Indian Financial System: Overview, Structure and Importance

The principle of give-and-take governs all aspects of life, from community interactions to national economies, won’t you agree? For instance, India’s economic growth relies heavily on the give-and-take idea, and that is what drives the financial system. In this chapter, we’ll explore this framework, consisting of various financial institutions and markets that facilitate the give-and-take that supports India's economic vitality. Let’s begin.

What Is a Financial System?

Put simply, the Indian financial system connects borrowers (who take) and lenders (who give) to ensure efficient fund exchange. We say efficient because, here, lenders get to put their excess funds to good use while borrowers get to meet their consumption needs or finance projects that promise returns.

The Indian financial system is vast and comprises several key components: financial institutions, financial instruments, financial services, financial markets, and, of course, the regulators of the system. Each plays a distinct role in capital formation, promoting savings and investment, assisting with risk diversification, financial security, market expansion, and overall economic development.

Let’s deep dive into some of the key components to understand our magnificent financial system. 

Financial Institutions 

Financial institutions are the key link between the borrowers and the lenders. Financial institutions may be described as organisations that facilitate the movement of excess capital into ventures that drive innovation and progress, benefiting the entire economy. Financial institutions enable this by offering a variety of services that individuals, businesses, and government entities can subscribe to. 

We’ll look into financial services later in this chapter, but to give you a quick view, through banking services, you are able to access funds, create deposits, withdraw money, and grow your money. Another example is your stock market broker, who provides you with Demat and/or trading services, enabling you to become a participant in the stock market. 

Now, financial institutions can be broadly categorised into:

1. Organised financial sector, comprising commercial banks, cooperative banks, foreign banks and regional rural banks
2. The unorganised financial sector, comprised mostly of money lenders and indigenous bankers who do not come under the purview of the regulators
3. Organised non-banking sector, which consists of investment institutions like LIC that collect funds from the public and invest with the government and
4. Unorganised non-banking sector comprising organisations such as housing finance companies, merchant banking companies, credit rating agencies, etc.

Let’s quickly move on to the next key component of the financial system - financial instruments. 

Financial Instruments 

In the Indian financial system, financial instruments are deemed to be documents or contracts that act as a liability for one party in a monetary asset-related transaction and an asset for the other. You can think of them as legally binding agreements that are assigned monetary values. Bonds, shares, cash deposits, mutual funds, ETFs, insurance, bills of exchange, receivables, and forex are among the common instruments used in our country. 

We spoke briefly about financial services earlier. Let’s delve into this component in the next segment.

Financial Services 

The Indian financial management system encompasses a wide array of financial services that enable individuals, public bodies, and private companies to save, invest, borrow, manage money, build wealth, and stay secure against uncertainties. 

Can you think of a few services that come under financial services? Yes! Banking services, including savings and deposit accounts, credit and debit cards, treasury and merchant services, and loans, are financial services provided by the banks. Wealth management, merger and acquisition advisory, investment due diligence, real estate consulting, etc., come under professional advisory services under financial services. Insurance, tax consulting and filing,  portfolio management and trading services are also different types of financial services.   

Now, the place where all these participants make their transactions is the financial market. Let’s learn about this aspect of the financial system in some detail.

Financial Markets 

These are essentially where borrowers and lenders, or buyers and sellers, come together to deal in equities, bonds, bills, cash, bank deposits, and so on. Apart from providing a platform for financial transactions and mobilising savings, engagement in these markets encourages liquidity and credit allocation. This makes them instrumental in aiding steady economic growth. 

Broadly, the Indian financial system features two markets – the capital market and the money market. Here’s a closer look at them. 

Capital Market

In the simplest of terms, this market is (ideally) reserved for assets or securities that come with indefinite or lengthy maturity periods of at least more than a year. A capital market includes the stock market and the bond market, encompassing the government or gilt-edged securities market, the industrial securities market, and the long-term loans market, sub-categorised into mortgages, term loans, and financial guarantees markets. 

Money Market 

If you are looking to borrow or lend high-quality yet short-term (not more than a year’s maturity period) securities in a lesser-risk environment (compared with the stock market), this is the market for you to transact in. Apart from individual investors, the money market sees small companies, large organisations, financial entities, and government bodies engaging in transactions to handle immediate liquidity or cash flow needs or reap decent returns. Financial mobility or smooth fund transfer is one of the key aspects of this market, as it is aided by the use of almost-money assets (assets that can be very quickly converted to cash).   

That’s a lot of markets for investors and traders to explore. We are now going to deep dive into the markets where maximum activity happens and markets that have probably brought you to our wealth of informative content - The stock market and money market.

Decoding the Stock Market 

We’ve already read so much about the stock market, and let us tell you, the learning never stops. The dynamism of this market ensures there’s a new aspect unravelling at every turn. This is also why the stock market is said to be unpredictable, even with all the charts and analysis you do. But with the right knowledge, you can either be prepared for eventualities or diversify your risk so that there is minimal impact on your portfolio. 

Imagine someone undergoing a medical operation. That’s a really scary thought. There are plenty of factors affecting the success of the surgery and complete recovery. But knowing about the procedure and the post-care, not only reduces fear and prepares them for the procedure but also aids in quicker recovery through timely actions. That’s exactly what we hope to achieve by informing you about the stock market - prepare and make you aware of the possibilities.

This is probably a refresher since we’ve already tackled quite a bit about the stock market in the previous chapters. So, what is a stock market? In simple terms, a stock market is a marketplace where you can buy or sell shares with the ultimate aim of making a profit. Often, a stockbroker, who is a registered intermediary, enables this transaction for you and makes the trade on the stock exchanges of your choice. Some brokers may also provide research-backed guidance. Nowadays, you can conveniently trade equity on-the-go through mobile applications of brokers and advisories, too. 

Stock Market Products 

Wondering what kind of financial products you can trade in a stock market? Here is a quick look at them: 

• Stocks or shares:

When the capital of an organisation is divided into a finite number of equal but small units, each unit is deemed as a share. To make money from these, you need to buy a share at a lower price and sell it at a higher price. Though prices of shares fluctuate continuously, this volatility helps you make a profit. Usually, you also need to consider the number of shares in the market or stock volume before making a lucrative trade. 

• Bonds:

Generally offered by corporations or governments, bonds are a fixed-income investment. You are assured of a certain interest, along with the principal amount, on maturity. While the interest rate might be volatile, it will never go below the rate mentioned at the time of bond issuance. 

• Derivatives:

The value of these financial products depends on the underlying asset. Also known as futures and options stocks, derivatives involve a contract that outlines the purchase or sale of commodities at a certain rate and on a specific date. While a futures contract makes you obligated to make a transaction, an options contract has no obligation. 

• Mutual funds:

A mutual fund company invests the money collected from many investors to invest in multiple assets, including bonds, stocks, securities, etc. An experienced portfolio manager overlooks it all and manages the money for the best outcome possible. Since your investment portfolio is diversified, it helps lower your risk. 

It’s obvious that such a diverse and dynamic marketplace requires stringent regulation and oversight. This brings us to the role of the Securities and Exchange Board of India (SEBI), which ensures that all stock market activities are conducted fairly and transparently. 

Role of SEBI in Stock Market 

The SEBI is an integral part of the Indian financial system and the markets as it protects the interests of investors and maintains the market's overall health. To maintain smoothly functioning stock markets and avoid disruptions, SEBI has specific legally binding regulations for each of the entities involved, such as depositories and depository participants, credit rating agencies, merchant bankers, debenture trustees and asset management companies. 

SEBI plays a key role in ensuring that:

• Interests of small investors are protected. 
• Stockbrokers don’t engage in malpractices. 
• Corporates don’t leverage the stock market for undue benefits. 
• Large investors with a lot of cash don’t manipulate the market. 
• Overall, market development and growth can happen seamlessly. 

Let’s move on to the money market as an accessible and opportune space for your investments and transactions.

Decoding the Money Market

As you’ve already come to know, the money market occupies an important niche in the Indian financial system. It is a market that provides quick gratification for its multiple participants. Highly liquid debt securities that have maturity periods of a maximum of one year are traded in this market. This way, individual or institutional investors get to reap decent returns through small investments in a lower-risk setup, while banks, government entities, and corporations can raise working capital or meet their immediate financial obligations quickly and easily. 

Money Market Products

Understanding which financial products or instruments are traded in the money market will help you make an informed decision whether you choose to invest or borrow in this space.  

• Treasury bills:

Issued by the Indian Government, these are the oldest instruments still in circulation. Though they don’t generate any interest, treasury bills are issued at a discounted face value and can be categorised based on type or maturity. The return, though low, is devoid of risk. 

• Certificate of deposit:

Issued by commercial banks, these certificates are available for purchase via brokerage firms. The maturity date usually ranges between 3 months and 5 years, and you might incur a penalty if you choose to withdraw your investment before time. The maturity date and rate of interest are fixed, and the Federal Deposit Insurance Corporation insures these certificates. 

• Commercial papers:

These unsecured instruments are issued as promissory notes and were first introduced in 1990. Usually, big corporations issue them to raise funds that can meet their debt obligations in the short run. The company or bank issuing commercial papers pledge to pay the face value once the instrument matures on a specified date. 

• Repurchase agreements:

These are formal agreements involving two parties, where one sells a security to the other, promising to buy back the same at a future date. When the seller buys back the security on a pre-specified date, the amount includes the rate of interest that was promised to the buyer. 

• Banker’s acceptance:

One of the safest investment options, a banker’s acceptance is essentially a document that states that a commercial bank guarantees future payment against the same. The maturity period of such documents generally ranges between 30 and 180 days and they are extensively used in foreign trade. 

Role of RBI in Money Market 

Like the SEBI is the overseeing authority for the stock markets, the Reserve Bank of India, RBI, takes precedence here over other agencies. The RBI essentially controls and regulates the money supply in our country’s economy through a slew of monetary policies. By leveraging open market operations, repo rate, reverse repo rate, and other tools, it facilitates money market trading, manages liquidity, and keeps India's financial system stable. 

• Open market operations involve the sale and purchase of government securities. 
• Repo rate is the rate charged by RBI when it lends money to banks. 
• Reverse repo rate is the rate RBI charges while accepting deposits from banks. 

The RBI crafts guidelines and rules for all participating financial institutions in the money market, to prevent unfair or unethical occurrences and ensure peace of mind for investors. The RBI also carries out periodic inspections of such institutions, tracks their performance and compliance, and undertakes corrective measures if necessary. It coordinates with other regulators as well to ensure the efficient functioning of the overall financial system. 

Stock Market vs Money Market 

Now that you have a basic understanding of the stock market and money market, we will dive into the differences between the two. This will help you make an informed investment decision that aligns well with your current financial situation, objectives, and attitude towards risk. 

Parameters	Stock Market	Money Market
Function	To mobilise savings effectively, help companies raise large amounts of capital, and drive overall economic growth and development	To provide companies and government entities liquidity in the short run, while helping investors earn a modest return safely
Objective	To help firms raise funds enough to form their asset base	To meet a company’s working capital needs, which means the organisation borrows a small part of its asset base
Market Nature	Formal, structured, and regulated	Informal and not well-structured
Transaction Mode	Transactions primarily happen through stock exchanges	Most transactions are over-the-counter in nature
Financial Instruments	Stocks, bonds, and derivatives	Commercial papers, treasury bills, certificate of deposit, banker’s acceptance, repurchase agreements
Liquidity	Instruments are not as liquid as in money market	Instruments are highly liquid and with short maturity periods
Risk	Instruments are riskier as raised capital is invested in long-term projects	Low-risk instruments as funds are used for short-term operational or working capital needs mostly
Maturity Period	Maturity period is usually long and not stipulated	Maximum maturity period is one year
Returns	Unlimited profit potential, owing to long-term investment duration and the higher associated risk	Returns commensurate with current rate of interest or capital cost
Participants	Retail investors, stockbrokers, mutual funds, insurance companies, underwriters, stock exchanges, commercial banks	Banks and financial entities like pension funds and mutual funds are most active

Conclusion

As we close this chapter, it's clear that understanding the Indian financial system is important for anyone looking to navigate the complexities of investing and managing money in India. Each component, whether focused on investment, lending, or saving, plays a vital role in economic growth and offering individuals and businesses the tools to achieve financial success.

This brings us to the end of this chapter. See you in the next!