Banking Awareness Notes : Indian Financial System

 

The ‘Indian Financial System’ is an important topic in the general awareness section of banking exams. In this blog post, we bring to you everything you need to know about the financial system in India.

What is a financial system?

While performing economic activities some units (such as shops, companies etc.) will be placed in surplus/deficit/balanced budgetary situations.

A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit.  A Financial System is a composition of various institutions, markets, regulations and laws, practices, money manager, analysts, transactions and claims and liabilities.

In other terms,

A financial system helps in wealth creation by linking savings with investments. It facilitates the flow of funds from the households (savers) to business firms (investors) and thus aids the development of both sides.

The financial system is mostly concerned about money, credit and finance – these terms are related but differ from each other as well. The Indian financial system primarily consists of the following:-

• Financial Services 
• Financial Assets/Instruments
• Financial Markets 
• Financial Intermediaries

The following sections discuss each of these in detail.

Financial Services

These refer to the activities concerning the design and delivery of financial instruments to individuals and businesses within the area of banking and related institutions, personal financial planning, leasing, investment, assets, insurance etc. These include:-

• Operations & services provided by the banks 
• Currency exchange, foreign exchange banking or the wire transfer
• Asset management, hedge fund management and the custody services
• Selling insurance policies, brokerages, insurance underwriting or the reinsurance

Financial Markets

It is defined as the market in which financial assets are created or transferred. Financial markets can be categorized as follows:-

1. Money Market– It is defined as the market for short-term money and financial assets that are near substitutes for money. The term short-term means generally a period upto one year and near substitutes to money is used to denote any financial asset which can be quickly converted into money with minimum transaction cost. It can be sub-categorized as follows:-

• Unorganized Market: money lenders, chit funds etc. 
• Organized Money Market: Instruments include: treasury bills, commercial papers, certificate of deposit etc. Organized Markets work as per the rules and regulations of RBI. RBI controls the Organized Financial Market in India.

2. Capital Market –  The capital market is designed to finance the long-term investments.  The transactions taking place in this market will be for periods over a year. It can be classified into three groups:-

• Corporate Securities Market: Corporate securities are equity and preference shares, debentures and bonds of companies. The corporate security market is a very sensitive and active market. It can be divided into two groups: primary and secondary. 
• Government Securities Market: In this market government securities are bought and sold. The securities are issued in the form of bonds and credit notes. The buyers of such securities are Banks, Insurance Companies, Provident funds, RBI and Individuals. 
• Long-Term Loans Market: Banks and Financial institutions that provide long-term loans to firms for modernization, expansion and diversification of business. It is further categorized into: Term Loans Market, Mortgages Market and Financial Guarantees Market

3. Forex Market – The Forex market deals with the multi-currency requirements, which are met by the exchange of currencies.  Depending on the exchange rate that is applicable, the transfer of funds takes place in this market.  This is one of the most developed and integrated market across the globe.

4. Credit Market– Credit market is a place where banks, FIs and NBFCs purvey short, medium and long-term loans to corporate and individuals.

Financial Assets / Instruments

Financial Assets or Financial Instruments represents a claim to the payment of a sum of money sometime in the future and /or periodic payment in the form of interest or dividend.

A financial transaction involves creation or transfer of a financial asset (as against a real transaction that involves exchange of money for real goods or services).

Some important financial assets / instruments are briefly discussed below :-

1. Call /Notice-Money Market

• It’s money borrowed or lent on demand for a very short period.
• Thus money borrowed on a day and repaid on the next working day is called call money.
• When money is borrowed or lent for more than a day and up to 14 days it is called notice money.
• No collateral is required to cover these transactions.

2. Inter-Bank Term Money

Deposits with maturity period beyond 14 days is referred as the term money. The entry restrictions are the same as that of Call/Notice Money. However, lending beyond 14 days is not allowed. 

3. Treasury Bills

These are short term (up to one year) borrowing instruments of the union government. It is an IOU by the Government (i.e. a promise by the Government to pay a sum of money after expiry of the stated period in less than one year). They are issued at a discount to the face value, and on maturity the face value is paid to the holder. The rate of discount and the corresponding issue price are determined at each auction.

4. Certificate of Deposits

It is a negotiable money market instrument and is issued in a de-materialized form or as a Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period.

These can be issued by:-

(i) Scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs)

(ii) Select pan India financial institutions that have been permitted by RBI to raise short-term resources within the fixed limit.

(iii) Banks have the freedom to issue CoDs depending on their requirements.

5. Commercial Paper

CP is a note in evidence of the debt obligation of the issuer. It is thus an unsecured promissory note privately placed with investors at a discount rate to face value determined by market forces. A company shall be eligible to issue CP provided-

(i) the tangible net worth of the company is not less than Rs. 4 crores

(ii) the working capital (fund-based) limit of the company from the banking system is not less than Rs.4 crore and

(iii) the borrowal account of the company is classified as a Standard Asset by the financing bank/s.

The minimum maturity period of a commercial paper is 7 days.

Capital Market Instruments

It consists of the following long term period (i.e. more than one year period) financial instruments:-

• Equity shares, preference shares, convertible preference shares, non-convertible preference shares etc
• Zero coupon bonds, deep discount bonds etc.

Financial Intermediation

The role of the financial intermediary is to distribute funds from people who have extra inflow of money to those who don’t have enough money to fulfill the needs.

The best example of an intermediary is a bank which transforms the bank deposits to bank loans.

Some of the important intermediaries operating in the financial markets include: investment bankers, underwriters, stock exchanges, registrars, depositories, custodians, portfolio managers, mutual funds, financial advertisers financial consultants, primary dealers, satellite dealers, self regulatory organizations, etc.

Intermediary	Market	Role
Stock Exchange	Capital Market	Secondary Market to securities
Investment Bankers	Capital Market, Credit Market	Corporate advisory services, Issue of securities
Underwriters	Capital Market, Money Market	Subscribe to unsubscribed portion of securities
Registrars, Depositories, Custodians	Capital Market	Issue securities to the investors on behalf of the company and handle share transfer activity
Primary Dealers Satellite Dealers	Money Market	Market making in government securities
Forex Dealers	Forex Market	Ensure exchange ink currencies

Hope this helps.

All the best!!