Unit 1- Introduction to Indian financial system BCom-final year

INTRODUCTION TO FINANCIAL SYSTEM

Introduction
 A financial system plays an important role in the economic development of the
country.
 In finance, a finance system is the system which allows the transfer the money from
the sabers and borrowers.
 It consists of closely interconnected financial institutions, markets, services,
instruments, transactions and practices.
 Finance is monetary resources and financing means the activity of providing required
monetary resources to the needy person and institution.
 Financial system operates at national level, global level and firm specific level.
 It includes the public, private, government spaces and financial instruments which
can relate to countless assets and liabilities.

Meaning:
 Financial system refers to a system that is concerned with mobilization of savings of
the public and providing necessary funds to the needy persons and institutions for
enabling the production of goods and provision of services.
 Financial system consists of complex and closely related services, markets and
institutions used to provide an efficient services and regular linkage between
investors and depositors.

Definitions:
 “It is a set of institutions, instruments and markets which fosters savings and
channels them to their most efficient use”. (- H. R. Machiraju)

 According to Prasanna Chandra, “Financial system consists of variety of institutions,

markets and instruments related in a systematic manner and provides the principal
means by which the savings are transformed into the investments”.

 In the words of Van Horne, “Financial system allocates savings efficiently in an

economy to ultimate users either for investment in real assets or for consumption”.
From the above definition’s we can say that the primary function of the financial
system is the mobilization of the savings, their effective utilization for investment in
various sectors of economy and stimulating capital formation to accelerate the
process of economic growth.

Significance of Financial system:

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Leads to savings

Meets the requirement of buisness through financial market

Enables invetsment

Leads to capital formation

Ultimately brings economic growth

Components of financial system:
India being a democratic economy has independent pillars of financial system especially in
the areas of banking, capital and stock market, insurance, liability claims and investments.
The Structure of Indian financial system has important components they are:

Financial assets

Financial intermediaries / Instituions

Financial market

Financial rate of returns

Financial instruments

Financial services

1. Financial assets: These are the goods or products that are traded in the financial
market.
The objective is to provide convenient trade in financial market based on the
requirements of those who seek credit

Financial assets include:

 Call money: without any assurance(security), loan is lent for just one day and
repaid the next day.
 Notice money: without any assurance(security), loan is lent for more than a
day but less than the duration of 14 days.
 Term money: when the duration of the maturity of particular amount is
more than 14 days.
 Treasury bills: with the duration of maturity of less than one year, these
belong to the government in the form of bond or debt. These are bought in

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the form of government T-bills which are taken as loans from the
government.
 Certificate of deposit: These are funds that remain deposited in particular
bank for fixed period of time.
 Commercial papers: used by corporate, it is instrument that is not secured
even though for short duration of debt.

2. Financial institutions: they act as a mediator between borrower and lender. They
gather savings from various commercial markets. They collect large deposits and
lend It as a loan. They balance between the loan taker and amount depositor.
Financial institutions are divided into two:
 Banking and depository institutions: their role is to collect deposits from the
public. Interest is paid on these deposits made. The loan is lent whenever
needed. Interest is charged on those who take the loan.
 Non-Banking or Non depository institutions: their role is to sell commercial and
financial goods and products. They offer insurance, mutual fund schemes,
brokerage etc. they are further divided into three categories:
Regulators: they regulate and control the complete financial system. Example:
RBI, IRDA, SEBI etc.
Intermediates: those institutions offer financial counselling and help by offering
loans. example: PNB, Axis, HDFC etc.
Non intermediates: these institutions help corporate visitors with their finance,
Examples: NABARD, SIDBI etc.

3. Financial markets: the market where trade or exchange of securities like bonds,
shares, etc. takes place between buyers and sellers. There are four major types of
financial markets they are:
 Capital market: deals with the securities whose maturity is more than one
year.
 Money market: they are market for short term securities. the market is
dominated by government, Banks and other institutions. It is a wholesale
debt market having low risk and high liquidity.
 Foreign exchange market: It a market which deals with several currencies. It
is responsible for foreign transfer of funds.
 Credit market/ debt market: Involves short- and long-term duration loans
given to both individuals and organizations. They are granted by several
banks, financial institutions, non-financial institutions etc.

Difference between money market and capital market:

On the basis of Money market Capital market
Meaning Involves dealing in short Involves dealing in long
term funds term funds
Financial assets Deals with assets like Deals with shares,
treasury bills, commercial debentures, bonds etc.
papers, bills of exchange,
certificate of deposits etc.

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Participants Commercial Banks, NBFC Stock brokers,

etc. underwriters, mutual fund
companies, investors etc.
Regulators Regulated by RBI Regulated by SEBI

4. Financial rate of return: refers to the percentage of income generated from the
financial assets. There are two types of rates of return, dividend from shares and
interest on securities, the second type return is capital appreciation. Capital
appreciation is nothing but increase in the value of the asset. The returns from
government securities are comparatively less from that of commercial securities. But
in government securities the risk involved is comparatively less.

The rate of return on any security depends upon the risk involved, the purpose for
which investment is used etc. The interest rate policy of the country is designed by
central bank to achieve the following objectives:
 To enable government to borrow funds at lower rate of interest.
 To ensure striking balance between the economic growth and inflation.
 To mobilize savings in the economy.
 To support specific sector through concessional lending rate.

Illustration
Mr. A subscribes to the equity shares of RKS Ltd on 1/14/2014 for Rs. 1,00,000. After
receiving dividend 15% from the company, he sells the equity shares at Rs 1,20,000.
What is financial rate of return?
Solution:
Investment value Rs 1,00,000 income generated
= Dividend + capital appreciation
= 15000+20000
= Rs 35000
Financial rate of return = (Income generated/ Investment) X 100
= (35000/100000) X 100
= 35%

5. Financial instruments: Financial instruments refers to the documents that

represents financial claim.
A financial claim is claim to repayment of aa certain amount of money at the end of a
specific period along with interest or dividend.
Shares, debentures, Bonds, mutual funds, LIC policies etc. are examples of financial
instruments.
These financial instruments are further classified into
 primary securities
 secondary securities
Primary securities are financial instruments that are issued directly to the savers by
the users of the funds. For example, shares or debentures issued by joint stock
company are directly issued to public.

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Secondary securities: these are financial securities that are issued to the savers by
some intermediaries. For example: Units issued by UTI and other mutual fund
companies
Again, these securities may be classified on the basis of duration:
1. Short- term securities
2. Medium – term securities
3. Long term securities
Short term securities are those securities which mature within a period of one year
example: Bills of exchange, Treasury bill etc.
Medium term securities are those which have maturity period ranging between one
and five years. For example: debentures
Long term securities: whose maturity is more than five years. For example,
government bonds maturing after 10 years.

Characteristics of financial instruments:

1. Most of the instruments are easily transferred from one hand to another
without much cumbersome formalities.
2. They have ready market i.e., they can be bought and sold frequently and
thus trading in these is made possible.
3. They possess liquidity i.e.; some instruments can be converted into cash
readily.
4. Most of the securities posse’s security value, they can be kept as security for
the purpose of raising loans.
5. Some security enjoys tax benefits, some Government securities enjoy tax
benefits.
6. They carry risk in the sense that there is uncertainty with regard to payment
of principle or interest or dividend as the case may be.
7. These instruments facilitate further trading as to cover risks due to price
fluctuations, interest rate fluctuations etc.
8. Instruments involve less handling cost since expenses involved in buying and
selling these securities are generally much less.
9. The return on these instruments is directly proportionate to the risk.
10. These instruments may be short term or medium term or long-term
depending upon the maturity period of these instruments.

6. Financial services: Financial assistance Provided by the financial institutions are

financial services.
The major objective is to provide counselling to the customers regarding the
purchase or selling of property, permitting transactions, deals, lending etc.
Financial services include:
 Banking services: Functions performed by bank such as provision of loans,
accepting of deposits, account openings, money transfer etc. are part of
these services.
 Insurance services: these include services of offering insurance, selling
polices etc.
 Investment services: These services include overlooking and management of
investments, assets and deposits.

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 Foreign exchange services: these include currency exchange functions,

foreign exchange and foreign fund transfers.

FUNCTIONS OF THE INDIAN FINANCIAL SYSTEM:

1. Provision of Liquidity: In financial system, liquidity means the ability to convert into
cash. The financial market provides the investors the opportunity to liquidate their
investments, which are in instruments like shares, debentures, bonds, etc. Price is
determined on the daily basis according to the operations of the market force of
demand and supply.

2. Mobilization of savings: another important function is to mobilize savings and

channelize them to productive activities. The financial system should offer
appropriate incentive to attract savings and make them available for more
productive ventures. Thus, the financial system facilitates transformation of savings
into investment and consumption.

3. Size transformation function: generally, the savings of small investors are in small
unit which cannot find any fruitful avenue for investment unless it is transformed
into a perceptible size of credit unit. Banks and other financial intermediaries
perform the size transformation function by collecting deposits from major small
customers and giving them as a loan of sizable quantity.

4. Maturity transformation function: the financial intermediaries accept the deposit

from the public in different maturities according to their liquidity preference and
lend them to the borrowers in the different maturity according to the need and
promote the economic activity.

5. Risk transformation function: Most of the investors hesitate to directly invest in

stock market. The financial intermediaries collect the savings from the public and
distribute it in different investment units with their knowledge and expertise. Thus,
the risk of investors gets distributed.

KEY ELEMENTS OF FINANCIAL SYSTEM:

Key elements of financial system are:
1. A strong legal and regulatory environment: capital market is regulated by SEBI
which acts like watch dog of security market. Likewise, money market is
regulated by RBI. Thus, a strong legal system protects the rights and interest of
investors and acts as a most important element of sound financial system.

2. Stable money: financial system ensures stability in the flow of money. Frequent
fluctuations and depreciations in the value of money lead to financial crises and
restrict economic growth.

3. Sound public finances and debt management: setting control on public

expenditures and revenues to fund these expenditures efficiently. Public debt
management is the process of establishing and executing strategy for managing

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the government debt in order to raise required amount of funding. It includes

developing and maintain an efficient market for government securities.

4. Central bank: a central bank supervises and regulates the operations of banking
system. It acts as a banker to the banks and government, manager of money
market and foreign exchange market and also lender of last resort. The monetary
policy of the central bank is used to keep the pace of economic growth.

5. Sound banking system: a well-functioning system must have variety of bank both
private and public sector having domestic and international operations with an
ability to withstand adverse national and international events. They perform
varied functions such as operating the payment and clearing system and foreign
exchange market.

6. Information system: proper information disclosure practices form the basis of

sound financial system for example: corporates have to disclose their financial
statements and performance. Similarly at the time of IPO’s the companies have
to disclose the information regarding their financial health and efficiency.

7. Well-functioning securities market: security market ensures the issue of both

equity and debt. An efficient security market help in deployment of funds raised
through the capital market to the required sections of the economy, lowering the
cost of capital for the firms, enhancing liquidity and attraction of foreign
investment.

ROLE OF FINANCIAL SYSTEM IN ECONOMIC DEVELOPMENT

The development of any country depends on the economic growth the country achieves
over a period of time. Economic growth deals about investment and production and also the
extent of Gross Domestic Product in a country. Only when this grows, the people will
experience growth in the form of improved standard of living, namely economic
development.
The following are the roles of financial system in the economic development of a country.
1. Savings-investment relationship to attain economic development, a country needs
more investment and production. This can happen only when there is a facility for
savings. As, such savings are channelized to productive resources in the form of
investment. Here, the role of financial institutions is important, since they induce the
public to save by offering attractive interest rates. These savings are channelized by
lending to various business concerns which are involved in production and
distribution.
2. Financial systems help in growth of capital market: Any business requires two types
of capital namely, fixed capital and working capital. Fixed capital is used for
investment in fixed assets, like plant and machinery. While working capital is used
for the day-to-day running of business. It is also used for purchase of raw materials
and converting them into finished products.
 Fixed capital is raised through capital market by the issue of debentures and shares.
Public and other financial institutions invest in them in order to get a good return
with minimized risks.

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 For working capital, we have money market, where short-term loans could be raised
by the businessmen through the issue of various credit instruments such as bills,
promissory notes, etc.
 Foreign exchange market enables exporters and importers to receive and raise funds
for settling transactions. It also enables banks to borrow from and lend to different
types of customers in various foreign currencies. The market also provides
opportunities for the banks to invest their short-term idle funds to earn profits. Even
governments are benefited as they can meet their foreign exchange requirements
through this market.

3. Government Securities market: Financial system enables the state and central
governments to raise both short-term and long-term funds through the issue of bills
and bonds which carry attractive rates of interest along with tax concessions. The
budgetary gap is filled only with the help of government securities market. Thus, the
capital market, money market along with foreign exchange market and government
securities market enable businessmen, industrialists as well as governments to meet
their credit requirements. In this way, the development of the economy is ensured
by the financial system.

4. Financial system helps in Infrastructure and Growth: Economic development of any

country depends on the infrastructure facility available in the country. In the
absence of key industries like coal, power and oil, development of other industries
will be hampered. It is here that the financial services play a crucial role by providing
funds for the growth of infrastructure industries. Private sector will find it difficult to
raise the huge capital needed for setting up infrastructure industries. For a long time,
infrastructure industries were started only by the government in India. But now, with
the policy of economic liberalization, more private sector industries have come
forward to start infrastructure industry. The Development Banks and the Merchant
banks help in raising capital for these industries.
5. Financial system helps in development of Trade: The financial system helps in the
promotion of both domestic and foreign trade. The financial institutions finance
traders and the financial market helps in discounting financial instruments such as
bills. Foreign trade is promoted due to per-shipment and post-shipment finance by
commercial banks. They also issue Letter of Credit in favour of the importer. Thus,
the precious foreign exchange is earned by the country because of the presence of
financial system. The best part of the financial system is that the seller or the buyer
do not meet each other and the documents are negotiated through the bank. In this
manner, the financial system not only helps the traders but also various financial
institutions. Some of the capital goods are sold through hire purchase and
instalment system, both in the domestic and foreign trade. As a result of all these,
the growth of the country is speeded up.
6. Employment Growth is boosted by financial system: The presence of financial
system will generate more employment opportunities in the country. The money
market which is a part of financial system, provides working capital to the
businessmen and manufacturers due to which production increases, resulting in
generating more employment opportunities. With competition picking up in various

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sectors, the service sector such as sales, marketing, advertisement, etc., also pick up,
leading to more employment opportunities. Various financial services such
as leasing, factoring, merchant banking, etc., will also generate more employment.
The growth of trade in the country also induces employment
opportunities. Financing by Venture capital provides additional opportunities for
techno-based industries and employment.
7. Venture Capital: There are various reasons for lack of growth of venture capital
companies in India. The economic development of a country will be rapid when
more ventures are promoted which require modern technology and venture capital.
Venture capital cannot be provided by individual companies as it involves more risks.
It is only through financial system; more financial institutions will contribute a part of
their investable funds for the promotion of new ventures. Thus, financial system
enables the creation of venture capital.
8. Financial system ensures Balanced growth: Economic development requires a
balanced growth which means growth in all the sectors simultaneously. Primary
sector, secondary sector and tertiary sector require adequate funds for their growth.
The financial system in the country will be geared up by the authorities in such a way
that the available funds will be distributed to all the sectors in such a manner, that
there will be a balanced growth in industries, agriculture and service sectors.

9. Financial system helps in fiscal discipline and control of economy: It is through the
financial system, that the government can create a congenial business atmosphere
so that neither too much of inflation nor depression is experienced. The industries
should be given suitable protection through the financial system so that their credit
requirements will be met even during the difficult period. The government on its
part, can raise adequate resources to meet its financial commitments so that
economic development is not hampered. The government can also regulate the
financial system through suitable legislation so that unwanted or speculative
transactions could be avoided. The growth of black money could also be minimized.

10. Financial system’s role in Balanced regional development: Through the financial
system, backward areas could be developed by providing various concessions or
sops. This ensures a balanced development throughout the country and this will
mitigate political or any other kind of disturbances in the country. It will also check
migration of rural population towards towns and cities.

GROWTH OF FINANCIAL SYSTEM IN INDIA:

Until independence in the year 1947, there was no strong financial system in India. Private
sector and unorganized financial intermediaries played the key role of financing the
industry. They were not following any justifiable way in financing the trade and commerce.
On the whole, the financial system was facing a chaotic condition. The growth of India since
independence is discussed below:
 Nationalization of financial institutions: After independence with the adaption of
mixed economy the government started creating new financial institutions for the

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supply of finance for both industrial and agriculture purpose. The financial
institutions that were nationalized over the year are:
I. In the year 1949, Reserve Bank of India (established in 1935) was
nationalized.
II. In the year 1955, the Imperial Bank of India was nationalized and renamed
as State Bank of India.
III. In the year 1956, 245 Insurance business entities were merged and Life
insurance corporation came into existence.
IV. In the year 1969, 14 commercial Bank were nationalized.
V. In the year 1972, general Insurance business entities were merged
(consisting of 55 Indian companies and 52 other general insurance of other
countries) to form General Insurance corporation of India.

 Establishment of Unit trust of India: The UTI was established in the year 1964 to
strengthen the Indian mutual fund sector and financial system. It was entrusted with
the work of mobilizing the savings and provision of credit facility for productive
purpose. In recent years it has established subsidiaries like
I. The UTI bank
II. The UTI investor service Ltd.
III. The UTI security exchange Ltd.

 Establishment of development Banks: Another landmark in the history of

development of Indian financial system is the establishment of new financial
institutions to supply institutional credit to industries
I. . The first development bank was established in 1948. That was Industrial Finance
Corporation of India (IFCI).
II. In 1951, Parliament passed State Financial Corporation Act. Under this Act, State
Governments could establish financial corporations for their respective regions.
III. The Industrial Credit and Investment Corporation of India (ICICI) were set up in
1955. It was supported by Government of India, World Bank etc.
IV. The Refinance corporation of India (RCI) was established in the year 1958 to
provide refinance facilities to banks against term loans granted by them to medium
and small units.
V. Industrial Development Bank of India (IDBI) was established on 1st July 1964 as a
wholly owned subsidiary of the RBI. On February 16, 1976, the IDBI was delinked
from RBI. It became an independent financial institution
VI. On April 2, 1990 the Small Industries Development Bank of India (SIDBI) was set up
as a wholly owned subsidiary of IDBI.

 Establishment of Institution for Agricultural Development: In 1963, the RBI set up

the Agricultural Refinance and Development Corporation (ARDC) to provide
refinance support to banks to finance major development projects, minor irrigation,
farm mechanization, land development etc. In order to meet credit needs of
agriculture and rural sector, National Bank for Agriculture and Rural Development
(NABARD) was set up in 1982. The main objective of the establishment of NABARD is
to extend short term, medium term and long-term finance to agriculture and allied
activities.

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 Establishment of Export and Import Bank of India: it was established in the year
1982 to take over the operations of the international wing of IDBI. Its primary
objective is to provide finance to exporter and importer.

 Establishment of National housing Bank: The National Housing Bank (NHB) has been
set up in July 1988 as an apex institution to mobilise resources for the housing sector
and to promote housing finance institutions.

 Establishment of Stock Holding Corporation of India (SHCIL): In 1987, another

institution, namely, Stock Holding Corporation of India Ltd. was set up to strengthen
the stock and capital markets in India. Its main objective is to provide quick share
transfer facilities, clearing services, support services etc. to investors.

 Establishment of mutual funds industry: Mutual funds refer to the funds raised by

financial service companies by pooling the savings of the public and investing them
in a diversified portfolio. They provide investment avenues for small investors who
cannot participate in the equities of big companies.

 Establishment of venture capital industry: Venture capital is a long-term risk capital

to finance high technology projects. The IDBI venture capital fund was set up in
1986. The ICICI and the UTI have jointly set up the Technology Development and
Information Company of India Ltd. in 1988 to provide venture capital.

 Establishment of credit rating agencies: credit rating agencies like CRISIL, ICRA,
CARE, etc. are being established to help investors make decision of their investment
and also protect them from risky ventures.

 Introduction of new financial instruments: new and different financial instruments

like public sector bonds, national saving certificate, post office saving schemes,
different types of shares debentures and insurance etc are introduced as per the
needs of investors.

 Legislative support: over a period of time many legislative measures are taken up to
protect the interest of investors like capital issue and control act 1947, securities
contract and regulation act 1956, foreign exchange regulation act 1973 etc to
support the smooth functioning and growth of Indian financial system.

REFORMS IN THE FINANCIAL SYSTEM:

Financial sector is the backbone of every economy it plays an important role in mobilization
and allocation of resources. Financial sector reforms have been long regarded as an
important part of policy reforms in the developing country. This is because they are
expected to increase the efficiency of resource mobilization and allocation in real economy
which in turn expect to generate higher rate of growth.
Meaning of financial reform:
Financial reform means to improve the allocate efficiency of resources and ensure financial
stability and maintain confidence in the financial system by enhancing its soundness and

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efficiency. Reforms of the financial sector was recognized from the very beginning as an
internal part of economic reforms initiated in 1991.
Objectives of financial sector reforms:
1. The main objective of the financial sector is to allocate the resources efficiency,
increasing the return on investment and accelerated the growth of real sector in the
economy.
2. Create an efficient, competitive and stable that could contribute measure to
stimulate growth.
3. Relaxation of eternal constrains in the operation of banking sector, restructuring,
recapitalization in the competitive element in the market through entry of new
banks.
4. Increased transparency in banking system through the introduction of prudential
norms and increase the role of the market forces due to the deregulated interest
rate.
5. Remove financial repression and provide operational and functional autonomy to
institutions.
6. Promote the maintenance of financial stability even in the face of domestic and
external shocks.
PHASES OF SECTOR REFORMS
1. The first phase is also known as first generation reform. By which the Indian
economy has achieved high growth in an environment of micro economic and
financial stability. The objective was to create an efficient, productive and profitable
financial services in industry. Narasimha committee view that in this phase India
should not have focused on the financial weakness but should strive to eliminate the
root cause of challenges faced by the Indian economy.

2. Second generation reforms: It commenced in the mid 1990’s and laid emphasis on
strengthening the financial system on the introduction of the structural
improvement. Narasimha committee II was entrusted with the responsibility of
future reforms for the growth of the Banking sector wit international standards.

PRINCIPLES OF FIANNCIAL REFORMS:

1. Development of financial institutions.
2. Development of efficient, competitive and stable financial sector.
3. Development of financial infrastructure in terms of technology, changing real frame
framework, setting up of supervision body lying down of audit standards.
4. Introduction of complementary reforms in monetary and fiscal and external sector.
5. Initiative to nurture integrate and develop money, forex and debt market.

Approaches of financial sector reform

Financial sector reforms can be divided into four approaches.
1. Banking sector reforms
2. Debt Market reforms
3. Forex market reforms
4. Reforms in another segment

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1. Banking sector reforms: Despite the general approach of the financial sector reforms
process, many of regulatory and supervisory norms were started out first for commercial
banks and thereafter were expanded to other financial intermediaries. It consists of a two -
fold process. Firstly, the process involved recapitalization of banks from government
resources to bring them at par appropriate capitalization standards. On a second level, an
approach was adopted replacing privatization. The main idea was to increase the
competition in the banking system. The main aim of banking sector reforms was to promote
a diversified, efficient and competitive financial system with ultimate goal of improving the
allocate efficiency of resources through operational flexibility, improved financial viability
and institutional strengthening. There are many reforms taken for enhancing the
effectiveness of banking system like prudential norms, supervisory measures, technology
related measures.
1. Introduction and phased implementation of international best practices
2. Norms for risk -weighted capital adequacy requirements, accounting, income recognition
3. Measures to strengthen risk management through recognition of different components
of risk, norms on connected lending, risk concentration.
4. Granting of operational autonomy to public sector banks, transparency norms for entry
of Indian private sector, foreign and joint -venture investment in the financial sector in the
form of FDI (foreign direct investment)
5. Establishment of board for financial supervision as the apex supervisory authority for
banks, financial institution and NBFC (non-banking financial companies)

2. Debt Market reforms Major : reforms have been carried out in the government securities
debt market .Functioning of Government securities debt market was really initiated in the
1990s.The system had to essentially move from a strategy of pre-emption of resources from
banks at administrated interest rates and through monetization of a SLR(statutory liquidity
ratio)The high SLR reserve requirement lead to the creation of a captive market for
government securities which were issued at low administrated interest rate .Major reforms
in the debt market is
1. Administrated interest rates on government were replaced by an auction system for price
discovery.
2. Primary dealers were introduced as market makers in the government securities market
3. Repo was introduced as a tool of short -term liquidity adjustments.
4. Foreign institutional investors were allowed to invest in government securities in certain
limit
5. 91-day treasury bills were introduced for managing liquidity.

3.Forex Market Reforms: The forex market exchange market in India had been
characterized by heavy control since the 1950s along with increasing trade control designed
to foster import substitution. Both current and capital accounts were shut and forex was
made available through a complex licensing system undertaken by the RBI. The reforms
were taken in forex market are
1. Evolution of exchange rate regime from a single -currency to fixed exchange rate
system to fixing the value of rupee against a basket of currencies.
2. Replacement of the earlier FERA act 1973, by the market Friendly FEMA act 1999.
3. Development of rupee -foreign currency swap market.

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4. Permission to various participants in the foreign exchange market including

exporters, FIIS (foreign institutional investors).
5. Foreign exchange earners permitted to maintain foreign currency account.

6. Reforms in other segments of the financial sector:

 Measures aimed at establishing prudential regulation, supervision,
competition and efficiency enhancing measures have also been introduced
for non-bank financial intermediaries (NBFs). Development finance
institution, NBFs, urban cooperative banks, specialized term lending
institution and primary dealers all of these have been brought under the
regulation of the board for financial supervision.
 Another important reform is establishment of SEBI act 1992 as a regulator
for equity markets.
 Mutual funds have been permitted to open offshore funds for the purpose
of investing in equities.
 The Indian corporate sector has been allowed to tap international capital
markets through ADRs (American depository receipt), GDRs (Global
depository receipt), FCCBs (foreign currency convertible bonds), and NRIs
(non-resident Indians) have been allowed to invest in Indian companies.

LIMITATIONS OR WEAKNESS OF INDIAN FINANCIAL SYSTEM

After the introduction of planning, rapid industrialization has taken place. It has in turn led
to the growth of the corporate sector, government sector. In Order to meet the growing
requirements of the government and the industries, many innovative financial instruments
have been introduced. Besides, there has been a mushroom growth of financial
intermediates to meet the ever-growing financial requirements different types of
customers. Hence, the Indian financial system is more developed and integrated today that
what it was 50 year ago. Yet suffers from some weakness as listed below:
(I) Lack of Co-ordination between Different Financial Institutions
There are a large number of financial intermediaries. Most of the vital financial institutions
are owned by the Government. At the same time, the Government is also the controlling
authority of these institutions. In these circumstances, the problem of co-ordination arises.
As there is multiplicity of institutions in the Indian financial system, there is lack of co-
ordination in the working of these institutions.

(ii) Monopolistic Market Structures

In India some financial institutions are so large that they have created a monopolistic
market structure in the financial system. For instance, the entire life insurance business is in
the hands of LIC. The UTI has more or less monopolized the mutual fund industry. The
weakness of this large structure is that it could lead to inefficiency in their working or
mismanagement of lack of effort in mobilizing savings of the public and so on.

(iii)Dominance of development Banks in Industrial finance: The development banks

constitute the backbone of the India financing system occupying an important place in the

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Unit 1- Introduction to Indian financial system BCom-final year

capital market. Tire industrial financing today in India is largely through tire

financial institutions created by the Government both at tire national and regional levels.
These development from their sponsors. As such, they fail to mobilize the savings of the
public. This would be a serious bottleneck which stands in the way of the growth of an
efficient financial system in tire country. For industries abroad, institutional finance has
been a result of institutionalization of personal savings through media like banks, UC,
pension and provident funds, unit trusts and so on.

(iv) Inactive and erratic capital market: The important function of any capital market is to
promote economic development through mobilization of savings and their distribution
to productive ventures. As far as industrial finance in India is concerned, corporate
customers are above to raise their financial resources through development banks. So, they
need not go to the capital market. Moreover, they don't resort to capital market since it is
very erratic and inactive. Investors too prefer investments in physical assets to investments
in financial assets. The weakness of the capital market is a serious problem in our financial
system.

(v) Imprudent Financial Practice

The dominance of development banks has developed imprudent financial practice among
corporate customers. The development banks provide most of the funds in the form of term
loans. So, there is a preponderance of debt in the financial structure of corporate
enterprises. This predominance of debt capital has made the capital structure of
the borrowing concerns uneven and lopsided. To make matters worse, when corporate
enterprises face any financial crisis, these financial institutions permit a greater use of debt
than is warranted. It is against the traditional concept of a sound capital structure. 

However, in recent times all efforts have been taken to activate capital market. Integration
is also taking place between different financial institutions. For instance, the unit linked
insurance schemes of the UTI are being offered to the public in collaboration with the LIC.
Similarly, the refinance and rediscounting facilities provided by the IDBI aim a integration.
Thus, Indian financial system has become a developing one.

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