI) was set up in 1988 and became a statutory body in 1992 under the SEBI Act, 1992. Head office: Mumbai.

Organisation: a Board with a Chairman (appointed by the Central Government), members from the Ministry of Finance and RBI, and whole-time and part-time members; work is done through departments and regional offices.

Objectives: protect the interests of investors, promote the development of the securities market, and regulate the securities market.

Functions: (1) Protective – stop insider trading, price rigging and fraud, investor education; (2) Regulatory – register and regulate stock exchanges, brokers, merchant bankers, mutual funds, rating agencies; frame rules for issues and takeovers; (3) Developmental – training of intermediaries, new products, efficient trading.

Powers: call for information, inspect and investigate, search and seize records, impose penalties, suspend or cancel registration, issue directions and pass orders.

Investor Protection Measures and Achievements of SEBI

• Disclosure rules for IPOs (ICDR Regulations), KYC, ASBA so money is blocked, not paid, until allotment.
• SCORES online complaint system and online dispute resolution; Investor Protection Funds at exchanges.
• Insider trading and fraud regulations, surveillance, heavy penalties.
• Achievements: screen-based trading, dematerialisation, shorter settlement (T+1), strong mutual fund rules, safer derivatives market, better corporate governance (LODR Regulations, 2015).

RBI – Objectives, Organisation and Regulatory Functions

Objectives: price stability while keeping growth in mind, a sound banking and financial system, an efficient payment system, adequate supply of currency and credit, and management of foreign exchange.

Organisation: managed by a Central Board of Directors headed by the Governor, with Deputy Governors and directors nominated by the Government; four Local Boards (Mumbai, Kolkata, Chennai, New Delhi); head office in Mumbai. A six-member Monetary Policy Committee decides the repo rate (check the latest RBI figure).

Regulatory functions: licensing and supervision of banks under the Banking Regulation Act, 1949; regulation of NBFCs; control of credit through CRR, SLR and policy rates; regulation of payment systems; foreign exchange regulation under FEMA, 1999; regulation of the money and government securities markets.

Likely exam questions

1. (Long, 8/16 marks) What is SEBI? Explain its organisation, objectives, powers and functions, and discuss the investor protection measures taken by SEBI.
2. (Long, 8/16 marks) What is factoring? Explain its types, costs and benefits. Distinguish between factoring and forfaiting.
3. (Short, 4 marks) Explain the meaning and steps of venture capital financing.
4. (Short, 4 marks) Write a short note on the role of CRISIL, ICRA and CARE.
5. (Short, 4 marks) What are depository services? State their benefits.