Indian Financial System Overview, Functions, Structure

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Overview of Indian financial system

Overview of Indian Financial System: The financial system enables borrowers and lenders to exchange funds. Indian Financial System is regulated by independent authorities in sectors such as insurance, banking, capital markets, and various service sectors.

An efficient articulate and developed financial system is indispensable for the rapid economic growth of any economy. The process of economic development is always accompanied by a corresponding and parallel growth of financial organisations. However, these organizations vary widely in their operating policies, institutional structure, and regulatory and legal framework. These organizations are largely influenced by the prevailing politico-economic environment. Planned economic development in India greatly influenced the course of financial development. The deregulation, liberalization, and globalization of the Indian economy since the early nineties have had important implications for the future course of the development of the financial system. The evolution of the Indian financial system, from the viewpoint of exposition, can be categorized into three distinct phases:

1) Upto 1951, corresponding to the post-independence scenario, on the eve of the initiation of planned economic development.

2) From 1951 to the mid-1980s, reflecting the requirements of planned economic growth.

3) After the early nineties, responding to the requirements of a deregulated, liberalized, and globalized economic environment.

Below is a brief description of the three phases of the Indian financial system:

Phase 1: Pre-1951 Organisation

During the first phase, the organization of the financial system was immature and rudimentary, reflecting the underdeveloped nature of the industrial economy of the country. It was incapable of sustaining a high level of capital formation and an accelerated pace for industrial development.

Phase 2: 1951 to Mid-Eighties

During the second phase, the mixed economy model with the growing accent on an ambitious industrialisation program had a significant bearing on the evolution of the financial system and greatly conditioned the regulatory framework and institutional structure. The main elements of the financial organisation in planned economic development could be categorised into four broad groups:

1) Public/Government ownership of financial institutions,

2) Fortification of the institutional structure,

3) Protection of investors, and

4) Involvement of financial institutions in corporate management.

In brief, a unique financial system emerged in India by the mid-eighties, in conformity with the requirements of planning and the dominant role of the government in the Indian economy.

Phase 3: Post Nineties

With the liberalisation/globalization of the economy, especially since the beginning of the nineties, the organisation of the Indian financial system has been characterised by profound transformation. The notable developments during this phase are concerning:

1) Privatisation of financial institutions,

2) Re-organisation of institutional structure, and

3) Investor’s protection.

Banking growth and development were haphazard and unsystematic. India inherited an extremely weak banking structure at the time of independence. The number of banks in existence then was 648, an unwieldy number not amenable to closer monitoring and control. They had 4,288 branches, mostly in urban areas. Only some banks, especially in the south, had branches in smaller towns and rival areas, 15 exchange banks were operating in Bombay, Madras and Calcutta financing the foreign trade. Thus, most of the banks lacked the all-India character and had limited prographical coverage in their business. The Imperial Bank was operating with its imperialistic posture, distancing itself away from the common man Commercial banks were generally characterised by conservation, rigidity and lack of farsightedness, during the period of traditional banking which broadly continued up to the year 1951.

Meaning of Indian Financial System

The financial system is possibly the most important functional and institutional mechanism for driving economic transformation. Finance is a bridge between the present and the future and whether it is the mobilization 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.

Definition of Indian Financial System

According to Christy, 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”.

A financial system or financial sector acts as an intermediary and facilitates the flow of funds from areas of surplus to areas of deficit. It is a composition of various institutions, markets, regulations and laws, practices, finance managers, analysts, transactions and claims and liabilities. The flow of financial services is explained in the image given below:

The term “financial system,” with the inclusion of the word “system,” implies a complex and closely connected set of institutions, agents, practices, markets, transactions, claims, and liabilities in the economy.

The financial system is concerned with money, credit, and finance; these three terms are intimately related, yet somewhat different from each other. The Indian financial system comprises financial institutions, financial instruments, financial markets and financial intermediation.

Nature of Indian Financial System

The nature of the financial system is as follows:

1) The financial system facilitates the expansion of financial markets over space and time.

2) The financial system provides an ideal linkage between depositors and investors, thus encouraging both savings and investments.

3) The financial system influences both the quality and the pace of economic development.

4) The financial system promotes the efficient allocation of financial resources for socially desirable and economically productive purposes.

Functions of Indian Financial System

A successfully functioning financial sector is an important condition for the growth of the economy in every country. The functions of the financial system are explained under the following heads:

1) Accelerate the Volume and Rate of Savings

Besides mobilizing savings, the financial system helps accelerate the volume and rate of savings by providing a diversified range of financial instruments and services through intermediaries.

This results in increased competition in the financial system which channelizes resources towards the optimised return or highest potential return investment for a given degree of risk. This reduces financial intermediation costs and promotes economic growth.

2) Increase the Output of the Economy

The presence of a well-functioning financial system facilitates economic activity and growth. The growth of financial structure is a basic prerequisite for fostering economic growth. In other words, markets, institutions, and instruments are the prime movers of economic growth. The financial system of a country diverts the country’s savings towards more productive uses and so it helps to increase the output of the economy.

3) Evaluating Assets, Increasing Liquidity, Producing and Spreading Information

In addition to affecting the rate and nature of economic growth, a financial system is useful in evaluating assets, increasing liquidity, and producing and disseminating information.

4) Makes Innovation

A sophisticated financial system makes innovation the least costly and most profitable, thereby enabling faster economic growth. Countries whose financial systems encourage diverse financing arrangements can maintain international competitiveness by updating their productive capacities.

5) Stability and Resilience

Financial markets represent the deep end of the financial system, the deeper the system, the greater its stability and resilience. A well-developed money and government securities market helps the Central bank conduct monetary policy effectively with the use of market-based instruments.

Well-developed financial markets are also required for creating a balanced financial system in which both, financial markets and financial institutions play important roles. An imbalance between the two leads to a financial crisis, as it happened in South-East Asia.

6) Risk Management Services

It happens often that a financial system develops in response to changing patterns of demand for funds. In the 1970s, there was a worldwide increase in the demand for more risk management services. Many financial systems met this demand by increasing trading activity and by the development of many new risk management products. Hence, economic growth can also stimulate the growth of the financial system.

7) Accelerates the Rate of Economic Growth

There has been much theorizing about a two-way and symbiotic relationship between the financial system and economic growth. A sophisticated and sound financial system accelerates the rate of economic growth, and, in turn, the financial system develops further with higher economic growth.

8) Disciplining and Guiding the Management Companies

The financial system plays an important role in disciplining and guiding management in companies, leading to sound corporate governance practices. When linked to the international financial system, the domestic financial system increases capital flow through financial markets. This link reduces risk through portfolio diversification and helps accelerate economic growth.

Features of Indian Financial System

Features of Indian financial system are as follows:

1. It encourages both savings and investment.

2. It plays an important role in the economic development of a country.

3. It helps in capital formation.

4. It links savers and investors.

5. It facilitates the expansion of financial markets.

6. It helps in the allocation of risk.

Structure of Indian financial system

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