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Indian Financial System

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Table of contents

  1. Components of Formal Financial System
  2. Investment for Consumption and Business
    Financial Investment and Physical Investment
    Investment avenues
    Risk and Return Relationship

The Indian financial system can be broadly classified into the formal (organized) financial system and the informal (unorganized) financial system.

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The formal financial system comes under the purview of the Ministry of Finance (MOF) Reserve Bank of India (RBI), Securities Exchange Board of India (SEBI) and other regulatory bodies.

The informal financial system consists of:

  • (i) Individual money lenders such as neighbors, relatives, land lords, traders, store owners and so on.
  • (ii) Groups of persons operating as funds or ‘associations’. These groups function under a system of their own rules.
  • (iii) Partnership firms consisting of local brokers, pawn brokers and non banking financial intermediaries such as finance, investment, chit fund companies. In India the spread of banking in rural areas has helped in enlarging the scope of the formal financial system.

Components of Formal Financial System

Formal financial system consist of four segments, these are financial institutions, financial markets, financial instruments and financial services.

Financial institutions are intermediaries that mobilize the savings and facilitate the allocation of funds in an efficient manner. Financial institutions are classified as banking and non banking financial institutions. Banking institutions are creator of credit while non banking financial institutions are purveyors of credit. In India non banking financial institutions namely the Development Financial Institutions (DFIs) and Non Banking Financial Companies (NBFCs) as well as Housing Finance Companies (HFCs) are the major institutional purveyors of credit. Financial institutions are further classified as Term Finance Institutions such as Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI), Industrial Financial Corporation of India (IFCI), Small Industries Development Bank of India (SIDBI) and Industrial Investment Bank of India (IIBI). Specialized finance institutions like the Export Import Bank of India (EXIM), Tourism Finance Corporation of India (TFCI), ICICI Venture, Infrastructure Development Finance Company (IDFC) and sectoral financial institutions such as National Bank for Agricultural and Rural Development (NABARD) and National Housing Bank (NHB). Investment institutions in the business of mutual funds (UTI, Public Sector and Private Sector Mutual Funds) and insurance activity (LIC, GIC and 67 its subsidiaries) are also classified as financial institutions. There are state level financial institutions such as State Financial Corporation and State Industrial Development Corporation (SIDCs) which are owned and managed by the State Governments.

Financial markets are a mechanism enabling participants to deal in financial claims. Money market and capital market are the organized financial markets in India. Money market is for short term securities while capital market is for long term securities. Primary market deals in new issues, the secondary market is meant for trading in outstanding or existing securities.

Financial instrument is a claim against a person or an institution for the payment at a future date a sum of money or a periodic payment in the form of interest or dividend. Financial instruments may be primary or secondary securities. Primary securities are issued by the ultimate borrowers of funds to the ultimate savers e.g. Bank Deposits, Mutual Fund Units, Insurance Policies, etc. Financial instruments help the financial markets and the financial intermediaries to perform the important role of channelising funds from leaders to borrowers.

Financial services include merchant banking, leasing, hire purchase, credit rating etc. Financial services rendered by the financial intermediaries’ bridge the gap between lack of knowledge on the part of the investors and increasing sophistication of financial market and instruments.

The four components are interdependent and they interact continuously with each other. Their interaction leads to the development of a smoothly functioning financial system. Savings and Investment Saving is abstaining from present consumption for a future use. Savings are sometimes autonomous coming from households as a matter of habit but the bulk of the savings come for specific objectives like interest on income, future needs, contingencies, precautionary purposes, growth in future wealth, leading to rise in the standard of living etc. Investment is the exchange of the money or cash for a future claim on money or the purchase of a security or a promise to pay at a later date along with a regular income as in the case of a share, bond, debenture etc. Investment is also a service like consultancy, construction, hotel or hospital and services in future as in the case of consumer durables.

Securities purchases are investment for the economy and some investments are offset by corresponding disinvestments. Gross investments are total investments made from all sources by an economy or a single economic unit and net investment are those which are gross investment minus disinvestments for an economic unit. Gross Assets and Investments minus Depreciation for the economy or a company or corporate sector or government sector is net investment, which is termed as capital formation. 69 Changes or fluctuations in economic activity may occur when investment spending is greater or smaller than the savings at a given level of income. The resources going into the productive process, i.e. capital formation, may have direct relationship with economic growth. All economic activities – agricultural, industrial or services – depend on the availability of financial resources. The amount of financial resources and the volume of capital formation depend upon the intensity and efficiency with which savings are encouraged, gathered and directed towards investment.

The investment purpose of public may be set out in terms of their savings for:

  • (i) Transactions purpose (for daily needs or regular payments)
  • (ii) Precautionary purposes (for contingencies or special needs)
  • (iii) Speculative or asset purposes (for capital gains and building of assets).

Investment for Consumption and Business

The income is divided into two components namely Consumption and Investment. The amounts not consumed are saved and invested. Investments are also useful for present and future consumption in the case of consumer durables, cars, gold and silver etc. Investments generally promote larger 70 consumption in future as they lead to more income and larger capital appreciation in the years to come. Investment and speculation Purchases of assets like shares and securities can be for either investment or speculation or for both. Investment is long term in nature while speculation is short term. All investments are risky to some extent but speculation is most risky as it involves short term trading, buying and selling which may lead to profits sometimes and losses at other times.

Financial Investment and Physical Investment

The savings at household sector which account for the bulk of savings are measured by the total financial savings and savings in physical assets. The savings in financial form include savings in currency, bank deposits, non bank deposits, life insurance funds, provident and pension funds, claims on government, shares and debentures, units of UTI, mutual funds and trade debts. The currency and deposits are voluntary savings and motivated by transactions and precautionary motives and are governed by income and other incentives. The savings in life insurance, provident fund and pension fund are contractual savings governed by precautionary and contingency motives. The claims on government are compulsory deposits, tax credits and investment in government bonds, etc. The savings in the form of units, shares and debentures etc are 71 voluntary savings and are used for investment in the business sector directly or indirectly. The gross savings of the household sector is around 19 percent of the GDP. This constitutes more than one third is in physical assets and three fourth in financial assets. The savings in physical form include agricultural implements, tools, tractors, consumer durables, gold, silver etc among the rural households and such items as real estate, buildings etc among all households. The savings in physical form are less productive while savings in financial form are more productive in various degrees depending on the efficiency of their rise. The household sector in India has emerged as the single most important contributor to Gross Domestic Savings. A sustained annual growth rate of 10 percent can be achieved with the right policies aimed at increasing the domestic savings on the one hand and attracting a larger flow of capital from abroad, on the other.

Investment avenues

There is large number of investment avenues for savers in India. Some of them are marketable and liquid while others are more risky and less safe. Risk and return are the major characteristics which an investor has to face and handle. The investor has to choose proper avenues from among them 72 depending on his objectives, preferences, needs and abilities to take the minimum risk and maximize the returns. Return Return being prime mover to induce investment and probably is one to sustain it. Market participants are always tempted to scout for better investment alternatives for higher return or yield. But the measurement of investment return has an uphill task with investment literature because presence of idiosyncratic variables with regard to periodicity of return measurement and performance – return horizon. If the two coincides (which never do) the measurement criteria become very simple and straightforward. Risk Commensurate to investment objectives risks distracts investment flows with added agility. Conservatism is embedded in investors psychological texture while making investment decisions. Portfolio investment is primarily designed to mitigate risk through diversification.

Risk and Return Relationship

Risk and returns are positively related variables. These go along in the investment process: A higher return is always accompanied with a larger risk so that lower risk yields lesser return. Under such circumstances investors face dilemma as to preference for one and distraction for other. Therefore one is 73 destined to face the drama orchestrated by the risk return duo. Preference for one over the other determines the contour of investment philosophy followed by investors and fund managers. A conservative investor pre-empts risk reduction over return magnifications and thus search for such investments alternatives commensurate with given level of risk tolerance. Aggressive investors on the other hand pay more weight to return magnification and readily been the risk accompanied thus scout for investment alternatives commensurate on this risk return tolerance and preference. The investor has to choose proper avenues from among them depending on his objectives, preferences, needs and abilities to take the minimum risk and maximize the returns.

The financial investment avenues are classified under the following heads:

  1. Corporate Shares, Debentures, Deposits, etc.
  2. Bank Deposits and Schemes
  3. UTI and Mutual Fund Schemes.
  4. Post Office Deposits/Certificates, etc
  5. Government and Semi-Government Bonds/Securities
  6. PSU Shares and Bonds.

Recent Trends in Indian Securities Market Transfer of resources from those with surplus resources to others who have a productive need for them is perhaps the most efficiently achieved through the securities markets. Securities market provide channels for allocation of savings to investment and thereby decouple these two activities. As a result, the savers and investors are not constrained by their individual abilities, but by the economy’s abilities to invest and save respectively, which investably enhances savings and investments in the economy. Securities markets channel the savings to the most productive investments which increases the rate of return on investments. Thus the securities market fosters economic growth by augmenting the quantities of real savings and capital formation from any given level of national income and also by raising the productivity of investments by improving allocation of investible funds.

The securities market has two interdependent and inseparable segments, the new issues (primary) and the stock (secondary) markets. The primary market provides the channel for scale of new securities while the secondary market deals in securities previously issued. The prime signals, which subsume all information about the issuer and his business including associated risk, generated in the secondary market, help the primary market in allocation of funds. The issuers of new securities in the primary market to raise funds for investment and/ or to discharge some obligation. They do so either through public issue or private placement. It is a public issue if any body and everybody can subscribe for the securities. If the issue is made to select people, it is called private placement. If the securities are issued exclusively to the existing shareholders it is called ‘rights issue’. If a public issue of the offer is made to public at large. There are two major types of issuers who issue securities. The corporate entities issue mainly debt and equity instruments (shares, debentures, etc) while the governments (central and state governments) issue debt securities (dated securities and treasury bills).

The securities market has essentially three categories of participants, namely the issuers of securities, the investors in securities and the intermediaries. The issuers and the investors are the consumers of services rendered by the intermediaries while the investors are consumers of securities issued by the issuers. Those who receive funds in exchange of securities and those who receive securities in exchange for funds often need the reassurance that it is safe to do so. This reassurance is provided by law and custom often enforced by the regulator. The regulator ensures a high standard of service from the intermediaries and supply of quality securities and non manipulated demand for them.

In the Indian context the regulators have an additional 76 responsibility of developing the market and also the responsibility of protecting the interest of investors in securities. There are three main sets of entities depend upon securities market. The corporate and governments raise resources from the securities markets to meet their needs of investment and the households invest their savings in the securities. During 2003-04, corporate sector and governments together raised a total of Rs.267660 crores from the securities market while the household sector invested Rs.2254 crore of their financial savings through securities market. The central government and the state governments nowadays finance about two third and one third of their fiscal deficits respectively through borrowings from the securities market. Corporate sector finances about one third of its external finance requirements through the securities market. The household invest about six per cent of their financial savings in securities.

The societies for capital market research and development carries out periodical surveys of households to estimate the number of investors. The first survey was carried out in 1990 which placed the total number of share owners at 90-100 lakh. Their second survey estimated the number of share owners at around 140-150 lakh by mid 1993. Their latest survey estimates the number of share owners at around 2 crore by 1997 end. Approximately half of the share owners at the end of 2000 had, for the first time entered the market.

According to the first SEBI-NCAER survey of Indian investors 1999, an estimated 12.8 million or 7.6% of all Indian households representing 19 million individuals had directly invested in equity shares and debentures at the end of financial year 1998-1999. More than 156 million or 92% of all Indian households were non investor households who did not have any investments in equity/debentures. The lack of awareness about securities market and absence of dependable infrastructure and distribution network coupled with aversion to risk prevents the non-investor households from investing in the securities market. An estimated 15 million (nearly 9%) of all households representing at least 23 million unit holders had invested in units of mutual funds.

According to the second SEBI-NCAER Survey conducted in late 2000, 13.1 million or 7.4% of all Indian households representing 21 million individuals directly invested in equity shares and or debentures during the financial year 2000-2001. There were 19 million unit holders who had invested in units of MF’s in 2000-01. Of the 48 million urban households an estimated 8.8 million households (18%) representing 13 million urban investors owned equity shares and/or debentures. Of the 121 million rural households only about 4 million households or 3% representing nearly 6 million rural investors owned these instruments. An indirect but very authentic source of information about distribution of investors is the database of beneficial accounts with the depositories.

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At the end of March 2004 there were 5.2 million and 0.6 million beneficial accounts with the National Securities Depository Limited (NSDL) and Central Depository Services (India) limited (CDSL) respectively. Average annual capital mobilization by non government public companies from the primary market is about Rs.70 crore in 1960s and about Rs.90 crore in the 1970s, increased manifold during the 1980s, with the amount raised in 1990-91 being Rs.4312 crore.

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