Financial Institutions in India

Table of Contents:

  • Introduction to Financial Institutions in India
  • Functions of Financial Institutions in India
  • Classification of Financial Institutions in India

Introduction to Financial Institutions in India

Financial institutions in India play an important role in the country’s economy by serving as money managers. They are the backbone of the Indian Financial System. These institutions include banks, insurance, and investment companies, which offer different services to people, businesses and government. Financial management helps businesses and people save money, get insurance to protect themselves, and invest to make their money grow.

The term financial institution includes all kinds of organisations which intermediate and facilitate financial transactions of both individuals and corporate customers. Thus, it refers to all kinds of financial institutions and investing institutions which facilitate financial transactions in financial markets. They may be in the organised sector or the unorganised sector.

Financial Institutions in India, established mainly by the government, aim to provide industry with medium and long-term financial assistance. Recognized as ‘development financial institutions’ or ‘development banks,’ these institutions specialize in providing developmental finance, especially for investments in fixed assets. Financial institutions receive funds for their financing operations primarily from the government or other public institutions. These institutions also raise funds from the capital market. The various features of financial institutions are as follows:

1) Its assistance directs attention to projects, not security.

2) It provides both debt capital and equity capital.

3) It offers medium-and long-term finance to entrepreneurs.

4) It acts as a “partner in progress”, and guides, supervises and advises the entrepreneurs.

Functions of Financial Institutions in India

The functions of financial institutions are as follows:

1) Information Acquisition and Resource Allocation

Without financial institutions, savers are not prepared to commit their savings to investors who are engaging in long-term risky projects, because it is difficult and costly to monitor and evaluate such projects. In addition, savers may not have the time, capacity or means to collect and process information on a wide array of enterprises, managers and economic conditions.

2) Management of Liquidity Risk

The complexity of economic structures gives rise to transaction and information costs. Financial institutions emerge to minimise the risks associated with these costs through trading. hedging and pooling of risk. Financial institutions reduce liquidity risk through banking intermediation and the trading of equities.

3) Mobilisation of Savings

Mobilisation of savings is very costly. Financial systems that are more effective at pooling the savings of households affect economic development since better savings mobilisation improves resource allocation and consequently boosts technological innovation. Thus, by effectively mobilising resources for projects, financial institutions play a crucial role in promoting the use of better technologies, thereby encouraging growth.

4) Monitoring of Investment Projects

Another role of financial institutions is to reduce the cost of acquiring information and monitoring investment projects. Financial institutions reduce information costs because they can mobilise the savings of many individuals and lend these resources to project owners. Financial institutions improve corporate control promote faster capital accumulation and contribute to economic growth by improving the allocation of capital.

5) Resolving the Issue of Market Imperfection

Financial institutions play an important role in resolving the problems caused by market imperfections. They accept funds from surplus units and direct them towards deficit units.  Financial institutions can be classified into two main types: depository institutions and non-depository institutions.

6) Supply of Capital

These institutions have supplied capital to the small, medium and large-scale industries in India in the form of capital, venture capital, and services to foster industrial growth in India. These have contributed magnificently to the growth and development of industries.

7) Facilitating the Exchange of Goods and Services

In addition to mobilising savings and thereby expanding production technologies, financial institutions minimise transaction costs and promote specialisation, technological innovation and growth. The financial system promotes specialisation and productivity movements because its activities lead to lower transaction costs, thereby facilitating the exchange of technology in the market and allowing creative individuals to specialise in innovations that strengthen economic growth.

8) Promotion of Financial Education

Financial institutions can invest in financial education programs across the globe. Sponsors and promoters can support and encourage the increase of students in educational institutes promoting financial education. They can participate by providing funding as well as logistics support and financial planning expertise.

9) Promotion of Saving

Financial institutions (banks, securities companies, pension funds and investment management companies) occupy a unique place in market economies. Financial institutions collect the savings of the public, exchange and analyze information about prospective users of financial resources, assess risk and return, and channel resources to entities in the economy that appear most profitable, while also promoting change in those with deficient performance.

10) Other Roles

It includes:

i) Catalytic Role: As institutional investors, they play a catalytic role in providing for the equilibrium in the capital market operations. They have played a leading role in the development of a healthy capital market through their underwriting and merchant banking operations.

ii) Balanced Development: By providing maximum assistance to projects coming up in backward areas, they have facilitated the balanced regional development of the country.

iii) Industrial Development: Financial institutions in India have come to play a vital role in the rapid and planned industrialisation of the country. They provide all the financial and other facilities that are required by the program of industrial development that our country has taken up.

iv) Professional Services: They have offered professional company promotion services and helped in the launching of many new and varied industries.

v) Employment Opportunities: Their financial help to numerous new projects has provided employment opportunities to millions of people during the last 35 years.

Classification of Financial Institutions in India

The term financial institutions includes all kinds of organizations which intermediate and facilitate financial transactions of both individuals and corporate customers. Thus, it refers to all kinds of financial institutions and investing institutions which facilitate financial transactions in financial markets. Financial institutions are intermediaries that mobilize savings and efficiently facilitate the allocation of funds.

They may be classified into three categories:

1) Regulatory

Regulatory Financial Institutions in India are SEBI, IRDA, RBI, AMC etc. Before investors lend money, they need to be reassured that it is safe to exchange securities for funds. This reassurance is provided by the financial regulator who regulates the conduct of the market and intermediaries to protect the investors’ interests. For example, the Reserve Bank of India regulates the money market and the Securities and Exchange Board of India (SEBI) regulates the capital market. Some of the regulatory institutions are given as follows:

i) Securities Exchange Board of India (SEBI)

The Securities and Exchange Board of India (SEBI) was established in 1988 by the Government of India through an executive resolution. It was later upgraded to a fully autonomous body, a statutory Board, in the year 1992 with the enactment of the Securities and Exchange Board of India Act (SEBI Act) on January 30, 1992. Instead of government control, a statutory and autonomous regulatory board with defined responsibilities, covering both the development and regulation of the market and endowed with independent powers, has been established. Paradoxically, this positive outcome stems from the Securities Scam of 1990-91.

ii) Reserve Bank of India (RBI)

The Reserve Bank of India serves as the regulatory authority for the money market in India. As the central bank, it injects liquidity into the banking system, when it is deficient and contracts the same in the opposite situation.

The Reserve Bank of India (RBI) functions as the central bank of the country. It was established as a body corporate under the Reserve Bank of India Act, which came into effect on 1 April 1935. The Reserve Bank was started as a share-holders bank with a paid-up capital of t5 crores. On establishment, it took over the function of management of currency from the government of India and the power of credit control from the Imperial Bank of India.

iii) Insurance Regulatory & Development Authority (IRDA)

To provide better insurance coverage to citizens and augment the flow of long-term sources of financing infrastructure, the government reiterated its 1996 announcement in its budget speech in 1998. This included opening up the insurance sector and setting up a statutory IRDA. The IRDA Act was enacted in 1999 to establish the IRDA, aiming to protect the interests of policyholders, regulate, promote, and ensure the orderly growth of the insurance industry, and address matters connected therewith or incidental thereto. The act also included amendments to the Insurance Act, of 1938, the LIC Act, of 1956, and the General Insurance Business (Nationalization) Act, of 1972.

The Insurance Regulatory and Development Authority Act, 1999, provides for the establishment of an Authority to protect the interests of insurance policyholders, regulate, promote, and ensure the orderly growth of the insurance industry, and address matters connected therewith or incidental thereto. It also aims to amend the Insurance Act of 1938, the Life Insurance Corporation Act of 1956, and the General Insurance Business (Nationalization) Act of 1972 to end the monopoly of the Life Insurance Corporation of India (for life insurance business) and the General Insurance Corporation and its subsidiaries (for general insurance business).

2) Intermediaries

Intermediaries supply only short-term funds to corporate and individual customers. They consist of banking and non-banking intermediaries. Examples of banks are SBI and PNB, and examples of non-banking intermediaries are LIC, UTI, GIC, etc. Financial intermediaries provide key financial services such as merchant banking, leasing and hire purchase, credit rating and so on. These financial services are vital for the creation of firms, industrial expansion and economic growth.

3) Non-Intermediaries

These non-intermediaries mainly provide long-term funds to individuals and corporate customers. They consist of term lending institutions like financial corporations and investment institutions like NABARD, IDBI, IFCI, etc. Non-Banking Financial Institutions (NBFI) or Non-Banking Financial Companies (NBFC) also come in the non-intermediaries because they do not hold my banking license from the government.

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