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Indian Financial System

Welcome to the class

Dr M Manjunath Shettigar
MA (Econ), MBA, MPhil, PhD

Indian Financial System

Unit 1 Introduction

Financial System

Financial system plays a vital role in economic development They provide finance and other financial services required for economic/ business development

Financial System

Is a set of interrelated parts or subsystems, such as financial institutions, financial markets, financial instruments and financial services, which facilitate the functioning of the economic system. The main function of financial system is facilitating efficient financial intermediation

Features of Financial System

Is made up of a set of sub-systems, such as financial institutions, financial markets, financial instruments and financial services It plays the role of financial intermediary It includes regulatory mechanisms to ensure stability and efficiency of the financial system

Objectives of Financial System

2. 3.

5. 6. 7. 8.

Financial intermediation Mobilisation of savings Channelizing savings for productive use Providing an efficient payments mechanism Facilitating capital formation Providing liquidity Providing safety for savings and investment Making available risk management services

Functions of Financial System

1. 2. 3. 4. 5. 6. 7.


Encouragement of Saving Mobilization of Saving and Resources Reallocation of Financial Resources Diversification and Risk Reduction Enhancement of Investment and Capital Stock Promotion of Technological Innovations Supporting Payment Mechanism Facilitating Growth and Development

Financial System



Evolution of Financial sector

Economic planning allocation of resources to preferred sectors at low cost directed credit programs and interest rate controls
1970s: disillusionment with the policies of command and control in many developing countries Liberal view: financial repression (a combination of heavy taxation, interest controls, and government participation in the credit allocation process) would lead to both a decrease in the depth of the financial system and a loss of the efficiency with which savings are intermediated Liberal view: complete liberalization of the financial sector is essential to economic development

Evolution of Financial sector

Far reaching financial liberalization in the 1970s and 1980s in many Latin American countries Efficiency gains did not materialise, wide spread bankruptcies, sustained periods of high interest rates, high inflation Lessons learned: (i) macro economic stability is an essential precondition for successful reforms (ii) adequate bank supervision is an essential component of reform (setting up of an appropriate regulatory framework) (iii) financial sector reforms must be accompanied by real sector reforms (trade and industrial liberalization)

Evolution of Financial sector

Re-intervention of the government. The motivating factors were: (i) Latin American experience (ii)Experiences of East Asian Countries: rapid economic growth with relatively underdeveloped or repressed financial system (e.g.. directed credit programs to exporters). Some points to note are: - (a) extent of financial repression was much less - (b) financial sector was not used persistently for financing the government deficit - (c) directed credit program was conditional on export performance - (d) vibrant informal sector in some countries mitigated the negative effect of financial repression

Evolution of Financial sector

(iii) Application of the theories of asymmetric information to financial markets

Market failures are more pervasive in financial markets than in other markets Assumption of the liberal view: all relevant information is freely available to all agents in the market Asymmetries of information between those who provide and those who seek capital is the reality - for e.g., insiders have more information than outsiders Asymmetric information explains the existence of financial intermediaries it would be costly for each individual investor to evaluate the borrowers

Evolution of Financial sector

By avoiding duplication in verification, financial intermediaries exploit economies of scale in information provision and thereby reduce the cost of finance
Problem of asymmetric information may be more acute in developing countries because of segmented markets, firms with a short history of operations, absence of information gathering institutions (such as credit rating agencies), significant presence of small firms Bottom line: a liberalized but well regulated and competitive environment is important Setting up of an appropriate regulatory framework is a necessary pre-condition to financial sector liberalization

Indian Financial Sector: different phases

Three distinct periods: 1947-68, 1969-91, 1991 onward 1947-68: relatively liberal environment - the role of RBI was to supervise and control the banks 1969-91: Bank nationalization and Financial repression banking policies re-oriented to meet social objectives such as the reduction in inequalities and the concentration of economic power interest rate controls and directed credit programs 1991 onward: financial sector liberalization

Indian Financial Sector: Pre-Nationalization

RBI Act: scheduled commercial banks are required to maintain a minimum cash reserve of 7% of their demand and time liabilities SLR was 20% (cash, gold, govt. securities) LIC formed in 1959 by nationalizing the existing insurance companies 1962: RBI was empowered to vary the CRR between 3% and 15% empowered to stipulate minimum lending rates and ceilings rates on various types of advances Problem of bank failures and compulsory merger of weak banks with relatively stronger ones (no. of banks fell from 566 in 1951 to 85 in 1969 due to mergers).

Indian Financial Sector: Pre-Nationalization

1962: Deposit insurance scheme with the establishment of the Deposit Insurance Corporation
1964: RBI directly regulated the interest on deposits (prior to this, interest rates were governed by a voluntary agreement among the important banks) Certain disquieting features: (i) banking business was largely confined to the urban areas (neglect of rural and semi-urban areas) (ii) agriculture sector got only a very small share of total bank credit (iii) within industry, the large borrowers got the greatest share of credit The pattern of credit disbursement was inconsistent with the goal of achieving an equitable allocation of credit and the priorities set in the plans - bank nationalization in 1969

Indian Financial Sector: Bank nationalization

1969: 14 largest scheduled commercial banks nationalized; 22 largest banks accounting for 86% of deposits had become public sector banks; 6 more banks nationalized in 1980 bringing the share of public sector banks deposits to 92%
Rural branch expansion to mobilize deposits and enhancement of agriculture credit Priority sector lending (agriculture, small scale industries, retail trade, transport operators etc); requirement was 33%, raised to 40% in 1979. UTI and IDBI, IFCI and ICICI were set up with specific objectives in mind

Indian Financial Sector: 1980s

Increasing reliance of the govt. on the banking sector for financing its own deficits The govt. used the banking sector as a captive source of funds by means of SLR (the proportion of net demand and time deposits that banks have to maintain in cash, gold, and approved securities) SLR originally intended as an instrument of monetary policy, but in effect served two other purposes: (i) allocate banks resources to the govt. (ii) allocate cheap resources to development finance institutions Steady increase of SLR: 28% (in 1970-1) to 38.5% (in 1989-90) Increased monetization of the deficit (budget deficit to GDP ratio increased from 0.96% during the first half the 1970s to 2.09% during the second half of the 1980s)

Indian Financial Sector: 1980s

To neutralize the effects of deficit financing on monetary growth, CRR steadily increased from 7% (1973-4) to 15% (1989-90) Larger portion of the bank funds locked into non interest bearing bank reserves Suppressed the govt. securities market to keep the cost of borrowing low for the govt.; open market operations lost its effectiveness as a tool of monetary policy Problems:(i) heavy segmentation of markets, (ii) in-efficient use of credit, (iii) poor bank profitability due to restrictions on the use funds, (iv) rigidity due to the imposition of branch licensing requirements (v) lack of competition and efficiency due to entry restrictions and public sector dominance

Indian Financial Sector: Reforms

Chakravarty Committee (1985): suggest measures for improving the effectiveness of monetary policy. Main recommendations: (i) develop treasury bills as a monetary instrument so that open market operations could gradually become the dominant instrument of monetary policy (ii) revise upwards the yield structure of govt. securities so as to increase the demand for them and limit the degree of monetization

Money markets were underdeveloped till the mid 80s: Few large lenders (LIC and UTI) and large no. of borrowers (commercial banks) ceiling of 10% on the rate

Reforms in the money market

Vaghul Committee (1987): to study the money market; recommendation to achieve a phased decontrol and development of money markets Introduction of the 182 days Treasury Bills; withdrawal of the ceilings on call money rates; new short term instruments (Commercial Paper and Certificates of deposits)

Discount and Finance House of India (DFHI) was instituted by RBI in 1987 DFHI was allowed to participate as both lender and borrower; No. of lenders increased
Instability in the rates and RBI intervention to stabilize

Significant deregulation and development of money market by the late eighties little progress in the deregulation of credit and capital markets

Narasimham Committee Recommendations

Narasimham Committee (1991) to study the working of the financial system. (i) bring down SLR in a phased manner to 25% over five years (ii) use CRR as an instrument of monetary policy rather than using to neutralize the effect of monetization (iii) phase out directed credit programs and reduce the requirement to lend to the priority sectors down to 10% of aggregate credit

(iv) bring the interest rate on govt. borrowing in line with other market determined interest rates and phase out concessional interest rates

Narasimham Committee Recommendations

(v) allow the more profitable public sector banks to issue fresh capital to the public through the capital market (vi) abolish branch licensing closing and opening of branches left to the judgment of individual banks (vii) liberalize policies towards foreign banks (viii) quasi-autonomous body under the aegis of the RBI to be set up to supervise banks and financial institutions (ix) phase out the privileged access of development finance institutions to concessional finance

Reforms in the credit market

Interest rate deregulation in a phased manner: total freedom to the banks to set their own lending rates (from 1994) Since 1991, term lending institutions can charge interest rates in accordance with perceived risks Contraction of subsidized and captive source of funds to term lending institutions forced to borrow at market rate of interest

Diversification of term lending institutions in to banking, MFs etc.

Some decline in the priority sector lending particularly agriculture credit

Reforms and changes in the capital market

Upward revision of interest rates for govt. securities (T bills and dated securities) and significant growth in the primary market for T bills Use of open market operations by the RBI (by selling and buying the govt. securities) to absorb a part of the excess liquidity in the banking system caused by the surge in foreign capital inflows The proportion T bills outstanding with the RBI came down significantly from the earlier level of about 90% Dated Securities: alignment of the interest rate with other interest rates in the financial sector reduction in the maximum maturity from 20 to 10 years

Reforms and changes in the capital market

Creation of the Securities and Trading Corporation of India (STCI) in 1993: the task is to develop an efficient secondary market in govt. securities and public sector bonds Stock Market: prior to 1992, the primary issues market was very closely regulated, which discouraged corporations from using new issues to raise funds Creation of SEBI (1992): regulatory authority for new issues of companies; companies are now free to approach the capital market after a clearance from SEBI Free entry of FII (pension funds, mutual funds, investment trusts, asset management companies) initial registration with SEBI

Indian Financial System An Overview

* Upto 1951 * 1951 to 1990 * Early Nineties * Present Status Pvt. Sector Public Sector Privatization Globalization


Indian Financial System An Overview

Orderly mechanism & structure in economy. Mobilises the monetary resources/capital from surplus sectors. Distributes resources to needy sectors. Transformation of savings into investment & consumption. Financial Markets Places where the above activities take place

Pre 1951
1. 2. 3. 4. 5. 6. 7. 8.


Control of Money Lenders No Laws / Total Private Sector No Regulatory Bodies Hardly any industrialization Banks Traditional lenders for Trade and that too short term Main concentration on Traditional Agriculture Narrow industrial securities market Absence of intermediatary institutions in long-term financing of industry Industry had limited access to outside saving/resources.

1951 to 1990
PVT. SECTORS TO PUBLIC SECTOR MIXED ECONOMY 1st 5 year PLAN in 1951 Planned Economic Process. As part of Alignment of Financial Systems Priorities laid down by Govt. Policies. Main Elements of Fin. Organisations i. Public ownership of Financial Institution ii. Strengthening of Institutional Structure iii. Protection to Investors iv. Participation in Corporate Management v. Organisational Deficiencies.


1956 (take-over of Imperial Bank of India) 1956 (Merges of over 250 Life Insurance Companies) 1969 (14 major banks with Deposits of over Rs. 50 Crs. nationalized) 1980 (6 more Banks) 1972 (General Insurance Corp. GIC by New India, Oriental, united and National.




Directing the Capital in conformity with Planning priorities Encouragement to new entrepreneurs and small set-ups Development of Backward Region IFCI (1948) State Finance Corporation (1951) Purely Mortgage institution IDBI (1964) As subsidiary of RBI to provide Project / Term Finance ICICI (1966) Channelizing of Foreign Currency Loan from World Bank to Pvt. Sector and underwriting of Capital issues. SIDCs & SIIC State Level Corporations for SME sector UTI (1964) to enable small investors to share Industrial Growth IRCI (1971) to take care of rehabilitation of sick-mills promoted by IDBI, Banks & LIC-Name changed to IIBI in 1997

POST 1990s

Development Financial Institutions (DFIs) Started providing Working Capital also Set up CREDIT RATING AGENCIES - CRISIL , ICRA, CARE , FITCH Privatization of DFI Reduction in Govt. holding & increase in Public Participation e.g. IFCI Ltd., IDBI Ltd., ICICI Ltd. Conversion into Banking / Merger into Banking Companies IDBI Bank & ICICI Bank Issuance of Bond by DFIs without Govt.s Guarantees to mobilize resources. Reduction in holding of Govt. in Banks, i.e. Public Participation / Listing


POST 1990

Rise & Growth of Service Sector industries. Reliance & Dependence on technology. E-mail & mobile made sea-change in communication, data collection etc. Computerization a catch phrase and inevitable need of an hour. Dependent on Capital Market rather than only Debts dependency. Scalability of operations through globally competitive size. Broad basing of Board. Professional Management.


NBFC under RBI governance to finance retail assets and mobilize small/medium sized savings. Very large NBFCs are emerging (Shri Ram Transport Finance, Birla, Tata Finance, Sundaram Finance, Reliance Finance, DLF, Religare etc.

POST 1990

Commercial Bank Mutual Funds Capital Market Secondary Market Money Market



IBRD (World Bank) Long-Term Capital Assistance IFCI IDA To finance PRIVATE enterprises in the form of loans & equity Affiliate of World Bank Soft Loan window of the Bank. Mainly for developing & under-developed nations. Re-payment period up to 50 years Govt. & Private, both, eligible.

MIGA (1988)

Multilateral Investment Guarantee Agency an affiliate of World Bank Provides guarantee for investment in needy countries.
Asian region


Global Financial System An Overview

Functions of Financial Market

Price Discovery Liquidity Cost of Transactions (saver search & information costs) Transfer of savings from one sector to other Reflects as Barometer for economic growth

Financial Assets

Treasury Bonds Debt Equity Commercial Paper/Debentures etc. Euro Bonds. Gold/Silver Cross Border Bonds /instruments.


Debt Market Primary / Secondary

Forex Market

Capital Market Primary / Secondary & Depository

Insurance Life/General

Banks (including RRBs, co-op etc)

Mutual Funds, Venture Funds, Investment Bonds