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CONTENTS

Introduction

Features of Financial System

Role of Financial System

Back Drop of Financial System

Indian Financial System from 1950 1980

Indian Financial System Post 1990s

INTRODUCTION

The economic scene in the post independence period has seen a sea change; the
end result being that the economy has made enormous progress in diverse fields.
There has been a quantitative expansion as well as diversification of economic
activities. The experiences of th
1980s have led to the conclusion that to obtain all the benefits of greater reliance
on voluntary, market-based decision-making, India needs efficient financial
systems.
The financial system is possibly the most important institutional and functional
vehicle for economic transformation. Finance is a bridge between the present
and the future and whether it be the mobilisation of savings or their efficient,
effective and equitable allocation for investment, it is the success with which the
financial system performs its functions that sets the pace for the achievement of
broader national objectives.
1.1 S IGNIFICANCE AND D EFINITION
The term financial system is a set of inter-related activities/services working
together to achieve some predetermined purpose or goal. It includes different
markets, the institutions, instruments, services and mechanisms which influence
the generation of savings, investment capital formation and growth.
Van Horne defined the financial system as the purpose of financial
markets to allocate savings efficiently in an economy to ultimate users
either for investment in real assets or for consumption. Christy has
opined that the objective of the financial system is to "supply funds to
various sectors and activities of the economy in ways that promote the
fullest possible utilization of resources without the destabilizing
consequence of price level changes or unnecessary interference with
individual desires."
According to Robinson, the primary function of the system is "to provide a link
between savings and investment for the creation of new wealth and to permit
portfolio adjustment in the composition of the existing wealth."
From the above definitions, it may be said that the primary function of the
financial system is the mobilisation of savings, their distribution for
industrial investment and stimulating capital formation to accelerate the
process of economic growth.

The financial system or the financial sector of any country consists of:-
(a) specialized & non specialized financial institution
(b) organized &unorganized financial markets and
(c) Financial instruments & services which facilitate transfer of funds.

Procedure & practices adopted in the markets, and financial inter relationships
are also the parts of the system. These parts are not always mutually exclusive.
For example, the financial institution operate in financial market and are,
therefore a part of such market. The word system in the term financial system
implies a set of complex and closely connected or inters mixed institution,
agents practices, markets, transactions, claims, & liabilities in the economy. The
financial system is concerned about money, credit, & finance the terms
intimately related yet some what different from each other. Money refers to the
current medium of exchange or means of payment. Credit or Loan is a sum of
money to be returned normally with Interest it refers to a debt of economic unit.
Finance is a monetary resources comprising debt & ownership fund of the state,
company or person.
FEATURES OF FINANCIAL SYSTEM -:

1. It provides an Ideal linkage between depositors savers and


Investors Therefore it encourages savings and investment.
2. Financial system facilitates expansion of financial markets over
a period of time.
3. Financial system should promote deficient allocation of
financial resources of socially desirable and economically
productive purpose.
4. Financial system influence both quality and the pace of
economic development.

ROLE OF FINANCIAL SYSTEM:

The role of the financial system is to promote savings & investments in the
economy. It has a vital role to play in the productive process and in the
mobilization of savings and their distribution among the various productive
activities. Savings are the excess of current expenditure over income. The
domestic savings has been categorized into three sectors, household,
government & private sectors.

The savings from household sector dominates the domestic savings


component. The savings will be in the form of currency, bank deposits, non
bank deposits, life insurance funds, provident funds, pension funds, shares,
debentures, bonds, units & trade debts. All of these currency & deposits are
voluntary transactions & precautionary measures. The savings in the
household sector are mobilized directly in the form of units, premium,
provident fund, and pension fund. These are the contractual forms of
savings. Financial actively deals with the production, distribution &
consumption of goods and services. The financial system will provide
inputs to productive activity. Financial sector provides inputs in the form of
cash credit & assets in financial for production activities.

The function of a financial system is to establish a bridge between the


savers and investors. It helps in mobilization of savings to materialize
investment ideas into realities. It helps to increase the output towards the
existing production frontier. The growth of the banking habit helps to
activate saving and undertake fresh saving. The financial system
encourages investment activity by reducing the cost of finance risk. It helps
to make investment decisions regarding projects by sponsoring,
encouraging, export project appraisal, feasibility studies, monitoring &
execution of the projects.

BACK DROP OF INDIAN FINANCIAL SYSTEM


At the time of independence, India had a reasonably diversified financial system
Industrys share in credit doubled, agriculture, rural areas, SSI, exports still neglected

RRBs setup

1980s 1990s
1970s

1947 1960s

Neglected: long term, agricultural, and rural area credit


Nationalisation of Banks to ensure credit allocation as per
NABARD,
plan priorities
EXIM, SIDBI,
Credit NHB
to Industry
setup / Govt doubled
Need for specialized FIs felt. Highly segmented financial market, highly restricted
DFIs, SFCs, UTI, Co-op Banks setup.

in terms of intermediaries but a somewhat narrow focus on terms of


intermediation, i.e., a lack of a long term capital market and the relative neglect
of agriculture in particular and rural areas in general.

As India embarked on a process of industrialization and growth, RBI set up


Development Financial Institutions (DFIs) and State Finance Corporations
(SFCs) as providers of long term capital. Agricultures need for credit was met
by cooperative banks. UTI was set up to canalize resources from retail
investors to the capital market.

In essence, the understanding that requirement of financial needs for accelerated


growth and development was best met by specialized financial intermediaries
who performed specialized functions influenced financial market architecture.

To ensure that these specializations were adhered to, financial intermediaries


developed and promoted by the Reserve Bank of India had significant
restrictions on both the asset and liabilities side of their balance sheets.
In the 1950s and 1960s, despite an expansion of the commercial banking system
in terms of both reach and mobilization of resources, agriculture still remained
under funded and rural areas under banked. Whereas industrys share in credit
disbursed almost doubled between 1951 and 1968, from 34 to 67.5%,
agriculture got barely 2% of available. Credit to exports and small scale
industries were relatively neglected as well.

In view of the above, it was decided to nationalize the banking sector so that
credit allocation could take place in accordance in plan priorities.
Nationalization took place in two phases, with a first round in 1969 followed by
another in 1980.

By the mid-seventies it was felt that commercialized banks did not have
sufficient expertise in rural banking and hence in 1975 Regional Rural Banks
(RRBs) were set up to help bring rural India into the ambit of the financial
network. This effort was capped in 1980 with the formation of National Bank
for Agriculture and Rural Development (NABARD), which was to function as
an apex bank for all cooperative banks in the country, helping control and guide
their activities. NABARD was also given the remit of regulating rural credit
cooperatives.

Following with the logic of specialization, the 1980s saw other DFIs with
specific remits being set up e.g. The EXIM Bank for export financing, the
Small Industries Development Bank of India (SIDBI) for small scale industries
and the National Housing Bank (NHB) for housing finance.

Long term finance for the private sector came from DFIs and institutional
investors or through the capital market. However both price and quantity of
capital issues was regulated by the Controller of Capital Issues.
Therefore the deepening of financial intermediation had occurred with an
increase in the draft by both the commercial sector and the government on
financial resources mobilized.
At the end of the 1980s then the Indian financial system was characterized by
segmented financial markets with significant restrictions on both the asset and
liability side of the balance sheet of financial intermediaries as well as the price
at which financial products could be offered.

In the Indian context segmentation meant that competition was muted. In a


scenario where price was determined from outside the system and targets were
set in terms of quantities, there was no pressure for non-price competition as
well. As a result the financial system had relatively high transaction costs and
political economy factors meant that asset quality was not a prime concern.
Therefore even though the Indian financial system at the end of 1980s had
achieved substantial expansion in terms of access, this had come at the cost of
asset quality. In addition, was the fact that the draft of the government on
resources of the financial system had increased significantly. This in itself need
necessarily was not a problem but over this period, i.e., the 1980s, the
composition of government expenditure was changing as well, with shift
towards current rather than capital expenditure. In addition, in the absence of a
reasonably liquid market for government securities, an increase in net bank
lending to the government meant that the asset side of banks balance sheets
tended to become increasingly illiquid.

The impetus for change came from one expected and one unexpected quarter -
first, the importance of prudential capital adequacy ratios was underlined by the
announcement of BaselI norms (see Error: Reference source not found Error:
Reference source not found) That banks were expected to adhere to; second the
macroeconomic crisis of 1990-91.
The reform process that followed accelerated the process of liberalization
already begun in the 1980s and began a series of measured and deliberate steps
to integrate India into the global economy, including the global financial
network.

Briefly however, given the problems facing the financial system and keeping in
mind the institutional changes necessary to help India financially integrate into
the global economy, financial reform focused on the following: improving the
asset quality on bank balance sheets in particular and operational efficiency in
general; increasing competition by removing regulatory barriers to entry;
increasing product competition by removing restrictions on asset and liability
sides of financial intermediaries; allowing financial intermediaries freedom to
set their prices; putting in place a market for government securities; and
improving the functioning of the call money market.

The government security market was particularly important not only because it
was decided the RBI would no longer monetize the fiscal deficit, which would
now be financed by directly borrowing from the market, but also monetary
policy would be conducted through open market operations and a large liquid
bond market would help the RBI sterilise, if necessary, foreign exchange
movements.
INDIAN FINANCIAL SYSTEM FROM 1950 TO 1980

Indian Financial System During this period evolved in response to the objective
of planned economic development. With the adoption of mixed economy as a
pattern of industrial development, a complimentary role was conceived for
public and private sector. There was a need to align financial system with
government economic policies. At that time there was government control over
distribution of credit and finance. The main elements of financial organization
in planned economic development are as follows:-

1. Public ownership of financial institutions


The nationalization of RBI was in 1948, SBI was set up in 1956, LIC came in to
existence in 1956 by merging 245 life insurance companies in 1969, 14 major
private banks were brought under the direct control of Government of India. In
1972, GIC was set up and in 1980; six more commercial banks were brought
under public ownership. Some institutions were also set up during this period
like development banks, term lending institutions, UTI was set up in public
sector in 1964, provident fund, pension fund was set up. In this way public
sector occupied commanding position in Indian Financial System.

2. Fortification Of Institutional structure


Financial institutions should stimulate / encourage capital formation in the
economy. The important feature of well developed financial system is
strengthening of institutional structures. Development banks was set up with
this objective like industrial finance corporation of India (IFCI) was set up in
1948, state financial corporation (SFCs) were set up in 1951, Industrial credit
and Investment corporation of India Ltd (ICICI)was set up in 1955. It was
pioneer in many respects like underwriting of issue of capital, channelisation of
foreign currency loans from World Bank to private industry. In 1964, Industrial
Development of India (IDBI).

3. Protection of Investors
Lot many acts were passed during this period for protection of investors in
financial markets. The various acts 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 ; Securities & Exchange Board of India, 1988.

4. Participation in Corporate Management


As participation were made by large companies and financial instruments it
leads to accumulation of voting power in hands of institutional investors in
several big companies financial instruments particularly LIC and UTI were able
to put considerable pressure on management by virtual of their voting power.
The Indian Financial System between 1951 and mid80s was broad based
number of institutions came up. The system was characterized by diversifying
organizations which used to perform number of functions. The Financial
structure with considerable strength and capability of supplying industrial
capital to various enterprises was gradually built up the whole financial system
came under the ownership and control of public authorities in this manner
public sector occupy a commanding position in the industrial enterprises. Such
control was viewed as integral part of the strategy of planned economy
development.
INDIAN FINANCIAL SYSTEM POST 1990S

The organizations of Indian Financial system witnessed transformation after


launching of new economic policy 1991. The development process shifted from
controlled economy to free market for these changes were made in the
economic policy. The role of government in business was reduced the measure
trust of the government should be on development of infrastructure, public
welfare and equity. The capital market an important role in allocation of
resources. The major development during this phase are:-

1. Privatisation of Financial Institutions


At this time many institutions were converted in to public company and number
of private players were allowed to enter in to various sectors:

a) Industrial Finance Corporation on India (IFCI): The pioneer development


finance institution was converted in to a public company.
b) Industrial Development Bank of India & Industrial Finance Corporation
of India (IDBI & IFCI): IDBI & IFCI ltd offers their equity capital to
private investors.
c) Private Mutual Funds have been set up under the guidelines prescribed by
SEBI.
d) Number of private banks and foreign banks came up under the RBI
guidelines. Private institution companies emerged and work under the
guidelines of IRDA, 1999.
e) In this manner government monopoly over financial institutions has been
dismantled in phased manner. IT was done by converting public financial
institutions in joint stock companies and permitting to sell equity capital
to the government.
2. Reorganization of Institutional Structure
The importance of development financial institutions decline with shift to
capital market for raising finance commercial banks were give more funds to
investment in capital market for this. SLR and CRR were produced; SLR earlier
@ 38.5% was reduced to 25% and CRR which used to be 25% is at present 5%.
Permission was also given to banks to directly undertake leasing, hire-purchase
and factoring business. There was trust on development of primary market,
secondary market and money market.

3. Investors Protection
SEBI is given power to regulate financial markets and the various
intermediaries in the financial markets.

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