CHANGES IN THE INDIAN FINANCIAL SYSTEM SINCE 1991

SUBMITTED BY:NOOPUR GUPTA PG2010-2225

INDIAN FINANCIAL SYSTEM

INTRODUCTION A financial system plays an important role in the economic growth of the country. It is the intermediary between the savings and investment of the income earned by the citizens of that country. It mobilizes and usefully allocates scarce resources of the country. A financial system is a complex, well integrated set of subsystems of financial institutions, markets, instruments, and services which facilitates the transfer and allocation of funds efficiently and effectively. FORMAL AND INFORMAL FINANCIAL SECTORS The financial systems of most of the developing countries are characterized by the coexistence and cooperation between the formal and informal sectors. This coexistence of these two sectors is commonly referred to as financial dualism. The formal financial sector is characterized by the precence of an organized, institutional, and regulated system which caters to the financial needs of the modern spheres of the economy; the informal financial system is an unorganized, non regulated ayatem dealing with the traditional and rural spheres of the economy. The informal financial system has emerged as the result of the intrinsic dualism of economic and social structures in developing countries and financial repression which inhibitsthe certain deprived sections of the society from accessing funds. Advantages : Low transaction costs Minimum default risk Transparency of procedures Disadvantages: Wide range of interest rates Higher rates of interest Unregulated THE INDIAN FINANCIAL SYSTEM The Indian Financial System can also be classified into formal financial system and informal financial system. The formal financial system comes under the purview of Ministry of Finance, the Reserve Bank of India (RBI), the Securities Exchange Board of India (SEBI), and other regulatory bodies. The informal financial system consists of : Individual money lenders Groups of persons operating as funds or associations Partnership firms COMPONENTS OF FORMAL FINANCIAL SYSTEM The formal financial system consists of 4 segments or components: Financial institutions

Financial markets Financial instruments Financial services

Financial Institutions Financial institutions are intermediaries that mobilize savings and facilitate the allocation of funds in an efficient manner. They can be classified as: a. Banking and non banking b. Term finance c. Specialized d. Sectoral e. Investment f. State level Financial Markets Financial markets are mechanism enabling the participants to deal in the financial claims. The markets also provide the facility in which their demands and requirements interact to set a price for such claims. The most organized financial markets in India are the money market and the capital market. The first is the market ofr short term securities while second is the market for long term securities; i.e. securities having a maturity period of one year or more. Financial markets are also classified as primary and secondary markets. While the primary market deals in new issues, the secondary market is meant for trading in outstanding or existing securities. Financial Instruments A financial instrument is a claim against a person or an institution for payment, at a future date, of a sum of money or a periodic payment in the form of interest or dividend. Financial instrument represents wealth shares like shares, debentures, like bonds and notes. Many financial instruments are marketable as they are denominated in small amounts and traded in organized markets. Savings and investments are linked through a wide variety of complex financial instruments known as securities. Fianacial securities are financial instruments that are negotiable and tradeable. Types of financial securities: Primary Secondary Financial Services Financial services are those that help with: Borrowing and funding Lending and investing Buying and selling securities Making and enabling Payments and settlements Managing risks

These services refer to the process of designing, developing and implementing innovative solutions for unique needs in funding investing and risk management. The RBI regulates the money market and SEBI regulates the capital market. FUNCTIONS AND KEY ELEMENTS OF A FINANCIAL SYSTEM The functions of financial system include: Mobilise and allocate savings Monitor corporate performance Provide payment and settlement systems Optimum allocation of risk-bearing and reduction Disseminate price-related information Offer portfolio adjustment facility Lower the cost of transactions Promote the process of financial deepening and broadening The basic elements of a well-functioning financial system are: A strong legal and regulatory environment Stable money Sound public finances and public debt management Central bank A sound banking system An information system A well-functioning securities market FINANCIAL SYSTEM DESIGNS The two types of financial system designs are: Bank based Market based At one extreme is the bank-dominated system, such as in Germany, where a few large banks play a dominant role and the stock market is not that important. At the other extreme, is the marketdominated financial system, as in the US, where the financial markets play an important role while the banking industry is much less concentrated.

CHANGES IN THE FINANCIAL SYSTEM POST 1990s

In the post 1991 period, with a decline in the role of the Government, Indian financial system has undergone massive changes, also, since the announcement of new economic policy. Liberalization /globalization/deregulation has transformed Indian economy from closed to open economy. Major economic policy such as macro-economic stabilization, delicensing of industries, financial sector reforms or reforms in banking or capital market, disinvestment in public sector undertakings (PSUs), reforms in taxation and company law reforms in terms of simplifications and debureaucratisation were gradually implemented and, they have had far reaching impact on the structure of corporate industrial sector in India. Government role in the distribution of finance and credit has declined over the years. Financial system is focusing more attention towards the development of capital market which is emerging as the main agency for the allocation of resources among the public, private sector and the government. The essence of these developments is the fact that the IFS are poised for integration with the savings pool in the domestic economy and abroad. The notable developments in the organisation of the Indian financial system during this phase are briefly outlined below with reference to: Privatization of financial institutions Reorganization of institutional structure Investor protection PRIVATIZATION OF FINANCIAL INSTITUTIONS Since 90s, government control over financial institutions has diluted in a phased manner. Public/development financial institutions have been converted into companies, allowing them to issue equity or bonds to the public. Government has allowed private sector to enter into insurance and banking sector. IFCI has been converted into a public company (IFCI Ltd). The IDBI and IFCI Ltd offered their equity to private investors. Private mutual funds have been set up under the guidelines prescribed by the SEBI. A number of private banks under the RBI guidelines have also come into existence. Thus, the state monopoly over financial institutions in India till the early 1990s, has been dismantled in a phased manner mainly through the establishment of private financial institutions such as banks, mutual funds, and insurance companies. This is, indeed, a revolutionary change in the organisation of IFS. Reorganization of Institutional Structure Apart from the entry of private financial institutions, the institutional structure of the IFS has undergone and outstanding transformation to reflect the capital market-orientation in its evolution. This is illustrated with reference to the emerging changes in the role, organisation, operating policies, sponsorships of the institutions by DFIs/development banks/term-lending institutions, commercial banks, mutual funds, securities or capital market, money market and so on. CHANGING ROLE OF DEVELOPMENT/PUBLIC FINANCIAL INSTITUTIONS (DFIs/PFIs) Although the DFIs/PFIs constituted the backbone of the IFS and despite the fact that they still played a dominant role until 2000, their relative significance in the emerging financing scenario had been declining, indicating a shift in the corporate financing in India, in terms of greater reliance of industry

on non-institutional sources of financeand greater recourse to capital market. DFIs performed the role of term-lending institutions extending loans for project finance, underwriting, direct subscription, lease financing etc. They received funds from the Government and the RBI. But now, there is a remarkable shift in the activities of DFIs: DFIs engaged in non-fund based financial activities such as merchant banking, project counseling, portfolio management services, mergers and acquisitions, new issue management etc. DFIs raised funds through issue of bonds carrying floating rate of interests or bonds without Government guarantee. Earlier, DFIs sponsored infrastructural institutions such as Technical Consultancy Organisation(TCOs), Management development institute(MDI) and The Institute for Financial Management and Research (IFMR). Then focus shifted to development of capital market. As a result, following institutions were promoted by DFIs: a. Credit Rating Information Services of India Ltd. ( CRISIL) b. Investment Information and Credit Rating Agency Ltd. (ICRA) c. Credit Analysis and Research Ltd. (CARE) d. Over the Counter Exchange of India (OTCEI) Ltd. e. National Stock Exchange (NSE) Ltd. f. Stock Holding Corporation of India (SHCI) Ltd. g. IFCI Financial Services Ltd. h. IFCI Investors Services Ltd. i. IFCI Custodial Services Ltd. j. ICICI Securities Finance Ltd. The RBI guidelines stipulated the application of prudential norms in accounting for income, asset classification, provisioning and capital adequacy on the pattern of the commercial banks as envisaged by Narasimham Committee I, 1991. The extension of the internationally accepted accounting standartds to the term-lending institutions in India resulted in their operations shifting from quantitative sanctions/disbursements of assistance to financial viability, accountability and improving the bottom line of these organisations. Obviously, a new type of development banking emerged in India. The financial sector reforms started in 1991 had provided the necessary platform for the banking sector to operate on the basis of operational flexibility and functional autonomy enhancing productivity, efficiency and profitability. While several committees have gone in to the problems of commercial banking in India, the two most important of them are: Narasimham Committee I (1991). Narasimham Committee II (1998). EMERGENCE OF NON-BANKING FINANCIAL COMPANIES The NBFCs constitute a significant element of the organisation of the financial system. They broaden the range of financial services. They are partly fee based, partly asset/fund based. Their activities include equipment leasing, hire-purchase finance, bills discounting, loans/investments, venture

capital, housing finance, etc. Fee based services include portfolio management, issue management, loan syndication, merger and acquisition etc. Reflecting the imperatives of the evolution of vibrant, competitive and dynamic financial system, the NBFC sector in India has recorded growth in the recent years in terms of number, deposits and so on. A regulatory framework for their operations has evolved over the years on the basis of the recommendations of a number of committees in the context of the contemporary financial scenario. GROWTH OF MUTUAL FUNDS INDUSTRY A remarkable development in the reorientation of the IFS in the post-1991 years is reflected in the structural growth of mutual funds industry. Initially, UTI was the single organisation issuing the mutual fund units. But presently, mutual funds are sponsored not only by UTI but also by banks, insurance organisation, FIIs, private sector. There are off-share/country funds being sponsored by FIIs and Indian FIs. Between them they offer a wide variety of schemes focusing on income, growth, tax savings, insurance linkage and special categories like children and senior citizens, sector specific, money market mutuals to suit the investment requirements of the heterogeneous category of investors. Mutual Funds are gaining popularity among the small investors due to: Tax exemption on income from mutual funds. Units of mutual funds if held for 12 months are to be treated as long term asset, for the purposes of capital gains tax. Minimum investment in units has been enhanced from Rs. 1000 to Rs. 5000 in primary market. SECURITY EXCHANGE BOARD OF INDIA Although a fairly comprehensive legislative code has been built up earlier, the focus was on control. The framework was fragmented, both in terms of laws or acts under which the regulatory function fell and the agencies/government departments that administered them. The need for a focused/integrated regulatory framework, administered by an independent/autonomous body, found expression in the establishment of SEBI.The Securities Board Exchange of India was established under the SEBI Act, 1992 with the following purposes: To protect the interest of investors in securities. To promote the development of securities market. To regulate the securities market For matters connected therewith or incidental thereto.

DEVELOPMENTS IN THE SECONDARY MARKET/STOCK MARKET Capital market has undergone tremendous change over the years. From being a marginal institution in the mid eighties, it has come to occupy the centreage in the IFS. The structure of both primary and secondary market is characterized by significant changes. The reforms of the intermediaries as well as the pre and post issue procedure and activities, are indeed thorough going, as a consequence of which the primary market organisation has assumed, highly developed character, capable of catering to the requirements of the sophisticate and articulate securities market. Numbers of developments have taken place. It includes:

Issuance of regulations by SEBI in respect of brokers/sub brokers/dealers in trading/settlement. More transparency in trading and settlement practices. Regulation of badla trading. Introduction of derivative market (future/option trading) Setting up of the National Stock Exchange (NSE) and Over The Counter Exchange of India (OTCEI) Setting up of National Securities Depository Ltd. (NSDL) and Central Depository Services (India) Ltd. (CDSL) and system of electronic trading through dematerialization of shares etc.

SIGNIFICANT CHANGES IN THE FINANCIAL SYSTEM Some of the significant changes that have taken place over the last few and that may have implications on the Indian Financial System are listed below: The UTI, the leading mutual fund organisation has been split into two parts as a consequence of the repeal of the UTI Act Private sector has been allowed in the insurance sector thus breaking the monopoly of LIC and GIC. GIC has been delinked from its four subsidiaries. The introduction of derivative trading including index/stock/interest futures and options has also been one of the significant development having implications on the financial system. The merger of ICICI Ltd. and IDBI into ICICI Bank and IDBI Bank respectively and the proposed merger of IFCI into PNB.