UNIT 5 INDIAN FINANCIAL SYSTEM

Objectives
After reading this unit, you should be able to :
• explain the importance of the financial system;
• describe the structure and working of the money market and capital market;
• outline the structure of the banking system; and
• examine the working of the capital market along with its various instruments and
intermediaries.

Structure
5.1 Introduction
5.2 Financial System and Working of Financial Markets
5.3 Structure of Money Market
5.4 Banking Structure in India
5.5 Reserve Bank of India
5.6 Scheduled Banks in India
5.7 Structure of Capital Market
5.8 Summary
5.9 Key Words
5.10 Self -Assessment Questions
5.11 References/ Further Readings

5.1 INTRODUCTION

Before dwelling into the various intricacies of the financial system you need to understand
capital accumulation and its importance. In the previous units, you have read about different
theories of economic growth and have realised that for an economy to achieve higher levels
of both economic growth and indeed economic development, the role of capital formation is
indispensable. Capital formation means an addition/increment in the existing stock of real
capital available in the country. Capital in economics terminology does not mean money
alone. It is a wider term that encompasses both physical and human capital. Physical capital
like machines, tools, infrastructure, raw material, etc. leads to more production, profits and

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the creation of assets in future. Human capital on the other hand includes skills, training,
education, etc which improves the productivity of individuals and especially labour.

Saving and investment are two core components of capital formation. Saving in the simplest
sense means the part of income that is not consumed. When saving is used in such a manner
that it gives returns in future it becomes an investment. For example, you saved a certain
proportion of your income and bought a piece of land. So buying land is an investment
because if you sell it then the sale price of land will be higher than your purchase price and
the margin between the two will be the profit. Now, instead of selling that land, you
constructed a building on that land and then you gave it on rent. So, this rent will be an extra
income for you and it will add to your current level of income or profit. So when savings are
properly channelised it increases the stock of income or capital. As saving is important for an
individual it is of paramount importance for an economy. A higher level of savings leads to
more investment and capital formation which in turn becomes the source of economic
growth. So, it is the creation of savings, mobilisation of savings and conversion of savings
into capital assets that leads to capital formation.

There are large numbers of factors that affect the rate of capital formation in the country like
income levels of the people, institutional factors like availability, number and coverage of
financial institutions, the monetary and fiscal policy of the country, prevailing rate of interest,
population, size of the market, etc.

5.2 FINANCIAL SYSTEM AND WORKING OF FINANCIAL MARKETS

A financial system consists of a set of institutions, instruments and markets which brings the
savers and the investors to a common platform and provide the means by which savings are
translated to investment. The principal objective of the financial system or financial markets
is to channelise the savings into the most productive opportunity/avenues. In financial
markets, there are two players namely lenders and borrowers. Individuals/ Households
generate savings and have surplus funds. They can either put this amount of money in gunny
bags and hide it or keep it under lock and key as was done in yester years. This form of
savings did not yield any return and the constant fear of theft always lured upon the savers.
On the other hand, capitalists/ entrepreneurs could not undertake new projects of production
or expand the existing production capacity of the plant due to a dearth of capital. The major
role of the financial system of the financial market is to bring these two together. Those who
have savings (savers or lenders) put funds into banks and other financial institutions and

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 those in need of money or finance (borrower) take the money from these financial
institutions. In this interaction both the lenders and borrowers gain and ultimately due to
increased efficiency, production and exchange the whole economy gets benefitted.

The working of financial markets can be understood from the flow chart (Figure 5.1). The
households save money in the financial system and these funds are channelised and in the
form of loans are provided to the borrowers.

Savings Loans
Lenders Financial System Borrowers
Individuals/ households

Figure 5.1 : Working of Financial Markets

Financial markets perform many functions like:

• To connect borrowers and lender of funds and to lead to the process of price
discovery/determination.
• To provide liquidity in the system by allocation of funds in an efficient manner.
• Easy access of funds to the borrowers which in turn reduces the cost of the
transaction.
• Provides a way for managing uncertainty and controlling risks.

5.3 STRUCTURE OF MONEY MARKET

Financial markets have two main components money market and capital market and they
both are essential for the economic development of the country. In the following section, you
will read about the money market, its importance and various instruments. The money market
is a market for short-term financial assets and assets which are close substitutes of money.
Short term implies time period of less than one year and close substitutes of money refer to
those financial assets that can be converted to money with minimum/no transaction cost and
without loss in value. The major participants in the money market are scheduled commercial
banks (excluding regional rural banks or RRBs), cooperative banks (excluding land
development banks) and primary dealers (PDs).

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Objectives

The broad objectives or functions of the money market are :

• To provide equilibrating mechanism between short term surpluses and deficiencies.

• Maintaining liquidity in the system.
• Providing access to short term funds to the borrowers at minimum or realistic cost.
• To enable the central bank of the country intervention to influence and regulate
liquidity in the economy.

Instruments of the Money Market

The main instruments traded in the money market and the sub-market are:

• Call Market/ Notice Market

• Commercial Papers (CPs) Market
• Treasury Bills (T-Bills) Market
• Commercial Bills Market
• Certificate of Deposits (CDs) Market
• Money Market Mutual Funds (MMMFs)

Let us now discuss them in brief.

• Call Market/ Notice Market

It is a market for short term financial fundsthatare payable immediately and in full
when the lender demands them. It is for this reason that call money is also known as
“money at call”. The maturity period variesfrom one day to a fortnight (14 days).
When the funds are browed/lent for a day it is called call (overnight) money. If the
duration of funds borrowed/lent is more than a day and upto 14 days it is called notice
market. For conducting transactionsin the call/notice market there is no need for any
collateral security.The major players in the call market are banks and primary
dealers.The interest rate payable on call loans is known as the call rate.

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• Commercial Papers(CPs) Market

CPs are short term unsecured instruments issued by companies to raise short term
debts. They are issued in the form of promissory notes and in India they were
introduced in 1990. Large corporations, primary dealers and Financial Institutions (FI)
are authorised to issue CPs. The maturity duration of CPs is a minimum of 7 days and
a maximum of up to one year from the date of issue. They are typically issued to short
term financial obligations like funding of the new project. They can be issued in
denomination of Rs 5 lakh or multiples thereof.Further, all eligible participants need
to obtain a credit rating for the issuance of CPs. They need to have a minimum credit
rating of A2 as per the Securities and Exchange Board of India (SEBI) definition and
rating symbol. CPs are issued discount to face value basis (as discussed in the T-bills
example). They have many advantages like the option of diversification for the source
of finance, higher returns and liquidity.

• Treasury Bills or T- Bills

T-bills are short term borrowing instruments by the government of India. These are a
form of a bill that does not arise from any genuine transaction in goods. They are a
kind of promissory note issued by the Reserve Bank of India (RBI). The government
uses T-bills to raise short term funds to bridge the temporary/seasonal gaps when a
deficit arises due to shortfall ( situation when receipts fall short of expenditure). At
present T-bills of 91 days, 182 days and 364 daysare issued. These bills are bought
and sold on a discount basis means they are zero-coupon securities and yield no
interest. For example, a 91 days T-bill of Rs 200 (which is the face value) may be
issued at say Rs 198.20. So the discount on this T-bill is Rs. 1.80 and at the time of
redemption it will be redeemed at the face value (i.e. Rs. 200). The return which
investors gain is the difference between the face value (maturity value) and the issue
price. T-bills are issued by RBI through auctioning.RBI conducts auctions of T-bills
with a maturity period of 91 days, 182 days and 364 days every Wednesday. The date
and place of auction, maturity time period and the method of auction is announced by
the RBI from time to time.There are two main types of auctions namely multiple-price
auction and uniform-price auction.The main features of T-bills are they are negotiable
instruments, highly liquid because of the short time period, secured as they are backed

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 by the government guarantee, assured yield and low transaction cost. The net short
term market borrowing of the government through 91 days, 182 days and 364 days T
bills stood at Rs.37,528 crore during 2019-20.

• Commercial Bills Market

Commerical bills include bills of exchange and promissory notes. A promissory note
is a form of financial instrument in which the note’s issuer and the note’s payee
undertake a written promise whereby the issuer promise to pay a definite sum of
money either on demand or at a specified future date to a particular person or to the
bearer of the instrument. Commerical bills originate due to original trade transactions.
There are many types of bills like trade bills, commercial bills, inland bills, foreign
bills, indigenous bills and others. Rediscounting of bills is an important segment of
the bill market. Commercial banks often make use of such facilities.

Let us understand the concept of rediscounting with a help of an example. Suppose a

commercial bank buys 91 -days T-Bill at Rs 1000 and receives Rs 1100 at the time of
maturity. In this case, the difference between the purchase price and face value of the
bill is Rs 100 is called the discount. Re-discounting occurs when the short-term
negotiable debt instrument is discounted for a second time. In continuation with the
above example, let's assume that the same bank needs money urgently for say 30
days, it will approach the central bank of the country and the central bank can
purchase some of the bills from the bank say for Rs 1050 for a period of next 30 days
but before 90 days the date of maturity. In this case, the rediscount or the difference
between the purchase price and the face value is Rs. 50.

• Certificate of Deposits (CDs) Market

CDs are negotiable money market instrument against funds deposited in a bank or
other financial institutions for a fixed time period at a specific rate of interest. They
are the bearer documents and issued in dematerialised form. Scheduled commercial
banks ( except RRBs and local area bank) and selected all India FIs can issue CDs in
a minimum amount of Rs. 1 Lakh and in the multiples of Rs. 1 Lakh. The maturity
period of CDs is a minimum of 7 days and a maximum up to one year. They are
issued at a discount on face value. Banks have to maintain appropriate reserve

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 requirements i.e., Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) on
the issue price of CDs.

• Money Market Mutual Funds (MMMFs)

To increase the participation of individuals and small investors in the money market
and to provide additional short term funds avenues to the investors MMMFs were
introduced in April1991 and the detailed scheme of MMMFs was announced by RBI
in 1992. A mutual fund is an investment scheme mostly run by an asset management
company. Money is collected from a large number of investors and this pool of
money is invested in stocks, bonds and other securities. MFs are mostly beneficial for
small investors like the salaried class who park their funds in MMMFs and can gain
better returns. They offer diversification of short terms assets in terms of issues,
maturity and volume, thereby spreading the risk. Whenever investor buys mutual
funds they are allotted units/share of the mutual fund. These MFs are professionally
managed and investors earn income in the proportion to the number of units owned by
them. Initially, only banks, FIs and their subsidiaries were allowed to set up MMMFs
but corporates and others were allowed for the same from 1996. All MMMFs are
governed and regulated by SEBI.

Structure of Money Market in India

The structure of the money market in India is presented in Figure 5.2. The money
market is divided into two parts i) Organised and ii) Unorganised.

Money Market

Organised Unorganised

RBI Indigeneous
banks

Commercial
Banks Non Banking
Companies

Money
Lenders

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 Figure 5.2 : Structure of Money Market in India

The organised sector consists of the central bank of India or RBI, commercial banks both
nationalised and private. Further, foreign banks, cooperative banks, the discount and finance
house of India and other financial institutions like IFCI, ICICI, LIC, GCI and mutual funds
also operate in the money market. The unorganised sector consists of non-bank financial
intermediaries, indigenous bankers and money lenders.

5.4 BANKING STRUCTURE IN INDIA

As discussed previously banks are one of the most important segments of the money market.
Let us read about the banks, their functions, the structure of the banking system in India with
special reference to RBI.

Definition of Bank

According to the Banking Regulation Act 1949, a banking company is a company that
transacts the business of banking in India and banking means accepting deposit of money
from the public for the purpose of lending or investment however with the promise of
repayment on the demand by the depositor with the facility of withdrawal by cheque, draft,
order or otherwise.

The functions of banks have changed from traditional (accepting deposit and lending credit)
to many more functions like collection and payment of cheques, bills and promissory notes,
sale and purchase of securities, remittances of funds, merchant banking, services of
automated teller machines (ATM), electronic fund transfer system, dealing in foreign
exchange, and others.

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 Reserve Bank
of India (RBI)

Scheduled
Banks in India

Scheduled Scheduled
Commercial Banks Cooperative Banks

Public Sector Private Sector Foreign Banks Regional Rural

Banks Banks Banks

Nationalised State Bank of India Old Private New Private

Banks and its associates sector banks sector banks

Figure 5.3: Banking Structure in India

The structure of banking in India is presented in Figure 5.3. At the helm of the affairs, there is
RBI which is the regulator of the banking sector and supervises the monetary policy of the
country. After that, we have scheduled banks that are further classified as scheduled
commercial banks and scheduled cooperative banks. Public sector banks, private sector
banks, foreign banks and Regional Rural Banks(RRBs). Within the Public sector, there are
nationalised banks and the State Bank of India (SBI) and its associates. Private sectors banks
have two categories old and new private sector banks. In the following sections, you will
briefly read about them.

5.5 RESERVE BANK OF INDIA (RBI)

RBI is an apex bank of the country and acts as the regulator of the financial and monetary
system in the country. It was established after the recommendation of the ‘Hilton- Young
Commission’. It was established as a banker to the central government by the Reserve Bank
of India Act 1934 and it began its operations from April 1935 as a private shareholders bank
with the paid-up capital of Rs.5 crore and in 1949, RBI was nationalised.

Functions of the RBI

Some of the major functions of RBI are:

• Note Issuing authority

• Banker to the Banks

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 • Banker of the Government and Debt Manager
• Banking Sector Regulator
• Foreign Exchange Manager
• Maintaining Financial Stability
• Development Role
• Regulator of the Monetary Policy

Note Issuing Authority

RBI has a monopoly over note-issuing in India other than one rupee notes/coins and coins of
smaller denomination. RBI ensures that both currency notes and coins are available in an
adequate amount in the country. The currency notes issued by RBI are legal tender in the
length and breadth of the country. RBI can issue currency notes up to the denomination of Rs.
10,000. At present notes in the denomination of Rs 2, Rs 5. Rs 10, Rs 20, Rs 50, Rs 100, Rs
200, Rs 500 and Rs 2000 are issued. Similarly, coins in circulation comprise Rs 1, Rs 2, Rs5
and Rs 10.

Banker to the Banks

All the banks in the country havean account in the RBI via which banks settle inter-bank
transaction and customer transactions. It also enables banks in maintaining statutory reserve
requirements like SLR and act as lenders of the last resort. It also provides short term loans
and advances to banks as and when the need arises.

Banker of the Government and Debt Manager

RBI acts a banker to the central government of the country along with those state
governments which have agreed with RBI. It maintains the government accounts and does
financial transaction from this account along with the transfer of government funds. It
manages the government domestic debt and raises the money both from the public and
financial market to bridge the shortcoming of revenue.

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Banking Sector Regulator

RBI regulates and supervises the banking system of the country in accordance with the
various provisions of the RBI Act and Banking Regulation Act. RBI as a regulator does a
wide range of activities like providing licenses, prescribing capital requirement like capital
adequacy norms, paid-up capital and lending to the priority sectors of the economy like
farmers, women, etc. Regulation of interest rate, an inspection of the banks and bank
branches, setting of different regulatory norms and also to initiate new regulation in
accordance to changing circumstances.

Foreign Exchange Manager

As you may have read that trade is very essential for any economy. For conducting trade
adequate stock of foreign exchange reserves are an important requirement. RBI plays an
important role in both the development and regulation of the foreign exchange market. It
regulates the transactions which are related to both exports and imports and ensure smooth
conduct in the domestic foreign exchange market. It is the custodian of foreign exchange
reserves and the golds reserves of the country. The banks and selective institutions which
wish to deal in the foreign exchange need to have a license from RBI.

Development Role

RBI aims at promoting financial literacy and education among the public and also ensures
that credit is available to the productive sectors of the economy. For the development purpose
RBI has established many institutions like the National Bank for Reconstruction and Rural
Development (NABARD), Unit Trust of India (UTI), Deposit Insurance and Credit
Guarantee Corporation, Industrial Development Bank of India (IDBI) among others.

Regulator of Monetary Policy

Monetary policy is the policy of RBI through which it regulates the financial market of the
country and most importantly it is used for credit control. Credit creation is one of the chief
functions of the bank. Before we move forward let us understand what is credit creation.
Whenever the bank accepts a deposit from the customer, it retains some proportion( which is

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mandatory) of this deposit for the requirement of the depositor and the rest is given as a loan
to the buyer. So bank creates money out of money this process is called credit creation. It is
through credit creation that money flows into the system. However, both the excess and
deficiency of money circulation is damaging for the economy. If the supply of money is more
than the demand then we have the problem of inflation which you have read in previous
units. In contrast, if the money supply is less than demand then we have the problem of
deflation. So, RBI uses monetary policy to control credit. Methods adopted by RBI for credit
control are classified as i) Quantitative and ii) Qualitative.Lets us discuss these methods in
detail in the following sections and once we have discussed these methods we can understand
with the help of illustration how these methods are adopted for credit control.

Quantitative Methods

Quantitative methods are used to control total quantity or volume and the cost of the credit
created by banks. Within Quantitative methods, we have direct and indirect instruments. Cash
Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) and Refinance facilities are direct
tools. Bank rate, Repo and Reverse repo rate, Liquidity Adjustment Facility (LAF), Open
Market Operations, Market Stabilisation Scheme (MSS) and Marginal Standing Facility
(MSF) are indirect instruments.

Cash Reserve Ratio (CRR)

It is the minimum amount that banks keep with RBI as a proportion of their Net Demand and
Time Liabilities (NDTL). The CRR percentage is notified from time to time by RBI. CRR
ensures that banks have sufficient cash for their depositor's requirement.

Statutory Liquidity Ratio (SLR)

It is the percentage of NDTL that banks have to mandatory maintain in safe and liquid assets
like cash, gold or government securities. SLR restricts the expansion of bank credit, increases
bank’s participation in the security markets especially government securities, and it also
ensures the solvency of banks.

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Refinance Facility

This facility is used by RBI to provide adequate credit to selective sectors like the export
sector.

Bank Rate Policy

According to RBI Act, 1934, a bank rate is “the standard rate at which RBI is prepared to buy
or rediscount bills of exchange or other commercial paper eligible for purchase under this
act”. The bank rate has been aligned to the Marginal Standing Facility (MSF) and it changes
automatically when MSF changes.

Repo Rate

It is the rate at which RBI lend to the banks overnight against the collateral of government
and other approved securities under the arrangement of Liquidity Adjustment Facility (LAF).
In simple terms, it is the fixed interest rate at which banks borrow from RBI for the short
term. At present, Monetary Policy Committee (MPC) decides this policy rate along with the
reverse repo rate.

Reverse Repo Rate

It is a fixed interest rate at which RBI borrows from the banks in order to absorb liquidity for
the short term (overnight basis). RBI borrows against the collateral of eligible government
securities under the LAF.

Liquidity Adjustment Facility: This facility was introduced by RBI after it was suggested
by the Narasimham Committee on Banking Sector Reform of 1998. It is a mechanism for
managing the liquidity needs of the bank. It aims to inject/absorb liquidity from the system in
the situation of shortages and excess. The repo, reverse repo, term repo (auction), overnight
variable rate repo (auction), overnight variable rate reverse repo (auction) are the components
of LAF.

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 Policy Rates as on Arpil, 2021
Cash Reserve Ratio (CRR): 3.50 % Repo Rate: 4.00 %
Reverse Repo Rate: 3.35 % Marginal Standing Facility Rate: 4.25 %
Bank Rate: 4.25 % Statutory Liquidity Ratio: 18%

Source: Reserve Bank of India

Open Market Operations

It refers to buying and selling of government securities by RBI in the money market. Both the
purchase and sale of these securities may lead to expansion and contraction of the money
supply. For example, at the time of inflation, RBI sells these securities and banks buy them.
When banks buy these securities then bank credit is directed away from the public to RBI
which leads to less credit creation and less supply of money in the market.

Market Stabilisation Scheme

In 2004 this scheme of RBI was launched in order to withdraw excess liquidity from the
market by selling government bonds. The problem of excess liquidity was due to RBI
purchase of foreign currency. The bonds which the RBI sells are called Market Stabilisation
Bonds (MSBs) and they are owned by Government of India.

Marginal Standing Facility

It is a facility for banks that can be used in an emergency. Under this facility scheduled
commercial banks can borrow up to one percent of their NDTL at 100 basis points (1 percent)
more than the repo rate for the short term (overnight) from RBI. It provides a safety value to
banks against unanticipated liquidity shocks.

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 INFLATION/ DEFLATION AND QUANTITATIVE METHODS
Lets us take an illustration to demonstrate how RBI uses these methods in the time of
Inflation/deflation.Lets us assume that CRR is 10 percent and NDTL are to the tune of Rs.100. Now
CRR is the proportion of NDTL which banks have to keep with RBI. So out of this Rs.100 banks
have to keep Rs 10 with RBI so they can now create credit worth Rs.90. Now suppose that economy
is witnessing inflation in which supply of money is greater than demand for money. At the time of
inflation, RBI can increase CRR ( Repo, Reverse repo and bank rate) to 15 percent, so now instead
of Rs 10 banks have to keep Rs 15 with RBI and they can create credit worth Rs 85 only. So by
increasing CRR (or other policy rates) RBI can curb the credit creation capacity of banks and reduce
supply of money. On the other hand at time of deflation RBI reduces reserves so that more liquidity
can be pumped into economy.

Qualitative Methods/ Selective Methods

These methods focus on certain sectors only. By using these methods RBI can divert the flow
of credit from one sector to another. The different qualitative methods used by RBI are credit
rationing, consumer credit regulation, increasing margin requirement, moral suasion, direct
action and others. We will only discuss some of them in this section.

Credit Rationing

Under this method, RBI controls and regulate the purpose for which credit is granted by
banks. The central bank can put a ceiling on the amount of loans that can be advanced to the
banks.

Consumer Credit Regulation

This method helps in controlling excess spending by the consumers. RBI can direct banks to
fix a minimum percentage of down payment, instalment amount, loan duration, etc.

Margin Requirement

Margin requirement is the difference between the market value of the security which is
pledged for taking a loan and the maximum amount of loan which can be disbursed against
this security. For example, the margin requirement is 10 percent and you wish to take a loan.
You approach a bank for a loan with security which is worth Rs 1000. As the prescribed
margin is 10 percent the bank keeps this margin and will lend you only Rs 900. Now if there

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is an excessive money supply in the economy then RBI can increase this margin to say 30
percent. So instead of Rs 900, you will get a loan of Rs 700 against the same security. So in
the situation of inflation, this margin is increased and during deflation, it is reduced.

Moral Suasion

RBI requests or persuades commercial banks to behave in a particular manner according to

the financial situation of the economy. For example, during inflation RBI requests
commercial banks to restrict bank advances.It is a sort of advice and there is no compulsion
by RBI. The effectiveness of this policy depends upon coordination between RBI and
commercial banks.

Direct Action

It refers to the direction and the controls which RBI enforces on particular or all banks in case
of default or no adherence to advise of RBI. RBI can reject the request of banks for grants or
rediscounting facilities or it may levy penal rate interest on loans that banks borrow beyond
the prescribed limit.

5.6 SCHEDULED BANKS IN INDIA

Scheduled banks are those banks that are included in the second schedule of the RBI Act,
1934. These banks need to have paid-up capital and reserves of not less than Rs 5 lakhs.
These also need to maintain CRR balance with RBI and they can raise debts and loans from
RBI at the bank rate. Scheduled commercial banks are further classified as public sectors
banks, State Bank of India (SBI) and its associates, old and new private sector banks and
foreign banks.

Public Sector Banks(PSBs)

PSBs are those banks in which more than 50 percent of shares are held by the GoI. These are
the major type of banks in India. At present (2021) there are 12 PSBs namely SBI, Bank of
Baroda, Bank of India, Punjab National Bank (PNB), Indian Overseas Bank, Punjab and Sind
Bank, Indian Bank, UCO Bank, Bank of Maharashtra, Central Bank of India, Canara Bank
and Union Bank of India.

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SBI and its Associates

SBI is the biggest commercial bank in the country with nearly 25 percent market share and
has over 22000 branches and 58500 ATMs. SBI came into being on 1 July 1955 when the
GoIpassed the State Bank of India Act, 1955 by taking over assets and liabilities of the
Imperial Bank of India. Imperial Bank of India was formed in 1921 through the
amalgamation of three presidency banks namely Bank of Madras, Bank of Bombay and Bank
of Bengal. At present, SBI is a Fortune 500 company and is headquartered in Mumbai. SBI
initially had 7 associates namely State Bank of Bikaner and Jaipur, Hyderabad, Indore,
Mysore, Patiala, Saurashtra and Travancore. However, in 2008 and 2009 State Bank of
Saurashtra and Indore was merged with SBI and the remaining 5 associate banks were
merged in 2017.

Private Sector Banks

Private sector banks are those banks in which the majority of the stake is owned by private
shareholders. In India, private sector banks are classified as Old and New private sector
banks. The private banks which were not nationalized (in the year 1969) are collectively
known as the old private sector banks and include banks such as The Jammu and Kashmir
Bank Ltd., Lord Krishna Bank Ltd. etc. As of April 2021, the number of private sector banks
in India was 22. Some of the famous private sector banks are ICICI, HDFC,etc.

Foreign Banks

Foreign banks are those banks which have headquarter in a different country but has branches
in India. As of July 14, 2020, there are 46 foreign banks in India. These banks have to follow
rules both of home and host country. Bank of America, Bank of Ceylon, National Australia
Bank, BNP Paribas, etc are some of the foreign banks in India.

Regional Rural Banks (RRBs)

They were established in 1975 to develop the rural economy and creation of additional
channel to the cooperative credit structure to enhance the reach of institutional credit for the
rural and agriculture sector. There were 43 RRBs as of April 2021.

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Scheduled Co-operative Banks

Cooperative banks function on the concept of cooperative credit societies wherein the
members of the society join together to extend a loan to each other at a subsidised rate of
interest. Scheduled Co-operative Banks are of two types Scheduled State Co-operative Banks
and Scheduled Urban Cooperative Banks. There are 23 Scheduled State Co-operative banks
and 53 Scheduled Urban Cooperative banks.

Narasimham Committee on Banking Sector reforms

Government of India set up two expert committees under the chairmanship of
M.Narasimham for the restricting of Banking sector popularly known as Narasimham
Committee-1 (1991) and Narasimham Committee-II (1998).

Activity 1

1. Suppose you are hired as an advisor to the finance minister and the country is
witnessing a high rate of inflation. What advice would you offer regarding changing
the policy rate like CRR, Repo Rate, etc. and why?

_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________

2. The Govermnet of India is planning for more mergers of banks. How do you look
about this decision?

_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________

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 _____________________________________________________________________
_____________________________________________________________________

5.7 STRUCTURE OF CAPITAL MARKET

In the previous section, you have read about the money market which provides short term
funds to investors for less than one year. However, business units and investors need funds
for a longer duration also for undertaking business expansions or technology upgrading and
in this regard they approach the capital market. A capital market is a market for long term
securities or financial instruments having a maturity period of more than one year. Capital
markets are important for channelising savings, capital formation and industrial growth. The
structure of the capital market in India can be better understood with the help of Figure 5.4

Capital Market

Markets Instruments Intermediaries Regulator

Primary

Securties and
Secondary Exchange Board
of India (SEBI)

Figure 5.4: Structure of Capital Market in India

Capital markets comprised of two markets i) Primary Market and ii) Secondary Market. The
primary market is also known as the New Issue Market (NIM) where the issuer of the
securities (shares and bonds) sell the new securities to the investors directly without any
intermediaries. Whenever the securities are offered for sale for the first time by the
companies they are called Initial Public Offering (IPO). IPO is issued to raise capital for
funding purpose. Both the companies and government raise funds by the sale of new stocks in
the primary market.

The secondary market is also known as the stock market. It is a place where shares, bonds,
options, etc which were sold earlier are sold and purchased. In India, you must have heard

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about the Bombay Stock Exchange (BSE), National Stock Exchange (NSE) they are some of
examples of stock exchanges. The secondary market can be either an auction market or Over-
the-Counter. In the auction market, trading of securities is done through the stock exchange.
In Over-the-Counter the trading is conducted without using the platform of stock exchange, it
does not have any physical location and trading is done electronically.

Financial Instruments

Some of the major financial instruments used in capital markets are discussed below.

Shares

A share indicates a unit of ownership by the buyer of shares called shareholder/holers of the
company. A shareholder has ownership in the company and has voting rights and shares the
company profit or loss. The benefit which a shareholder receives out of company profit is
called a dividend. Let us understand it with an example. Assume that there is a company
know as XYZ limited and it needs funds (Rs 100 crore ) for further expansion. For raising
this fund the company will go to the public. This capital of Rs 100 crores is divided into
1,000,000 shares of Rs. 1000 per share. Now assume that there are two investors A and B and
they want to invest in this company so they will buy some shares. Investor A buys 500 shares
and investor B buys 800 shares so they are investing Rs 500000 and Rs 8000000 in this
company and have become the shareholders and will share the profit or loss of the company
in the proportion to their holdings. Further, shares are of two types namely equity shares and
preference shares.

Bonds

Bonds are issued by state and central governments, companies and municipalities to raise
money for a variety of projects and activities. They are debt instruments in which the entities
borrow the funds for a defined period of time at a variable or fixed interest rate. It is fixed-
income security and essentially a loan agreement between a bond issuer and an investor. The
bondholders unlike shareholders do not have any ownership of the company or have voting
rights.

Debentures

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Debentures are also a type of debt instrument which is issued by companies for raising funds
but they are not secured by physical assets or collateral. An investor buys debentures based
on the reputations and the creditworthiness of the issuer. The interest rate on debentures is
higher than that of bonds.

SENSEX also known as Sensitive Index ( or S&P BSE Sensex Index) is a benchmark index of
Bombay Stock Exchange. It is the market weighted stock of 30 companies.

Gilt Edge Market : The gilt-edged market refers to the market for Government and semi-government
securities and is backed by the RBI. Government securties are called Gilt -edged means ‘of the best
quality’ because they are highlighy liquid and risk free

Capital Market Intermediaries

There is a large number of intermediaries in the capital markets some of which are discussed
below:

Merchant Bankers

Merchant Bankers are intermediaries between the investors and the company. They act as an
advisor who advises the entrepreneurs from the stage of the conception of the project till the
production begins. SEBI defines merchant bankers as “any person who is engaged in the
business of issue management either by arranging for buying, selling or subscribing to
securities or acting as manager, consultant or rendering corporate advisory services in
relation to such issue management”.

Underwriters

When a company decides to go public to raise funds all of its securities maybe not fully
subscribed by the public, so there is a need for someone who can subscribe to those
securities. This work is done by the underwriter he agrees with the issuer company that in the
case of securities that are not subscribed then the underwriter would subscribe to the
securities itself or by others the unsubscribed securities. He is paid a fee called ‘underwriting
commission’ for this job. Underwriters can be both institutional (for example IDBI, UTI) or
non-institutional. All underwriters need to be registered with SEBI.

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Portfolio Managers or Portfolio Management Services (PMS)

A professional who enters into a contract with the client to advise or direct or undertake
investment decisions on behalf of the client. Portfolio managers are of two types
discretionary portfolio managers and non-discretionary portfolio managers. When the
portfolio manager manages the funds of the client independently according to the needs of the
client they are called discretionary portfolio managers. Whereas non-discretionary portfolio
manager manages the funds following the directions of the client. Some of the examples of
major Portfolio Management Services in India are Motilal Oswal PMS, Kotak PMS, ICICI
Prudential PMS, etc.

Stock Brokers

A stockbroker is an individual or firm which is an intermediary between an investor and a

securities exchange. The stockbroker trades in the stock exchange on the behalf of their
clients. In return for their services, they are paid commissions of fees. They handle all the
paperwork and maintain records of all transaction, manages their client's portfolio and advise
the investors on formulating different investment strategies in the dynamic world of financial
markets. All stockbrokers are registered with the SEBI.

Regulator of the Capital Market /SEBI

In India, the capital market is regulated by the Securities and Exchange Board of India
(SEBI). SEBI was established in 1988 as a non -statutory body but with the passing of SEBI
Act 1992, it was accorded statutory power. The major objectives of SEBI are to protect the
interest of investors and development and regulation of stock exchange, to prevent deceitful
malpractices and to regulate and develop a code of conduct for intermediaries such as
brokers, underwriters, etc. SEBI performs various functions like registration of stock
exchanges, mutual funds, underwriters, brokers and sub-brokers. Levys various fees and
other charges promote investors educations, audit and inspection of stock exchanges and
various intermediaries, prohibits unfair trade practices relating to the securities market and
insider trading.

Activity 2

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 1. Conduct a field survey of your neighbourhood and assess the awareness level of the
stock market.

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2. Nowadays there is a trend of investment among common man in Mutual Funds

through Systematic Investment Plan (SIP). Try to collect some information in your
neighbourhood about the factors which affect individuals decision to invest in MF.

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5.8 SUMMARY

This unit has given you detailed information about the financial system. Initially, you read
about the importance of the financial system whereby it brings the suppliers and the
borrowers of funds in the common platform. In the subsequent sections, the importance,
functions and instruments of the money market were discussed. One of the major components
of money markets is banks. In India, RBI is the apex bank and it formulates and regulates
monetary policy. Monetary policy has two instruments namely quantitativeand qualitative.
Quantitative instruments include various policy rates like CRR, Repo and Reverse repo rate,
bank rate, etc. which aims at controlling the quantum of credit. Qualitative methods like
moral suasion, direct action and others aim at directing the credit flow to a particular sector or
to prohibit the credit flow. RBI uses both instruments but quantitative methods are more
visible and easy to administer.

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In the next section, you developed an understanding of banks and the various functions of the
banks along with the structure of banking in India. The different categories of banks like the
public sector, private sector, foreign banks were discussed in some details. In the last section,
an understanding of the working of the capital market was highlighted with the emphasis on
the meaning of capital market, its various instruments, intermediaries and SEBI.

5.9 KEY WORDS

Financial System: It consists of a set of institutions, instruments and markets which brings
the savers and the investors to a common platform and provide the means by which savings
are translated to investment.

Cash Reserve Ratio (CRR): It is the minimum amount that banks keep with RBI as a
proportion of their Net Demand and Time Liabilities (NDTL).

Statutory Liquidity Ratio (SLR): It is the percentage of NDTL that banks have to
mandatory maintain in safe and liquid assets like cash, gold or government securities.

Bonds: Bonds are issued by state and central governments, companies and municipalities to
raise money for a variety of projects and activities.

5.10 SELF-ASSESSMENT QUESTIONS

1. Differentiate between money market and capital market.
2. Differentiate between shares and bonds.
3. What are the major functions of RBI?
4. Write about some of the instruments of the money market.
5. Write a note on SEBI.

5.11 REFERENCES/ FURTHER READINGS

1. Mishkin, Frederic. S. (2007) Financial Markets and Institutions. New Delhi, Pearson
Education Ltd.
2. Khan, M. Y. (2007). Indian Financial System. New Delhi. Tata McGraw Hill.
3. Machiraju, H.R. (2006). Indian Financial System. New Delhi. Vikas Publication.
4. Bhole, L.M. (2008). Financial Institutions and Markets. New Delhi. Tata McGraw
Hill.

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