Unit-1

An overview of the Indian financial system

The Indian Financial System refers to a set of institutions, markets, instruments, services,
and regulations that facilitate the flow of funds in the economy. It plays a key role in
mobilizing savings and channeling them into productive investments, promoting economic
growth.

Major Components of the Indian Financial System

The Indian Financial System has four main components:

1. Financial Institutions
These are organizations that provide financial services like accepting deposits, lending
money, and offering investment products. They are divided into two types:
a) Banking Institutions
• Examples: RBI, Commercial Banks (SBI, HDFC), Cooperative Banks
• Functions: Accept deposits, provide loans, issue credit, facilitate payments
b) Non-Banking Financial Institutions (NBFIs/NBFCs)
• Examples: LIC, HDFC Ltd., Bajaj Finance
• Functions: Provide loans, insurance, leasing, investment services
• NBFCs cannot accept demand deposits like banks
2. Financial Markets
These are platforms where financial assets (like stocks, bonds, etc.) are bought and sold.
They are classified into:
a) Money Market
• Deals in short-term funds (less than 1 year)
• Instruments: Treasury Bills, Commercial Paper, Certificates of Deposit
• Participants: RBI, banks, mutual funds
b) Capital Market
• Deals in long-term funds (more than 1 year)
• Instruments: Shares, Debentures, Bonds
• Divided into:
o Primary Market – where new securities are issued
o Secondary Market – where existing securities are traded (e.g., NSE, BSE)
c) Forex Market
• Deals in foreign currencies
• Participants: Banks, exporters/importers, RBI
d) Derivatives Market
• Deals in financial contracts like futures and options
• Helps in risk management (hedging)

3. Financial Instruments
These are the products used in financial markets for raising funds or investment.
Types:
• Equity Instruments – Shares (ownership in a company)
• Debt Instruments – Bonds, Debentures, Loans (fixed returns)
• Hybrid Instruments – Convertible debentures, Preference shares
These instruments help in capital formation and liquidity management.
4. Financial Services
These are services that help in the smooth functioning of financial institutions and markets.
Examples:
• Credit rating (e.g., CRISIL, ICRA)
• Asset management (mutual funds)
• Insurance services
• Investment advisory
• Wealth management
• Payment and settlement systems (e.g., UPI, NEFT)

Regulatory Framework of the Indian Financial System

The financial system is regulated to ensure transparency, stability, and investor protection.
Major Regulators:
• RBI (Reserve Bank of India): Regulates banks and money market
• SEBI (Securities and Exchange Board of India): Regulates capital and
derivatives markets
• IRDAI (Insurance Regulatory and Development Authority of India): Regulates
insurance sector
• PFRDA (Pension Fund Regulatory and Development Authority): Regulates
pension funds

Importance of the Indian Financial System

• Mobilizes savings and allocates them to productive sectors
• Promotes investment and entrepreneurship
• Maintains financial stability
• Facilitates economic development and poverty reduction
• Helps in the smooth functioning of trade and commerce
Conclusion
The Indian Financial System is the backbone of the country’s economy. It includes a
network of institutions, markets, instruments, and services that help in the effective
allocation of resources, promote economic growth, and maintain financial stability.

Major reforms in the last decade: Payment banks, GST, innovative

remittance services, Insolvency and Bankruptcy code:
India’s financial system has seen many important reforms in the past 10 years. These
reforms were introduced to increase financial inclusion, promote digital transactions,
improve tax systems, and strengthen the credit and insolvency process.

1. Payment Banks (2015)

What is it?
Payment Banks are a new category of banks introduced by the Reserve Bank of India
(RBI) to provide basic banking services to people who don’t have access to regular
banks, especially in rural areas.
Key Features:
• Can accept deposits up to ₹2 lakh per individual.
• Cannot give loans or credit cards.
• Can offer services like fund transfers, mobile payments, and bill payments.
• Operate mainly through digital platforms.
Examples:
Paytm Payments Bank, Airtel Payments Bank, India Post Payments Bank.
Importance:
They promote financial inclusion, especially among low-income individuals and in rural
areas, and support a cashless economy.

2. Goods and Services Tax (GST) – 2017

What is it?
GST is a single, unified indirect tax system that replaced multiple indirect taxes like
VAT, excise duty, and service tax.
Key Features:
• One Nation, One Tax.
• Applicable on the supply of goods and services.
• Includes CGST (Central), SGST (State), and IGST (for interstate trade).
• GST is collected at each stage of the supply chain but credit is given for previous
tax paid (input credit).
Importance:
• Simplifies the tax system.
• Reduces tax evasion and corruption.
• Encourages formalization of businesses.
• Boosts transparency and ease of doing business.

3. Innovative Remittance Services

What is it?
In recent years, digital payment systems have rapidly grown in India, especially after
demonetization in 2016. Several user-friendly and innovative remittance systems were
introduced.
Key Examples:
• UPI (Unified Payments Interface): Instant money transfer between bank accounts
using mobile apps.
• Mobile Wallets: Paytm, Google Pay, PhonePe, etc.
• IMPS/NEFT/RTGS: Online banking methods for sending money 24x7.
• QR Code Payments: Simple method for shopkeepers to receive payments.
Importance:
• Promotes digital transactions and reduces dependence on cash.
• Makes payments fast, safe, and cost-effective.
• Empowers small vendors and individuals in rural and urban areas.
4. Insolvency and Bankruptcy Code (IBC) – 2016
What is it?
IBC is a special law that provides a structured and time-bound process for dealing with
companies and individuals who cannot repay their loans.
Key Features:
• Initiated when a company defaults on its loan.
• Process handled by National Company Law Tribunal (NCLT).
• Tries to resolve insolvency within 180–270 days.
• If not resolved, the company’s assets are liquidated to repay creditors.
Importance:
• Helps banks recover loans quickly and reduce NPAs (bad loans).
• Makes companies more responsible in managing credit.
• Improves investor confidence and business environment.
• Boosts India’s global “Ease of Doing Business” ranking.

Conclusion
These major reforms—Payment Banks, GST, innovative remittance systems, and IBC—
have played a crucial role in transforming India’s financial system. They have increased
financial inclusion, promoted digitalization, simplified taxation, and strengthened
credit recovery mechanisms, leading to a more modern and transparent economy.
Regulatory Institutions in India: RBI, SEBI, IRDA,
PFRDA

Regulatory institutions are bodies established by the government to supervise and regulate
different sectors of the economy. In India, several regulatory bodies ensure that the
financial markets operate smoothly, ethically, and transparently. These institutions also
protect the interests of consumers and maintain financial stability.

1. RBI – Reserve Bank of India

Basic Definition:
The Reserve Bank of India (RBI) is the central bank of India, responsible for regulating
the country’s monetary and financial system.
Established: 1935
Headquarters: Mumbai
Regulates: Banking and monetary system
Key Functions:
• Monetary Policy: Manages inflation and money supply by setting key interest rates
(repo rate, reverse repo rate).
• Regulation of Banks: Grants licenses to banks and supervises their operations to
ensure they follow rules.
• Currency Issuer: Issues and manages currency notes in India (except ₹1 coins,
which are issued by the Ministry of Finance).
• Foreign Exchange Management: Regulates the foreign exchange market and
manages the country’s forex reserves.
• Financial Stability: Ensures the overall stability and growth of the financial
system.
Importance:
As India’s central bank, RBI is responsible for maintaining financial stability, controlling
inflation, and overseeing the banking sector to protect public and investor interests.
2. SEBI – Securities and Exchange Board of India
Basic Definition:
SEBI is the regulatory authority responsible for overseeing the securities market (capital
market), ensuring investor protection, and promoting fair practices.
Established: 1988 (became a statutory body in 1992)
Headquarters: Mumbai
Regulates: Capital markets (stock market, mutual funds, etc.)
Key Functions:
• Investor Protection: Ensures that investors are provided with accurate information
and are not misled by fraudulent activities.
• Regulation of Stock Exchanges: Oversees stock exchanges like BSE and NSE, and
monitors brokers and traders.
• Approval of IPOs: Reviews and approves companies issuing shares to the public.
• Prevention of Market Manipulation: Takes steps to prevent insider trading and
other unethical practices in the market.
Importance:
SEBI ensures that the capital markets operate transparently and efficiently, creating
investor confidence and safeguarding public and institutional interests.

3. IRDAI – Insurance Regulatory and Development Authority of India

Basic Definition:
IRDAI is the regulatory body for the insurance sector in India, ensuring that insurance
companies follow fair practices and protecting the interests of policyholders.
Established: 1999
Headquarters: Hyderabad
Regulates: Insurance sector (life and general insurance)
Key Functions:
• Licensing Insurance Companies: Ensures that only authorized companies operate
in the insurance sector.
• Policyholder Protection: Protects policyholders by enforcing fair pricing, claim
settlements, and transparency.
 • Regulation of Insurance Agents: Regulates the conduct of insurance agents to
ensure they operate ethically.
• Promotes Competition: Encourages healthy competition in the insurance market
to offer better products and services.
Importance:
IRDAI ensures that the insurance industry operates fairly, maintains consumer trust, and
provides secure, transparent services to policyholders.

4. PFRDA – Pension Fund Regulatory and Development Authority

Basic Definition:
PFRDA is the regulatory body responsible for overseeing pension funds in India,
ensuring that pension plans are well-managed and secure for the future.
Established: 2003
Headquarters: New Delhi
Regulates: Pension sector (National Pension System)
Key Functions:
• Regulates NPS (National Pension System): Oversees pension funds for
government and private sector employees.
• Monitors Pension Fund Managers (PFMs): Ensures that the pension funds are
managed effectively and meet required standards.
• Promotes Voluntary Retirement Savings: Encourages individuals to save for
retirement through voluntary pension schemes.
• Transparency and Security: Ensures that pension funds are invested securely and
transparently.
Importance:
PFRDA plays a vital role in helping individuals save for retirement and ensuring that their
pension funds are safely managed for future financial security.
Conclusion
These regulatory bodies — RBI, SEBI, IRDAI, and PFRDA — form the backbone of
India’s financial regulatory structure. They ensure fair practices, transparency, and
consumer protection in their respective sectors, contributing to the overall stability and
growth of the Indian economy. These institutions help build trust in financial markets and
ensure a sustainable and secure financial system.

Commercial Banking: Role of Banks, NPA, Risk

Management in Banks

Commercial banks play a crucial role in the financial system by providing various banking
services to individuals, businesses, and the government. They act as intermediaries in the
economy by collecting deposits and lending loans. However, they also face several
challenges such as managing risks and dealing with Non-Performing Assets (NPA),
which can significantly affect their financial health.
1. Role of Banks
Basic Definition:
Commercial banks are financial institutions that accept deposits from the public and
provide loans and other financial services.
Key Functions of Commercial Banks:
• Accepting Deposits:
Banks offer a safe place for individuals and businesses to deposit their money.
Types of deposits include savings accounts, current accounts, and fixed
deposits.
• Providing Loans and Advances:
Banks lend money to individuals, businesses, and the government. This includes
personal loans, home loans, business loans, and credit lines.
• Credit Creation:
By lending out deposited funds, banks create credit in the economy. The money
lent to borrowers circulates, fostering economic growth.
• Facilitating Payments:
Banks help with the transfer of money through methods like cheques, wire
transfers, and online payment systems (RTGS, NEFT, IMPS).
 • Investment Services:
Banks offer investment products such as mutual funds, bonds, and insurance to
help customers grow their savings.
• Foreign Exchange Services:
Banks deal with foreign currencies and help facilitate international trade by
providing foreign exchange services.
Importance of Commercial Banks:
• Banks facilitate economic development by making credit available to various
sectors, including agriculture, industry, and services.
• They play a key role in the monetary policy transmission by influencing the
money supply in the economy through lending and deposit activities.

2. Non-Performing Assets (NPA)

Basic Definition:
An NPA is a loan or advance that has not been repaid by the borrower for more than 90
days. If a borrower fails to repay the interest or principal of a loan for 90 days or more,
the loan is classified as an NPA.
Types of NPAs:
• Substandard Assets: Loans that are overdue for less than 12 months.
• Doubtful Assets: Loans overdue for more than 12 months.
• Loss Assets: Loans that are considered uncollectible.
Impact of NPAs on Banks:
• Financial Health of Banks:
NPAs represent bad loans that reduce the bank's income because it is not
receiving interest or principal payments. As a result, it affects profitability.
• Credit Flow:
Banks with high NPAs are less likely to lend to other borrowers, as they need to
focus on recovering the bad loans, which restricts the flow of credit in the
economy.
• Capital Adequacy Ratio (CAR):
To cover the losses from NPAs, banks need to set aside provisions, which can
 reduce their capital base. This can lead to lower CAR, affecting the bank's ability
to lend more.
Causes of NPAs:
• Poor Credit Appraisal:
Banks may lend to risky borrowers without proper evaluation.
• Economic Slowdown:
During economic downturns, many businesses and individuals struggle to repay
loans.
• Management Failures:
Lack of proper monitoring and recovery mechanisms leads to high defaults.
Measures to Manage NPAs:
• Restructuring of Loans:
Banks can restructure loans, allowing borrowers to repay in installments.
• Sale of NPAs:
Banks can sell their NPAs to Asset Reconstruction Companies (ARCs), which
specialize in recovering bad loans.

3. Risk Management in Banks

Basic Definition:
Risk management in banks involves identifying, assessing, and mitigating the risks
associated with banking operations, such as credit risk, market risk, operational risk, and
liquidity risk.
Types of Risks in Banks:
• Credit Risk:
The risk that a borrower will not repay their loan or default on interest payments.
This is the most significant risk for banks.
Mitigation:
o Proper Credit Appraisal: Evaluating the borrower’s ability to repay.
o Diversification: Lending to different sectors to spread the risk.
• Market Risk:
The risk of losses due to fluctuations in interest rates, foreign exchange rates, and
stock prices.
Mitigation:
o Hedging: Using financial instruments like derivatives to protect against
market fluctuations.
o Asset-Liability Management (ALM): Managing the bank’s balance sheet
to minimize market risks.
• Operational Risk:
The risk of loss due to failed internal processes, human error, fraud, or external
events.
Mitigation:
o Internal Controls: Ensuring proper checks and balances are in place.
o Technology and Automation: Using advanced software to reduce human
errors and fraud.
• Liquidity Risk:
The risk that a bank will not have enough liquid assets (cash) to meet its short-
term obligations.
Mitigation:
o Maintaining Cash Reserves: Banks are required to hold a certain
percentage of their funds in cash or liquid assets as per Cash Reserve
Ratio (CRR) and Statutory Liquidity Ratio (SLR).
o Diversifying Funding Sources: Banks should not rely on a single source
of funding.
• Interest Rate Risk:
The risk that changes in interest rates may affect a bank’s income or the value of
its assets.
Mitigation:
o Interest Rate Swaps: Using financial instruments to offset interest rate
movements.
o Gap Analysis: Analyzing the difference between a bank's assets and
liabilities that are sensitive to interest rate changes.
Universal Banking: need and importance, Core
banking solution (CBS), NBFCs and its types;
What is Universal Banking?
Universal Banking is a system where a single bank offers a wide range of financial
services. This includes traditional banking services like savings accounts, loans, and
deposits, as well as non-traditional services like investment banking, asset management,
insurance, and pension funds.
Need and Importance of Universal Banking:
1. Diversification of Services:
Universal banking allows banks to diversify their services, making them a one-
stop shop for all financial needs (e.g., retail banking, corporate banking, wealth
management, insurance).
2. Better Risk Management:
By offering a variety of services, banks can spread risk across different sectors.
For instance, the bank's profits from investment banking can offset losses from the
retail banking segment.
3. Financial Inclusion:
Universal banking helps in offering a wide array of financial products to
underserved or unbanked populations, which is crucial for promoting financial
inclusion.
4. Revenue Growth:
A wider range of services enables banks to generate more revenue from different
segments (like retail loans, asset management, etc.), thus improving profitability.
5. Customer Convenience:
Customers benefit from having access to various financial services under one roof,
making transactions and management easier.
Examples:
• A bank offering savings accounts, loans, insurance, mutual funds, and pension
plans, all within the same institution.
Core Banking Solution (CBS)
What is CBS?
Core Banking Solution (CBS) refers to a central platform where all branches of a bank
are connected digitally, allowing customers to access banking services from any branch
of the bank. It is a system that facilitates seamless and real-time banking operations and
transactions across the entire bank network.
Key Features of CBS:
1. Centralized Database:
All branches share a common database, so customers can perform banking
transactions at any branch, even if they have an account in another branch.
2. Real-Time Transactions:
CBS allows real-time processing of transactions, ensuring that customer account
balances are updated immediately.
3. 24/7 Banking:
With CBS, customers can access their accounts and perform transactions anytime,
regardless of the branch they visit.
4. Integration with Other Services:
CBS integrates with services like ATMs, internet banking, mobile banking, and
phone banking, providing a seamless experience across multiple channels.
5. Reduced Operational Costs:
CBS improves efficiency and reduces the need for manual intervention, which cuts
down on operational costs for banks.
Importance of CBS:
• Improves Efficiency:
Banks can operate more efficiently, as CBS automates routine processes like
deposits, withdrawals, and balance inquiries.
• Enhances Customer Experience:
It allows customers to easily access their accounts and conduct transactions at any
branch or online.
• Reduces Errors and Fraud:
CBS minimizes human error and fraud risks by automating and centralizing data
handling.
NBFCs – Non-Banking Financial Companies
What are NBFCs?
NBFCs (Non-Banking Financial Companies) are financial institutions that offer
services similar to traditional banks, but they do not have a full banking license. They are
not allowed to accept demand deposits (like checking accounts) or issue cheques, but
they provide a wide range of financial services such as loans, asset management,
insurance, and investment advisory services.
Types of NBFCs:
1. Asset Financing Companies (AFCs):
These NBFCs primarily provide loans for purchasing assets such as vehicles,
equipment, or property. They include companies like vehicle financing firms.
2. Loan Companies (LCs):
These NBFCs focus on providing personal loans, business loans, or small loans to
individuals and companies. They include both secured and unsecured loans.
3. Investment Companies (ICs):
These NBFCs invest in shares, debentures, bonds, or other securities to earn
income. They also manage investment portfolios for clients.
4. Infrastructure Finance Companies (IFCs):
These NBFCs specialize in financing infrastructure projects like roads, bridges,
airports, etc. They provide long-term funding for infrastructure development.
5. Microfinance Institutions (MFIs):
MFIs provide financial services like loans and insurance to low-income groups,
especially in rural areas, to promote financial inclusion.
6. Residuary Non-Banking Companies (RNBCs):
These are NBFCs that do not engage in any kind of lending, but instead engage in
accepting deposits from the public and investing in various instruments.
7. Housing Finance Companies (HFCs):

Provide home loans for purchasing or constructing homes.

Example: HDFC, LIC Housing Finance.
Importance of NBFCs:
1. Financial Inclusion:
NBFCs play an essential role in providing credit and financial services to sectors
that traditional banks might overlook, like small businesses and low-income
individuals.
2. Support to the Economy:
By providing loans for infrastructure, vehicles, and business expansion, NBFCs
contribute to economic growth and job creation.
3. Flexibility in Lending:
NBFCs are more flexible in their lending policies and are often more willing to
provide loans to higher-risk individuals or businesses, unlike traditional banks.
4. Alternative to Banks:
NBFCs act as an alternative financial provider, especially in areas where
traditional banking services are not available or not suitable for the customer.

Conclusion
• Universal Banking allows banks to offer a variety of financial products under one
roof, ensuring diversification and convenience for customers.
• Core Banking Solutions (CBS) provide a seamless, efficient, and real-time
banking experience across branches and channels, improving efficiency and
customer satisfaction.
• NBFCs (Non-Banking Financial Companies) fill the gap in the financial sector
by providing alternative financial services like loans, insurance, and asset
management, especially in areas under-served by traditional banks.
Comparison between Banks and NBFCs.
Banks and Non-Banking Financial Companies (NBFCs) are both financial institutions,
but they differ in several ways, including their services, operations, regulations, and roles
in the economy. Below is a clear comparison between the two:

1. Definition
• Banks:
Banks are financial institutions authorized by the government and regulated by the
Reserve Bank of India (RBI) to provide a wide range of financial services,
including accepting deposits, providing loans, and offering various payment
services.
• NBFCs (Non-Banking Financial Companies):
NBFCs are financial institutions that provide banking services such as loans,
advances, and investment products but cannot accept demand deposits (like
savings or checking accounts). They are also regulated by the RBI but operate
under different regulations compared to banks.

2. Core Services
• Banks:
o Accept demand deposits (e.g., savings, checking accounts).
o Provide loans, including personal loans, home loans, and business loans.
o Offer payment and settlement services (e.g., ATMs, fund transfers).
o Issue and manage credit/debit cards.
o Provide facilities like lockers, foreign exchange, and remittances.
• NBFCs:
o Provide loans (e.g., personal loans, vehicle loans, business loans).
o Invest in securities, bonds, and other financial products.
o Offer asset financing (e.g., vehicle financing, machinery loans).
o Offer housing finance, microfinance, and infrastructure financing.
o Do not accept demand deposits or provide payment services.
3. Acceptance of Deposits
• Banks:
Banks can accept demand deposits, meaning they can accept savings, current, and
fixed deposits from customers.
• NBFCs:
NBFCs cannot accept demand deposits. They are not allowed to take savings or
checking account deposits but may accept term deposits (fixed deposits) in
certain cases, subject to conditions.

4. Regulatory Framework
• Banks:
o Banks are regulated by the Reserve Bank of India (RBI) under the
Banking Regulation Act, 1949.
o Banks are subject to strict regulations regarding capital adequacy,
liquidity requirements, and reserve requirements (e.g., CRR, SLR).
• NBFCs:
o NBFCs are also regulated by the RBI but under the Reserve Bank of India
Act, 1934 and the NBFC Directions issued by the RBI.
o The regulatory framework for NBFCs is less stringent compared to banks,
especially regarding capital requirements and liquidity.

5. Role in Financial Inclusion

• Banks:
Banks play a central role in the economy by providing financial services to all
segments, including businesses, individuals, and government entities. They help in
promoting financial inclusion by offering a wide range of services.
• NBFCs:
NBFCs focus more on niche markets and cater to underserved sectors, such as
rural areas, small businesses, and low-income individuals. They are particularly
important in financial inclusion, offering loans to people and sectors that may not
have access to traditional banking services.
6. Access to Government Schemes
• Banks:
Banks are eligible to participate in government schemes like MUDRA, PMAY,
PMGDISHA, and other financial inclusion programs. They are key players in
implementing government welfare programs.
• NBFCs:
While NBFCs can offer products related to financial inclusion, they cannot
participate directly in many government schemes aimed at banking institutions.
However, they support certain programs, like providing microfinance and rural
financing.

7. Capital Requirements and Risk Management

• Banks:
Banks must maintain a minimum capital adequacy ratio (CAR), which ensures
they have enough capital to absorb potential losses. Banks also follow strict risk
management policies laid out by the RBI.
• NBFCs:
NBFCs are required to maintain capital adequacy ratios (but typically lower than
banks). However, they have more flexibility in terms of their risk management
strategies and operations.

8. Access to Public Funds

• Banks:
Banks are allowed to raise public funds by accepting deposits from the public
and offering a variety of investment products. They have access to the central
bank’s liquidity and other public funding sources.
• NBFCs:
NBFCs cannot raise funds through public deposits (demand deposits). They raise
funds through private sources like issuing debentures or bonds, borrowing from
banks, or raising capital through equity investments.
9. Lending and Interest Rates
• Banks:
Banks offer a wide range of loan products with regulated interest rates set by the
RBI. They also follow guidelines on interest rates for different types of loans,
which ensures consistency across the sector.
• NBFCs:
NBFCs have more flexibility in determining interest rates for their loans. They
can offer higher interest rates due to the higher risk associated with lending to
non-prime borrowers, such as in the case of microfinance or asset-backed loans.

10. Access to Government Support

• Banks:
Banks are seen as critical institutions for the country’s economic stability, and
thus, they are more likely to receive government support in times of financial
distress, such as bailouts or recapitalization.
• NBFCs:
NBFCs are less likely to receive direct government support in times of crisis.
However, they are indirectly supported by the RBI’s regulations and the broader
financial system.