What Is a Financial System?

A financial system is a set of institutions, such as banks, insurance companies, and stock
exchanges, that permit the exchange of funds. Financial systems exist on firm, regional, and
global levels. Borrowers, lenders, and investors exchange current funds to finance projects,
either for consumption or productive investments, and to pursue a return on their financial
assets. The financial system also includes sets of rules and practices that borrowers and
lenders use to decide which projects get financed, who finances projects, and terms of
financial deals.

KEY TAKEAWAYS

 A financial system is the set of global, regional, or firm-specific institutions and practices
used to facilitate the exchange of funds.
 Financial systems can be organized using market principles, central planning, or a
hybrid of both.
 Institutions within a financial system include everything from banks to stock exchanges
and government treasuries.

Meaning and Definition of Financial System

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

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

Seekers of funds Flow of Funds (Savings) Suppliers of funds

(mainly business (mainly
firms and households)
Incomes and Financial

Claims

Figure 1.1: Flow of Financial Services

The word “system”, in the term “financial system”, implies a set of complex and closely connected or interlined
institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. The financial system is
concerned about money, credit and finance – the three terms are intimately related, yet are somewhat different
from each other. Indian financial system consists of financial market, financial instruments and financial
intermediation.

Features of Financial System

The features of a financial system are as follows:
1) Financial system provides an ideal linkage between depositors and investors, thus encouraging both
savings and investments.
2) Financial system facilitates expansion of financial markets over space and time.
3) Financial system promotes efficient allocation of financial resources for socially desirable and
economically productive purposes.
4) Financial system influences both the quality and the pace of economic development.

Functions of Financial System

A good financial system serves in the following ways:
1) Link between Savers and Investors: One of the important functions of a financial system is to link the
savers and investors and thereby help in mobilizing and allocating the savings
efficiently and effectively. By acting as an efficient medium for allocation of resources, it permits continuous
up gradation of technologies for promoting growth on a sustained basis.
2) Helps in Projects Selection: A financial system not only helps in selecting projects to be funded but also
inspires the operators to monitor the performance of the investment. It provides a payment mechanism for the
exchange of goods and services, and transfers economic resources through time and across geographic regions
and industries.
3) Allocation of Risk: One of the most important functions of a financial system is to achieve optimum
allocation of risk bearing. It limits, pools, and trades the risks involved in mobilizing savings and allocating
credit. An efficient financial system aims at containing risk within acceptable limits and reducing the cost of
gathering and analyzing information to assist operators in taking decisions carefully.
4) Information Available: It makes available price-related information which is a valuable assistance to those
who need to take economic and financial decisions.
5) Minimizes Situations of Asymmetric Information: A financial system minimizes situations where the
information is asymmetric and likely to affect motivations among operators or when one party has the
information and the other party does not. It provides financial services such as insurance and pension and
offers portfolio adjustment facilities.
6) Reduce Cost of Transaction and Borrowing: A financial system helps in the creation of a financial structure
that lowers the cost of transactions. This has a beneficial influence on the rate of return to savers. It also
reduces the cost of borrowing. Thus, the system generates an impulse among the people to save more.
7) Promotion of Liquidity: The major function of the financial system is the provision of money and monetary
assets for the production of goods and services. There should not be any shortage of money for productive
ventures. In financial language, the money and monetary assets are referred to as liquidity. In other words, the
liquidity refers to cash or money and other assets which can be converted into cash readily without loss.
Hence, all activities in a financial system are related to liquidity – either provision of liquidity or trading in
liquidity.
8) Financial Deepening and Broadening: A well-functioning financial system helps in promoting the process
of financial deepening and broadening. Financial deepening refers to an increase of financial assets as a
percentage of the Gross Domestic Product (GDP). Financial broadening refers to building an increasing
number and a variety of participants and instruments.

Role of Financial System

Financial system performs play role of economic development and promotional role.

Role of Economic Development

Economic development or economic progress has been defined in two ways;
1) Economic Growth Means Growth of National Income of the Country: It implies an increase in the net
national product in a given periods, say, a year. Some economists consider this definition as inadequate and
unsatisfactory. They argue that even if the national income goes up, the general standard of living may go
down. This can happen if population of the country is rising more rapidly than the growth of the national
income. If the national income is rising at the rate of 2 percent and population is increasing at the rate of 3
percent, the level of living of the people is bound to go down. This is because on account of population
increasing at a higher rate than the growth of the national income, per capita income falls and when per capita
income goes down, we cannot call it economic growth. The country will
have registered economic growth only if per capita income has gone up and this will happen only if the
national income grows at a higher rate than the growth rate of the population.

2) Economic Growth Means the Increase in Per Capita Income of the Country at Constant Prices: A better
definition of economic development will be to base it on per capita income. Here economic growth means the
increase in per capita income of the country at constant prices. A higher per capita income would mean that
people are better off and enjoy a higher standard of living, and to raise the level of living of the people is the
main objective of economic development, but the increase in national income or per capita income must be
maintained for a long time. A temporary or short-lived increase will not connote real economic growth.

The best definition of economic development would be to say what a developed country would be like.
“Economic progress is the advancement of a community along the line of evolving new and better methods of
production, and rising of the levels of output through development of human skill and energy, better organization
and the acquisitions of capital resources.” This is, in a nutshell, what economic development means.

Promotional Role of the Financial System

The mutual interactions between the financial and real system may take promotional or developmental forms. It is
in this context that the development role of the financial system is to be emphasized.

This role assumes two forms; innovation and promotion, which are inter-related.
1) Innovation: The innovatory role relates to the creative activity of these institutions. Thus, dynamisms as well
as creative imagination can be in both the assets and liabilities side of the activities of financial institutions.
This takes the form of improving the quality of assets as well as showing new and more profitable activities or
keeping pace with the developmental priorities of the Government.

This creative element in the case of commercial banks can be seen in the Lead Bank Scheme, financing of
neglected sectors, opening of branches in the rural areas, etc. The creative role in the case of development
 banker takes the form of a critical examination of the appraisal and follow-up actions including the application
of social cost benefit analysis. The development banker follows sound appraisal techniques including the
economic and financial tools both from the point of view of the company as well as the economy. The
industrialist finds a contractive partner in the banker who will help him in improving his project plan and
prospects of investment.

2) Promotion: The financial institutions by virtue of long experience, expertise and information, which they
acquire during the course of their project appraisal, are in a better position to play the promotional role in the
economy.
Firstly, they can share their expertise with their clients and improve the project preparation, plug up the
loopholes in their schemes and advice them on improving project prospects as well as on the new areas they
can explore.
Secondly, these institutions have established their own training institutions or schools as in the case of IFC
(Management Development Institute) and ICICI (Institute of Financial Management), etc.
Thirdly, they are instrumental in setting up consultancy companies, accounting firms, leasing companies and
industrial estates, etc. The I.D.B.I. with the help of other institutions
Has set up at State levels various consultancy service centre. Iran and Greece have also set up similar
institutions.
Fourthly, development bankers can share their experience with the government in the formulation of their
financial policy as their experience with projects and project implementation would help the government.
Their day-to-day market knowledge about the demand pattern, export market etc., would also enable the
development bankers to advise the government.

Weakness of Financial System

After the introduction of planning, rapid industrialization has taken place. It has in turn led to the growth of the
corporate sector and the government sector. In order to meet the growing demand of the government and
Industries, many innovative financial instruments have been introduced. The Indian financial system is now more
developed and integrated today than what it was few years ago. Yet it suffers from some weaknesses.

Following are the weakness of Indian financial system.

1) Lack of Coordination between different Financial Institutions: There are a large number of FIs. Most of
the vital FIs are owned by the government. At the same time, the government is also the controlling authority
of these institutions. In these circumstances, the problem of coordination arises. As there is multiplicity of
institutions in the Indian financial system, there is lack of coordination in the working of these institutions.
2) Monopolistic Market Structures: In India, some FIs are so large that they have created a monopolistic
market structure of financial system. For instance, almost entire life insurance business is in the hands of LIC
of India. So large structures could delay development of financial system of the country itself.
3) Dominance of Development Banks in Industrial Financing: The development banks constitute the
backbone of the Indian financial system occupying an important place in the capital market. The industrial
financing today in India is largely through the FI created by the government, both at the national and regional
levels. As such, they fail to mobilize the savings of the public. However, in recent times attempts have been
made to raise funds from public through the issue of bonds, units, debentures and so on.
4) Inactive and Erratic Capital Market: The Indian capital market is not strong and dependable. Because of
regular scams and frauds, general public is not having faith in the Capital Markets. The weakness of the capital
market is a serious problem in Indian financial system.
5) Imprudent Financial Practices: The dominance of development banks has developed imprudent financial
 practice among corporate customer. The development banks provide most of the funds in the form of term
loans. So the predominance of debt capital has made the capital structure of the borrowing concerns uneven
and lopsided. However in recent times, all efforts have been made to activate the capital market. Integration is
also taking place between different FIs. Similarly, the refinance and rediscounting facilities provided by the
IDBI aim at integration.

Thus, the Indian Financial System is undergoing fast changes, to become a well developed one.
FINANCIAL SECTOR REFORMS IN INDIA

The New Economic Policy (NEP) of structural adjustments and stabilization programme was given a big thrust in
India in June 1991. The financial system reforms have received special attention as a part of this policy because of
the perceived inter-dependent relationship between the real and financial sectors of the modern economy.
Immediately after the announcement of NEP, the government had appointed a high level committee on financial
system “to examine all aspects relating to the structure, organization, functions and procedures of the financial
system”. The committee submitted its main report in November 1991. Since then, the authorities have introduced
a large number of changes or reforms in the Indian financial sector in the light of the said report.
The need for financial reforms had arisen because the financial institutions and markets were in a bad shape. The
banking sector suffered from lack of competition, low capital base, low productivity, and high intermediation
costs. The role of technology was minimal, and the quality of service did not receive adequate attention. Proper
risk management system was not followed, and prudential norms were weak. All these resulted in poor assets
quality. Development financial institutions operated in an over-protected environment with most of the funding
coming from assured sources. There was little competition in insurance and mutual funds industries.

Financial markets were characterized by control over pricing of financial assets, barriers to entry, and high
transactions costs. The banks were running either at a loss or on very low profits, and, consequently were unable
to provide adequately for loan defaults, and build their capital.

There had been organizational inadequacies, the weakening of management and control functions, the growth of
restrictive practices, the erosion of work culture, and flaws in credit management. The strain on the performance
of the banks had emanated partly from the imposition of high Cash Reserve Ratio (CRR), Statutory Liquidity
Ratio (SLR), and directed credit programs for the priority sectors – all at below market or concessional or
subsidized interest rates. This, apart from affecting bank profitability adversely, had resulted in the low or
repressed or depressed interest rates on deposits and in higher interest rates on loans to the larger borrowers from
business and industry. The phenomenon of cross-subsidization had got built into the system where concessional
rates provided to some sectors were compensated by higher rates charged to non- concessional borrowers.

Objectives of Financial Reforms Introduced in 1991

1) To develop a market-oriented, competitive, world-integrated, diversified, autonomous, trans- parent financial
system.
2) To increase the allocative efficiency of available savings and to promote accelerated growth of the real sector.
3) To increase or bring about the effectiveness, accountability, profitability, viability, vibrancy, balanced growth,
operational economy and flexibility, professionalism and de-politicization in the financial sector.
4) To increase the rate of return on real investment.
5) To promote competition by creating level-playing fields and facilitating free entry and exit for institutions
and market players.
6) To ensure that the rationalization of interest rates structure occurs, that interest rates are flexible, market-
determined or market-related, and that the system offers to its users a reasonable level of positive real interest
rates. In other words, the goal has been to dismantle the administered system of interest rates.
7) To reduce the levels of resource pre-emption and to improve the effectiveness of directed credit programs.
8) To build a financial infrastructure relating to supervision, audit, technology, and legal matters,
9) To modernize the instruments of monetary control so as to make them more suitable for the conduct of
monetary policy in a market economy i.e., to increase the reliance on indirect or market-incentives based
instruments rather than direct or physical instruments of monetary control.

Major Reforms After 1991 in Financial System

The reforms have had a broad sweep encompassing operational matters, banking, primary and secondary stock
markets, government securities market, external sector policies, and the system as a whole. These have been
classified into three areas: issues relating to creating a flexible banking system; development of institutions such
as private sector banks and mutual funds; and monetary policy instruments such as interest rates, reserve ratios,
and refinancing facilities. In other words, reforms relate to the issues of ownership and control, competition, and
policy and regulation stance.

Systemic and Policy Reforms

1) Most of the interest rates in the economy deregulated; a beginning made to move towards market rates on
government securities: the system of administered interest rates largely dismantled; and the structure of
interest rates greatly simplified.
2) The preemption of banks‟ resources through SLR in favor of the government was brought down and the rate
of return on SLR securities is maintained by and large at market rates. The SLR on incremental net domestic
and time liabilities (NDTL) of banks reduced from 38.5 percent in 1991-92 to 24 percent now.
3) Capital adequacy norms for banks, financial institutions, and virtually all market intermediaries introduced.
The Basel Committee framework for capital adequacy adopted.
4) A Board of Financial Supervision (BFS) with an advisory council and an independent department of
supervision established in RBI.
5) Recovery of Debts Due to Banks and Financial Institutions Act, 1993 passed to set up Special
 Recovery Tribunals to facilitate quicker recovery of loan arrears.
6) In order to moderate or minimize the automatic monetization of the budget deficit, the agreement to impose a
ceiling on the issue of ad hoc Treasury Bills (TBs) and to phase them out in due course signed by the
Government of India (GOI) and RBI in September 1994. Subsequently, the system of ad hoc treasury bills
abolished and replaced by the system of Ways and Means Advances effective April 1, 1997.
7) The private sector was allowed to set up banks, mutual funds, money market mutual funds, insurance
companies, etc. Public sector banks permitted diversified ownership by law subject to 51 percent holding of
government/RBI. SBI, IFCI and IRBI converted into public limited companies.
8) Capital Issues (Control) Act, 1947 repealed and the office of Controller of Capital Issues abolished.
9) Securities and Exchange Board of India (SEBI) made a statutory body in February 1992 and armed with
necessary authority and powers for regulation and reform of the capital market.
10) Convertibility clause is no longer obligatory in the case of assistance sanctioned by term lending institutions.
11) Floating interest rate on financial assistance (linked to interest rate on 364 – day TBs) introduced by all-India
development banks.
12) The Reserve Bank of India (Amendment) Act 1997 passed requiring all non-bank financial companies
(NBFCs) with net-owned funds of Rs.25 lacs and more to register with the RBI.
13) Over the Counter Exchange of India (OTCEI) and the National Stock Exchange (NSE) with nation-wide stock
trading and electronic display, clearing and settlement facilities established and made operational.

Banking Reforms
1) Interest rates on deposits and advances of all co-operative banks including urban cooperative banks
deregulated. Similarly interest rates on commercial bank loans above Rs.2 lacs, and on domestic term deposits
above two years, and Non-Resident (External) Rupee Accounts [NRNR] deposits decontrolled.
2) The State Bank of India and other nationalized banks enabled to access the capital market for debt and equity.
3) Prudential norms for income recognition, classification of assets and provisioning for bad debts for
commercial banks, including regional rural banks and financial institutions introduced. They are required to
adopt uniform and sound accounting practices in respect of these matters, and the valuation of investments.
Banks are required to mark to market the securities held by them.
4) The Performance Obligations and Commitments (PO & C) obtained by RBI from each bank; they provide for
essential quantifiable performance parameters which lay emphasis on increased but low-cost deposits, quality
lending, generation of more income and profits, compliance with priority sectors and export lending
requirements, improvement in the quality of investments, reduction in expenditure, and stepping up of staff
productivity.
5) Banks required making their balance sheets fully transparent and making full disclosures in keeping with
International Accounts Standards Committee.
6) Banks given greater freedom to open, shift, and swap branches as also to open extension counters.
7) The perceived constraints on banks such as prior credit authorization, inventory and receivables norms,
obligatory consortium lending and curbs in respect of project finance relaxed.
8) The budgetary support extended for recapitalization of weak public sector banks.
9) Banking Ombudsman Scheme 1995 introduced to appoint 15 ombudsmen (by RBI) to look into and resolve
customers‟ grievances in a quick and inexpensive manner. Most of the recommendations of Goiporia
Committee in connection with improving customer service by banks implemented.
10) Banks set free to fix their own foreign exchange open position limit subject to RBI approval.
11) Loan system introduced for delivery of bank credit. Banks were required bifurcate the maximum permissible
bank finance into loan component (short-term working capital loan) and cash credit component, and the policy
 of progressively increasing the share of the former introduced.

Primary and Secondary Stock Market Reforms

1) Primary issues to be made compulsory through the Depository Mode after a specified date.
2) 100 per cent Book Building in respect of issues of Rs. 25 crore and above.
3) Reduction in the number of mandatory collection centres in respect of issues above Rs. 10 crore to four
metropolitan cities
4) A norm of five shareholders for every Rs.1 lac of fresh issues of capital and 10 shareholders for every Rs.1
lac of offer for sale prescribed as an initial and continuing listing requirement.
5) The payment of any direct or indirect discounts or commissions to persons receiving firm allotment prohibited.
6) Debt issues not accompanied by an equity component permitted to be sold entirely by the book- building
process.
7) Housing finance companies considered to be registered for issue purposes, provided they are eligible for
refinance from the National Housing Bank.
8) Issuers were allowed to list debt securities on stock exchanges without their equity being listed. Mutual funds
permitted to underwrite public issues.
9) The stock exchanges required to disclose, carry forward position scrip-wise and broker-wise at the beginning
of carry forward session.
10) A ceiling of Rs.10 crore imposed on stock market members doing business of financing carry forward
transactions.
11) Depositories Act, 1996 passed to provide a legal framework for the establishment of depositories to record
ownership details in book entry form, and to facilitate dematerialization of securities.
12) Stock lending scheme without attracting capital gains introduced. Under this scheme, short sellers can borrow
securities through an intermediary before making such sales.
13) Stock exchanges asked to modify listing agreements in order to provide for the payment of interest by
companies to investors from the 30th day of the closure of public issue.
14) All stock exchanges required to institute the buy-in or auction process.
15) Stock exchanges was asked to collect 100 percent daily margins on the notional loss of a broker for every
scrip, to restrict gross traded value to 33.33 times the broker‟s base minimum capital, and to impose quarterly
margins on the basis of concentration ratios.
16) The stock exchanges are being modernized; many of them have introduced electronic trading system; the
Bombay Stock Exchange has started its on-line trading system, BOLT.
17) The Bombay Stock Exchange and other exchanges with screen-based trading system were allowed to expand
their trading terminals to locations where no stock exchange exists and to others subject to an understanding
with the local stock exchange.
18) Both short and long sales are required to be disclosed to the exchange at the end of each day, and they are to
be regulated through the imposition of margins.
19) There are many other stock market reforms which have been introduced during the past five to six years.

Government Securities Market Reforms

1) A 364-day treasury bill (TB) replaced the 182-day TB in 1992-93, and it is being sold by fortnightly
auction since April 1992.
2) Auction of 91-day TB commenced from January 1993.
3) Maturity period for new issues of Central government securities shortened from 20 to 10 years and that
for state government securities from 15 to 10 years.
4) Funding of Auction TBs into fixed coupon dated securities at the option of holders introduced since April
19, 1993.
5) Six new instruments were introduced:
i) zero coupon bonds on 18.1.94,
ii) tap stock on 29.7.94,
iii) partly-paid government stock on 15.11.94,
iv) an instrument combining the features of tap and partly-paid stocks on 11-9-95,
v) floating rate bonds on 29.9.95,
vi) Capital indexed bonds in 1997.
6) State governments and provident funds allowed participating in 91-day TB auctions on a
on-competitive basis from August 1994.
7) A scheme for auction of government securities from RBI‟s own portfolio as a part of its open market
operations announced in March 1995.
8) The institution of primary dealers in government securities market established and guidelines for them issued
in March 1995.
9) A system of Delivery vs. Payment (DVP) in Subsidiary General Ledger (SGL) transactions introduced in
Bombay in July 1995.
10) Reverse repo facility with RBI in government dated securities extended to Discount and Finance House of
India (DFHI) and Securities Trading Corporation of India (STCI).

External Financial Market Reforms

1) Flexible exchange rate system introduced and exchange controls largely dismantled.
2) Foreign Institutional Investors (FIIs) allowed access to Indian capital market on registration with SEBI. FIIs
permitted to invest up to 10 percent in equity of any company, to invest in unlisted companies, to set up pure
(100 percent) debt funds, and to invest in government securities. Foreign endowment funds, university funds,
foundations and charitable trusts/societies are allowed to register as FIIs.
3) Indian companies permitted to access international capital markets through various instruments including
euro-equity issues.
4) The Union Budget 1997-98 proposed the replacement of Foreign Exchange Regulation Act (FERA), 1973 by
a Foreign Exchange Management Act (FEMA) to facilitate easy capital flows.
5) Rupee made convertible on current account and a considerable progress made in introducing capital account
convertibility.
6) The rate of long-term capital gains tax on portfolio investments by NRIs reduced from 20 percent to 10
percent and brought on par with the rate for FIIs.
7) NRIs, OCBs, FIIs permitted to invest up to 24 percent in equities of Indian companies engaged in all activities
except those of agriculture and plantation.
8) In case of medium- and long-term external commercial borrowings (ECBs), on lending of the proceeds of
development finance institutions to different borrowers at different maturities permitted.
9) Companies permitted to retain euro-issue proceeds as foreign currency deposits with banks and public
financial institutions in India. Further, companies permitted to remit funds into India in anticipation of the use
of funds for general corporate restructuring and working capital needs.
10) RBI made a single-window agency for receipt and disposal of proposals for overseas investments by Indian
companies.
The Foreign Investment Promotion Board (FIPB) reconstituted and Foreign Investment Promotion Council
(FIPC) set up to promote foreign direct investment in India.

The Money market in India is the money market for short-term and long-term funds
with maturity ranging from overnight to one year in India including financial instruments
that are deemed to be close substitutes of money. A money market is a market for
borrowing and lending of short-term funds. It deals in funds and financial instruments
having a maturity period of one day to one year. It is a mechanism through which short-
term funds are loaned or borrowed and through which a large part of financial
transactions of a particular country or of the world are cleared. RBI describes money
market as “the center for dealings, mainly of a short-term character, in monetary assets, it
 MONEY MARKET
The Money market in India is the money market for short-term and long-term funds
with maturity ranging from overnight to one year in India including financial instruments
that are deemed to be close substitutes of money. A money market is a market for
borrowing and lending of short-term funds. It deals in funds and financial instruments
having a maturity period of one day to one year. It is a mechanism through which short-
term funds are loaned or borrowed and through which a large part of financial
transactions of a particular country or of the world are cleared. RBI describes money
market as “the center for dealings, mainly of a short-term character, in monetary assets, it
meets the short-term requirements of borrowers and provides liquidity or cash to
lenders”.

3.1 Salient features of Money Market

 The Money Market is a instrument that contracts with the loaning and borrowing
of short term funds (not more than one year)
 It is a section of the financial marketplace in which financial instruments with
high liquidity and very short maturities are operated.
 It does not actually deal in cash or money but deals with substitute of cash like
trade bills, promissory notes and government papers which can be converted into
cash without any loss at low transaction cost.
 It includes all individual, institution and intermediaries.
 Transactions have to be conducted without the help of brokers.

3.2 Functions of Money Market

1) It caters to the short-term financial requirements of the economy.

2) It supports the RBI in actual enactment of budgetary policy.
3) It offers instrument to attain equilibrium amongst demand and supply of short-
term funds.
4) It helps in distribution of short term funds through inter-bank dealings and money
market devices.
5) It also provides funds in non-inflationary way to the administration to meet its
shortfalls.
6) It simplifies economic enlargement.

3.3 Deficiencies of Money Market

Indian money market is comparatively underdeveloped when associated with progressive

markets like New York and London Money Markets. Its' main defects are as follows;
1. Dichotomy:-A main feature of Indian Money Market is the existence of dichotomy i.e.
presence of two markets: - organized Money Market and Unorganized Money Market. It
is difficult for RBI to integrate the organized and Unorganized Money Markets. Several
segments are loosely connected with each other. Thus there is dichotomy in Indian
 Money Market.
2. Lack of Co-ordination and Integration:-It is challenging for RBI to take part the
organized and unorganized sector of money market. RBT is completely effective in
organized sector but unorganized market is out of RBI’s control. Thus there is lack of
integration between various sub-markets as well as numerous institutions and activities.
There is less co-ordination among co-operative and commercial banks along with State
and Foreign banks. The indigenous bankers have their own ways of doing business.
3. Diversity in Interest Rates:-There are different rates of interest existing in different
segments of money market. In rural unorganized sectors the rate of interest are high and
hey vary with the purpose and borrower. There are
differences in the interest rates within the organized sector
also. Although wide modifications have been narrowed down, yet the existing differences
do hamper the efficiency of money market.
4. Seasonality of Money Market :-Indian agriculture is busy during the period November to
June resulting in heavy demand for funds. During this period money market suffers from
Monetary Shortage resulting in high rate of interest. During slack season rate of interest
falls so there are plenty of funds available. RBI has taken steps to reduce the seasonal
fluctuations, but still the variations exist.
5. Shortage of Funds: - In Indian Money Market demand for funds go beyond the supply.
There is lack of funds in Indian Money Market an account of various factors like
inadequate banking facilities, low savings, lack of banking habits, existence of parallel
economy etc. There is also vast amount of black money in the country which have caused
shortage of funds. However, in recent years development of banking has improved the
mobilization of funds to some extent.
6. Absence of Organized Bill Market: - A bill market refers to a mechanism where bills of
exchange are purchased and discounted by banks in India. A bill market provides short
term funds to businessmen. The bill market in India is not widely held due to
overdependence of cash dealings, high disregarding rates, problem of dishonor of bills
etc.

4. Organization of Indian Money Market

Indian money market is considered by its dichotomy i.e. there are two sectors of money
market. The organized sector and unorganized sector.
 Organized Sector
 Reserve Bank of India
 Discount and Finance House of India (DFHI)
 Public Sector Banks
 SBI and its seven Subsidiaries and 20 Nationalized Banks
 Regional Rural Banks
 Private Sector Banks
 Foreign Banks
 Scheduled Commercial Banks
 Non-Scheduled Commercial Banks
 Co-operative Sector Banks
 Development Banks
 Insurance Companies
. Unorganised Sector
 Moneylenders
  Indigenous bankers, and
 unregulated Non-Bank Financial Intermediaries
 Chit funds
 Nidhis
 Finance Brokers
4.1 Organised Sector
4.1.1 Reserve Bank of India (RBI)

The Reserve Bank of India (RBI) is India's central banking institution, which
controls the monetary policy of the Indian rupee. It was established on 1 April 1935
during the British rule in accordance with the provisions of the Reserve Bank of India
Act, 1934. The bank was set up based on the recommendations of the 1926 Royal
Commission on Indian Currency and Finance, also known as the Hilton–Young
Commission.
Under Section 22 of the Reserve Bank of India Act, the Bank has the sole right to
issue bank notes of all denominations.(except one rupee note and coin, which are issued
by Ministry of finance). The distribution of one rupee notes and coins and small coins all
over the country is undertaken by the Reserve Bank as agent of the government. For
printing of notes, the Security Printing and Minting Corporation of India Limited
(SPMCIL).
The Reserve Bank of India is the main monetary authority of the country and
beside that the central bank acts as the bank of the national and state governments. It
formulates, implements and monitors the monetary policy as well as it has to ensure an
adequate flow of credit to productive sectors.
RBI also works as a central bank where commercial banks are account holders
and can deposit money. RBI maintains banking accounts of all scheduled banks.[33]
Commercial banks create credit. It is the duty of the RBI to control the credit through the
CRR, bank rate and open market operations. As banker's bank, the RBI facilitates the
clearing of cheques between the commercial banks and helps inter-bank transfer of funds.
4.1.2 Discount and Finance House of India (DFHI)

Discount And Finance House of India Ltd (DFHI) DFHI was set up in March
1988 by Reserve Bank of India together with public sector banks and all India Financial
Institutions to improve the money market and to provide liquidity to money market
instruments as a sequel to Vaghul Working Group recommendations. After DFHI was
credited as a Primary Dealer in February 1996, its operations significantly increased
particularly in Treasury Bills and dated Government Securities.

4.1.3 Public Sector Banks

Public Sector Banks (PSBs) are banks where a common stake (i.e. more than
50%) is held by a government. The shares of these banks are listed on stock exchanges.
The Central Government come in the banking business with the nationalization of the
Imperial Bank of India in 1955. A 60% stake was taken by the Reserve Bank of India and
the new bank was named as the State Bank of India. The seven other state banks became
the subsidiaries of the new bank when nationalized on 19 July 1960.
The next round of nationalization took place in April 1980. The government nationalized
six banks. The total deposits of these banks amounted to around 200 crores. This move
led to a further rise in the number of branches in the market, increasing to 91% of the
total branch network of the country. Presently, 20 nationalized banks and SBI with its 7
subsidiaries come under the category of PSBs.
4.1.4 Private Sector Banks

In July 1993, as portion of the banking improvement process and as a extent to

convince competition in the banking sector, RBI allowed item by the private sector into
the banking system. This resulted in the introduction of nine private sector banks. The
Government of India permits foreign banks to operate through branches; a wholly owned
subsidiary; or a secondary with collective foreign investment of up to 74% in a private
bank. Banks have to maintain certain percentage of deposit with Reserve bank of India
(RBI) as CRR (Cash Reserve Ratio) on which they earn lower interest.
4.1.5 Co-operative Sector Banks

Cooperative banks are an important constituent of the Indian financial system.

They are the primary financiers of agricultural activities, some small-scale industries and
self-employed workers. Co-operative Bank are organized and managed on the principal
of co-operation, self-help, and mutual help. Co-operative banks, as a principle, do not
pursue the goal of profit maximization
Co-operative Banks provide limited banking products and are functionally
specialists in agriculture related products. However, co-operative banks now provide
housing loans also
4.1.6 Development Banks

A Development Bank is an all purpose institution giving a new shape to economic

development pattern and accelerating the activities of all branches of economy and
creating healthy financial and socio-economic infrastructure. They act as ‘gap filler’ in
the present set up of the entrepreneurial world. They are energetically and
enthusiastically engaged in the herculean task of planning, promoting and developing
industries in every sector of the national economy. They are operating as promotional,
innovative and entrepreneurial Development Banks in all over the world.
The objectives to be achieved by Development Banks may be enumerated as
speeding up economic growth, rapid industrialization, rural development, support to
industry, entrepreneurial development, project finance, refinance, development of
backward areas, housing. In addition, they are assigned a special role in (1) Planning,
promoting and developing industries to fill the gaps in the industrial structure (ii) Co-
ordinating the working of institutions engaged in financing, promoting or developing
industries, agriculture and trade (iii) Providing technical and administrative assistance
and (iv) Undertaking marketing and investment research and surveys.
IFCI LTD, ICICI, IDBI, IIBI, SIDBI and IDFC are the examples of Development Banks
in India,
4.1.7 Insurance Companies

The Government of India distributed an Ordinance on 19 January 1956

nationalizing the Life Insurance sector and Life Insurance Corporation came into
presence in the same year. The Life Insurance Corporation (LIC) captivated 154 Indian,
16 non-Indian insurers as also 75 provident societies—245 Indian and foreign insurers in
all.
The LIC had monopoly till the late 90s when the
Insurance sector was reopened to the private sector.
 Before that, the industry consisted of only two state insurers: Life Insurers (Life
Insurance Corporation of India, LIC) and General Insurers (General Insurance
Corporation of India GIC). GIC had four subsidiary companies. With effect from

4.2 Unorganised Sector

4.2.1 Indigenous Bankers (IBs)

Indigenous bankers are individuals firms who receive deposits and give loans and thereby
operate as banks. IBs accept deposits as well as lend money. They mostly operate in
urban areas, especially in western and southern regions of the country. The volume of
their credit operations is however not known. Further their lending operations are
completely unsupervised and unregulated. Over the years, the significance of IBs has
declined due to growing organized banking sector.
4.2.2 Money Lenders (MLs)

They are those whose primary business is money lending. Money lending in India is
very popular both in urban and rural areas. The operations of money lenders are prompt,
informal and flexible. The borrowers are mostly poor farmers, artisans, petty traders and
manual workers. Over the years the role of money lenders has declined due to the
growing importance of organized banking sector.
4.2.3 Unregulated Non - Banking Financial Companies (NBFCs)

They mainly consist of the following;

 Chit Funds: Chit funds are savings institutions. It has regular members who
make periodic subscriptions to the fund. The beneficiary may be selected by
drawing of lots. Chit fund is more popular in Kerala and Tamil Nadu. RBI has no
control over the lending activities of chit funds.
 Nidhis: Nidhis function as a kind of mutual benefit for their participants only.
The loans are given to memberships at a reasonable rate of interest. Nidhis
function mainly in South India.
 Loan or Finance Companies: Loan companies are establish in all parts of the
country. They give loans to retailers, wholesalers, artisans and self-employed
persons. They offer a high rate of interest along with other incentives to attract
deposits. They charge high rate of interest varying from 36% to 48% p.a.
 Finance Brokers: They are found in all major urban markets especially in cloth,
grain and commodity markets. They act as middlemen between lenders and
borrowers. They charge commission for their services.

5. Instruments of Money Market

The various traditional and new instruments for dealing in Money Market are;
1. Call/Notice/Term Money
2. Treasury Bill (T-Bills)
3. Commercial Bill
 4. Repurchase Agreement (Repo & Reverse Repo)
5. Commercial Papers (CPs)
6. Certificate of Deposits (CDs)
7. Money Market Mutual Fund (MMMF)
5.1 Call Money

The call money deals in short term finance repayable on demand, with a maturity
period varying from one day to 14 days. As loans are payable on demand and at the
option of either the lender or the borrower, they are highly liquid, their liquidity being
exceeded only by cash.
 Unlike in other countries, Call loans in India are unsecured and subject to
seasonal variations. Call money borrowings tend to increase when there is an
increase in the CRR.
 Commercial banks both Indian and foreign, co-operative banks, Discount and
Finance House of India Ltd.(DFHI), Securities trading corporation of India
(STCI) participate as both lenders and borrowers and Life Insurance Corporation
of India (LIC), Unit Trust of India(UTI), National Bank for Agriculture and Rural
Development (NABARD), Industrial Development Bank (IDBI), General
Insurance Corporation (GIC) can participate only as lenders.
 There are now two call rates in India: the Interbank call rate and the lending rate
of DFHI.
5.2 Treasury Bill (T-Bills)

Treasury bills is a particular kind of finance bill (not arise from genuine
transaction in goods) or a promissory note put out by the government. Treasury bills are
device of short-term borrowing by the Government of India, issued as promissory notes
under deduction. Bills are highly liquid because there cannot be better guarantee of
repayment of loan than the one given by the central government. TBs have assured yield,
low transactions cost, negligible capital depreciation and negligible risk of default and
most important, they are eligible for inclusion in Statutory Liquidity Ratio (SLR).
 TBs are issued at a discount by the RBI on behalf of the Central Government as
its agent.
 Presently, all types of TBs are sold through auctions.
 In case of 91-day TBs, the auction system was introduced from January 1, 1993
while in the case of other types of TBs, it was introduced from their respective
dates of launching. In case of 91-day TB, the auctions are weekly and the amount
of auction has to be notified whereas in the case of ther types of TBs, the auctions
are fortnightly and there is no need to notify the auction amount.
 With the introduction of the auction system, interest rates on all types of TBs are
being determined by the market forces.
 91-Day Treasury Bills
o Two types of TBs have been in vague in India. Adhoc and regular.
o The adhoc bills are allotted for investment by the state governments, semi
government sections and foreign central banks for momentary investment.
They are not sold to banks and general public. As adhoc bills were issued
in favor of the RBI only, they were purchased by RBI on tap. Ad-hoc bills were
abolished in April 1, 997.
o The treasury bills sold to the public and banks are called regular treasury
bills. They are freely marketable.
o Commercial banks buy entire quantity of such bills issued on tender.
They are bought and sold on discount basis.
 o They are issued by tender till 1965 but with effect from July 12, 1965 they
were available on tap throughout the week at rates announced from time to
time. The auction system was introduced from January 1, 1993
 182-Day Treasury Bills was introduced in November 1986 which was normally
issued at discount to face value for a minimum of Rs one lakh and its multiples
thereof but bills were discontinued from April 1, 1992.
 364-Day Treasury Bills was introduced from April 1, 1992. The yield on 364-
day TB has been quite attractive and higher than the yield on the other bill.
 14-Day Treasury Bills was introduced with a view to diversity the TBs market.
On April 1, 1997, the first type of 14-day TB known as Intermediate Treasury Bill
(ITB) was introduced which replace 91-day tad bill and sold only to state
government, foreign central banks and on May 20, 1997, the second types of 14-
day TB was introduced.
5.3 Commercial Bills

Commercial bills are short term, negotiable and self-liquidating money market
instruments with low risk. A bill of exchange is drawn by a seller on the buyer to make
payment within a certain period of time. Generally, the maturity period is of 30 days-180
days.
 The two main types of bills are demand bill and usance bill.
 A demand bill is payable “at sight” or “on presentment” to the drawee.
 Usance or time bill is payable at a specified later date.
 Bills can also be classified as clean bills, documentary bills, inland bills, foreign
bills and supply bills. The indigenous variety of a bill of exchange is called hundi.
 Commercial bill can be resold a number of times during the usance period of bill.
 The rates which reflects the cost of bill finance are bank rate, SBI hundi rate,
bazzar bill rate, SBI discount rate and commercial banks’ bill finance rate.
 In India, the commercial bill market is very much underdeveloped.
 RBI has introduced an innovative instrument known as “Derivative Usance
Promissory Notes, with a view to eliminate movement of papers and to facilitate
multiple rediscounting.

5.4 Certificate of Deposits (CDs)

The scheme of CDs was introduced in 1989 by RBI. Certificate of Deposit (CD)
is a negotiable money market instrument and issued in dematerialized form or as a
Usance Promissory Note against funds deposited at a bank or other eligible financial
institution for a specified time period.
  CDs can be distributed by scheduled commercial
banks (excluding Regional Rural Banks and Local Area Banks), and select All-
India Financial Institutions (FIs) that have been allowed by RBI to rise short-term
resources within the umbrella limit fixed by RBI.
 Banks have the freedom to issue CDs depending on their funding requirements.
 Minimum amount of a CD should be Rs.1 lakh, i.e., the minimum deposit that
could be accepted from a single subscriber should not be less than Rs.1 lakh, and
in multiples of Rs. 1 lakh thereafter.
 In 1992, RBI allowed four financial institutions ICICI, IDBI, IFCI and IRBI to
issue CDs with a maturity period of. one year to three years.
 CDs may be distributed at a discount on face value.
 The distributing bank / Financial Institutions is free to regulate the discount
coupon rate. The interest rate on floating rate CDs would have to be reset
periodically in accordance with a pre-determined formula that indicates the spread
over a transparent benchmark. The investor should be clearly informed of the
same.
5.5 Commercial Papers (CPs)

It was introduced in India in 1990 with a view to enabling much rated corporate
mortgagors to expand their sources of short-term borrowings and to offer an extra
instrument to investors.
 Commercial Paper (CP) is an unsecured money market tool issued in the form of
a promissory note.
 Corporates, primary dealers (PDs) and the All-India Financial Institutions (FIs)
are eligible to issue CP. However, A corporate would be eligible to issue CP
provided –
o the tangible net worth of the company, as per the latest audited balance
sheet, is not less than Rs. 4 crore
o company has been sanctioned working capital limit by bank/s or all-India
financial institution/s; and
o The borrowable account of the company is classified as a Standard Asset
by the financing bank/s/ institution/s.
 CP can be issued for maturities between a minimum of 7 days and a maximum of
up to one year from the date of issue.
 CP can be issued in denominations of Rs.5 lakh or multiples thereof.
 The aggregate amount of CP from an issuer shall be within the limit as approved
by its Board of Directors or the quantum indicated by the Credit Rating Agency
for the specified rating, whichever is lower.
 CP will be issued at a discount to face value as may be determined by the issuer.
 CPs are actively traded in the OTC market. Such transactions, however, are to be
reported on the Fixed Income Money Market and Derivatives Association of India
(FIMMDA) reporting platform within 15 minutes of the trade for dissemination of
trade information to market participation thereby ensuring market transparency.
 Only a scheduled bank can act as an Issuing and paying Agent (IPA) for issuance
of CP.
  Initially the investor in CP is required to pay only
the discounted value of the CP by means of a crossed account payee cheque to the
account of the issuer through IPA. On maturity of CP,
(a) when the CP is held in physical form, the holder of the CP shall present
the instrument for payment to the issuer through the IPA.
(b) when the CP is held in demat form, the holder of the CP will have to
get it redeemed through the depository and receive payment from the IPA.

5.6 Repurchase Agreement (Repo & Reverse Repo)

Repurchase Market which is also known as Repo or RP or Ready Forward

Agreement is a transaction in which one party (seller/lender of security or borrower of
cash) sells a security to another party (buyer/borrower of security or lender of cash)
simultaneously agreeing to repurchase it in future at specified date and time. Reverse
Repo is exactly opposite of RP in which a party buys a security from another party with a
commitment to sell it back to the latter at specified time and price. In the other words, for
one party who is seller of security, the transaction is Repo while for the other party who
is buyer of security, it is Reverse Repo.
 It was introduced in December 1992.
 Repo transactions are affected between banks and financial institutions and
among bank themselves, RBI also undertake Repo.
 In November 1996, RBI introduced Reverse Repo. It means buying a security on
a spot basis with a commitment to resell on a forward basis. Reverse Repo
transactions are affected with scheduled commercial banks and primary dealers.
 In March 2003, to broaden the Repo market, RBI allowed NBFCs, Mutual Funds,
Housing Finance and Companies and Insurance Companies to undertake REPO
transactions.
5.7 Money Market Mutual Funds (MMMFs)

Money Market Mutual Funds (MMMFs) are a part of short-term investment

pooling arrangement. Their basic function is to purchase large pools of short-term
financial instruments and sell shares in these pools of investment. As most of the money
market instruments have to be purchased in large amounts and the pooling arrangements
enable small investors to gain access to money market yields.
Money market funds allow retail investors the opportunity of investing in money market
instrument and benefit from the price advantage.
 Money Market Mutual Funds (MMMFs) were introduced in India in April 1991
to provide an additional short term investment avenue to investors and to bring
money market instruments within the reach of individuals.
 The guidelines for MMMFs were announced by the Reserve Bank in April 1992.
The Reserve Bank had made several modifications in the scheme to make it more
flexible and attractive to banks and financial institutions.
 In November 1995 RBI made the scheme more flexible. The existing guidelines
allow banks, public financial institutions and also private sector institutions to set
up MMMFs.
  MMMFs are allowed to issue
units to corporate enterprises
and others on par with other
mutual funds.
 Resources mobilised by MMMFs are now required to be
invested in call money, CD, CPs, Commercial Bills
arising out of genuine trade transactions, treasury bills
and government dated securities having an unexpired
maturity upto one year.
 Since March 7, 2000 MMMFs have been brought under
the purview of SEBI regulations.

Money Market Reforms Introduced in India

Following are the reforms introduced in the Indian Money Market:

Introduction of New Money Market Instruments

In order to widen the scope and diversify the Indian money market, the
Reserve Bank of India has introduced many types of money market
instruments such as 182-Day treasury bills, 364-day treasury bills, CDs, and
CPs. These instruments help the government, commercial banks, financial
institutions, and corporates to raise money via the money market.

Liquidity Adjustment Facility (LAF)

The Reserve Bank of India has introduced the LAF to adjust liquidity using
repos and reverse repo rates. These rates are used to stabilize short-term
interest rates or call rates. Repo rates are often revised by the RBI to keep
the economy in a balanced state.

Deregulation of Interest Rates

The ceiling on the interest rates on call money and on interbank short-term
deposits was removed and the rates were left to be decided by the market
forces. Deregulation helps commercial banks borrow money at lesser rates
and helps them avail of the benefits when the interest rates on their loans
are high.

Real Time Gross Settlement (RTGS) and National Electronic Fund Transfer (NEFT)
Real Time Gross Settlement (RTGS) and National Electronic Fund Transfer
(NEFT) were introduced as improved payment infrastructure. These digital
systems help transfer money from one entity to another quickly and more
transparently. They also improve the transfer4 system by removing the
paperwork and too many checks made by banking authorities.

Electronic payments

An electronic dealing system was introduced. Electronic payments are easy

to initiate and process. Therefore, they remove the checkpoints and repeated
interventions by humans which may lead to errors. Therefore, electronic
dealings are free from random human errors.