Indian Financial System – Formal, Informal Financial System

April 12, 2020
indian financial system
SEBI Grade A Test Series

Indian Financial System consists of complex network of financial institutions, regulators, financial instruments and services. In general financial system plays a crucial role in the functioning of the economy as it allows transfer of resources from savers to investors. It mobilises and usefully allocates scarce resources of a country.  The financial system transfers the financial resources from savers to investors in two ways:

  1. By mobilizing the savings of small investors to make them available for productive purposes.
  2. By intermediating between savers and investors to enable transfer from savers investors, who buy physical assets with those savings

Classification of Indian Financial System

The Indian financial system can be classified into the formal financial system and the informal financial system

Formal Financial System

The formal financial system comprises of network of banks, other financial and investment institutions and a range of financial instruments

Components of Formal Financial System

The formal financial system comprises of four major components:

  1. Financial Institutions
  2. Financial Markets
  3. Financial Instruments
  4. Financial Services

Financial Institutions

These are institutions that mobilise savings and facilitate the transfer of funds from surplus units to deficit units. These are institutions serving as a link between savers and investors. These institutions can be further classified into:

  1. Regulatory Institutions: The Regulatory Institutions are established primarily to safeguard the interests of a large number of savers/depositors and to ensure proper and efficient functioning of the institutions that are part of the financial system. The five major regulators in India are:
    1. Reserve Bank of India (RBI)
    2. Securities and Exchange Board of India (SEBI)
    3. Insurance Regulatory and Development Authority (IRDA)
    4. Forward Market Commission of India (FMC)
    5. Pension Fund Regulatory and Development Authority (PFRDA)
  2. Banking Institutions: Banking institutions are financial intermediaries which play an important role in the mobilisation of deposits and disbursement of credit to various sectors of the economy. They are further divided into Scheduled Commercial Banks and Non-Scheduled Banks.
    • Scheduled Commercial Banks: Scheduled commercial banks are those included in the 2nd schedule of the Reserve Bank of India Act, 1934. These include Public Sector Banks, Private Sector Banks, Foreign Banks, Regional Rural Banks and some co-operative banks.
    • Non-Scheduled Banks: Non-scheduled banks are those which are not listed in the 2nd schedule of the RBI act, 1934.
  3. Non-Banking Institutions: These are institutions which are not banks but carry out some kind of financial intermediation. These are divided into two categories: Non-Banking Financial Companies (NBFC) and Development Financial Institutions.
    1. Non-Banking Financial Companies (NBFC): These are companies which are not banks but carry out functions similar to banks.
    2. Development Financial Institutions: These are financial institutions that provide medium and long-term financial assistance to promote balanced development of the country. There are four Development Financial Institutions in India viz. Reserve Bank are Export-Import Bank of India (EXIM Bank), National Bank for Agriculture and Rural Development (NABARD), National Housing Bank (NHB) and Small Industries Development Bank of India (SIDBI).
  4. Mutual Funds: Mutual Fund is a financial intermediary by floating various unit schemes, and invests the amount so collected in various diversified securities.
  5. Insurance Companies: These are financial intermediaries that collects premium by issuing insurance policy and invest the collected premium in financial assets and markets to generate cash flows to pay future claims
  6. Housing Finance Companies: The housing finance companies are kind of non-banking financial companies whose principal business is providing housing finance.

Financial Markets

Financial Markets refers to the place or mechanism where financial assets are sold and purchased. It facilitates trading in financial assets. The financial markets are classified as money market and capital market

  1. Money Market: Money market deals with short-term funds. It involves financial assets that are close substitutes for money such as the bills of exchange, promissory notes, commercial paper, treasury bills etc. It is a market for overnight to short-term funds and instruments having a maturity period of one or less than one year.
  2. Capital Market: Capital Market is a market that deals with long-term funds. It consists of securities such as shares, debentures, bonds, etc. The capital market comprises the Primary market and the Secondary market.
    1. Primary Market: Primary Market is one in which new issues of securities are made.
    2. Secondary Market: Secondary Market is one in which existing (outstanding) securities are traded.

Financial Instruments

Financial Instrument is a contract between two parties. The contract gives rise to a financial asset of one party and a financial liability of another party. Some of the examples of financial instruments are equity shares, preference shares debentures, bonds, etc.

Financial Services

Financial services are services that ensure the smooth flow of financial activities in the economy. These are an important component of the financial system. They cater to the needs of financial institutions, financial markets and financial instruments which are geared to serve individual and institutional investors. It includes banking, insurance, stock broking and investment services as well as a wide range of other business and professional services.

Informal Financial System

The informal financial system comprises of moneylenders, indigenous bankers, lending pawn brokers, landlords, traders etc

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