Evolution of Financial system: Phase I, Phase II and Phase III in India

(The India Financial System falls into 3 different phases: Phase I: Pre-1951 organisation, Phase II: 1951 to Mid-eighties organisation, Phase III: Post-Nineties Organisation)

The evolution of the financial system in India may be divided into three broad phases: (I) the traditional phase (Pre 1951 organisation,) (II)   the transitional phase (1951 to Mid-eighties organisation,) and (iii) the modern phase (Post-Nineties Organisation).

Phase I: Pre-1951 Organization

The structure of the Indian Financial System during the Pre Independence Era was that of a traditional economy. It was a closed economy, reflecting the underdeveloped nature of the industrial economy of the country. The economy was incapable of sustaining a high level of capital formation and accelerated pace for industrial development. The Semi organised Securities Market, the closed-circle character of industrial entrepreneurship, restricted access to flow funds from abroad, and the non-existence of long-term industrial financing institutions were the main features of this phase.

Phase II: 1951 to Mid-Eighties

 The post-1951 phase was a breakthrough era in the history of the Indian Financial System. The Reserve Bank of India was nationalised with effect from 1st January 1949 based on the Reserve Bank of India (Transfer to Public Ownership) Act, 1948. The State Bank of India was incorporated on 01 July 1955. The Government nationalised 154 Indian, 16 foreign, and 75 provident societies into a single entity and LIC was created on September 1, 1956. In July 1969 fourteen major private commercial Banks were nationalised. In 1972 with the passing of the General Insurance Business (Nationalisation) Act, general insurance business was nationalized with effect from 1st January 1973. In addition to nationalization, the government created a wide range of new institutions in the public sector. The institutions were created to cater to the financial needs of industries and between them covered the whole range of Industries. The public sector occupied a commanding position in the industrial financing system in India like SIDBI, IFCI, IDBI, UTI, etc.

In addition to the above, the government passed various acts such as the Companies Act, of 1956, the Capital Issues Act, of1947, the Securities Contracts Act, of 1956; the Monopolies & Restrictive Trade Practices Act, of 1970, Foreign Exchange Regulation Act, of 1973, a measure of protection to the investors. During this period, the Government adopted a mixed-economy model Public/Government ownership of financial institutions, and fortification of the institutional structure, with ambitious industrialization programs.

In short, a distinctive financial system emerged in India by the mid-eighties in conformity with the requirements of planning and the dominant role of the government in the Indian economy.

 Phase III: Post Nineties

The economic reform process that began in 1991 took place amidst two acute crises involving the financial sector after the Balance of Payment crisis of 1991 and the threat of insolvency confronted by the Indian banking sector which had for years concealed its problems with the help of defective accounting policies.

The post-1991 era transformed the Indian Financial System with a newer type of organizational infrastructure like Credit Rating Agencies, Technical Consultancies, Custodian Service Providers, portfolio managers; and Foreign Institutional Investors bringing much-needed dynamism to the economy. The Government leadership headed by Late P.V.Narashimha Rao and then Finance Minister Manmohan Singh embraced the ideals of a liberal market economy. The reforms were aimed to make the financial sector in line with international accounting standards and to free it from government control. With the deregulation of the interest rate, the Indian banking system has become more market-oriented since 1991.

The declaration of the New Industrial Policy witnessed a profound transformation in the Indian Financial System. The conservative philosophy of the development process in India shifted to free market economies. The changes in the financial sector started a reorganization of the financial system at a fundamental level. The government established three new regulators, namely SEBI (Est. 1992, Statutory status was given), IRDAI (Est. 1999), and PFRDA (Est. 2003).

Under the initiation of the liberalization /globalization of the economy, especially since the beginning of the nineties, the organization of the Indian financial system has been characterized by profound transformation. Indian capital market grew leaps and bounds in the post-1991 era.  India’s mutual fund industry has witnessed remarkable growth, with assets nearing the 60-trillion rupee mark in May 2024. The Association of Mutual Funds in India (AMFI) reported that the total assets under management (AUM) reached 58.6 trillion rupees ($701.90 billion), showcasing the fastest rise on record. The robust participation of the public in investing in equities, mutual funds, and ETFs, has been a key factor behind the unprecedented surge in Indian equities in recent years. The capital market has emerged as the main agency for the allocation of resources.

In brief, the conservative philosophy of the development process in India shifted to free market economies. The declaration of the New Industrial Policy witnessed a profound transformation in the Indian Financial System. The institutional structure of the Indian Financial System has undergone an outstanding transformation. It became more capital market-oriented. This is reflected in the changes in roles, organizational policies, term lending, commercial banks, mutual funds, etc. The major steps initiated during this phase were to privatize important financial institutions. For example: Bharat Aluminum Company was privatized in 2005, Privatization of Delhi and Mumbai airports in 2006, and Tata Group acquired Air India in January 2022 from the government. IFCI has been converted into a public limited company. IDBI offered its equity to private investors. These were all the part of privatization of financial institutions.

Liberalization of imports and exports:  The Government of India for the first time introduced the Indian Exim Policy on April I, 1992. To bring stability and continuity, the Export-Import Policy was made for 5 years. The FTP during the 1990s focused on the liberalization of trade policies to promote international trade. These reforms included reducing import tariffs, deregulating markets, and lowering taxes, which led to an increase in foreign investment and high economic growth.

Foreign Investment:  The government also introduced policies to simplify the approval process for FDI and provide a more conducive environment for foreign investors. During the 1990s, India became one of the most dynamic Asian host countries for foreign direct investment (FDI), according to the United Nations Conference on Trade and Development’s (UNCTAD’s) World Investment Directory 2000:  During the decade, annual average FDI flows to India expanded more than six times, rising to $2.7 billion in 1995–98 and reaching a peak of $3.6 billion in 1997, from $470 million in 1991–94. FDI flows slowed once during the decade in 1998—the first time in 11 years—in the wake of that year’s financial crisis in Asia. The report says India’s share in total flows to Asia and the Pacific tripled to 3.3 percent from 1.1 percent, while the region’s share in world annual average flows decreased to 18 percent from 20 percent. Preliminary estimates for 1999 show that inflows have remained stable. (Source: IMF e-library).

Exchange rate reforms: The Rupee was devalued in 1991 because of the large fiscal and current account deficits, dwindling international confidence in India’s economy, inflation, and consistent trade deficits. The government allowed the rupee to depreciate against the US dollar, which made Indian exports cheaper in the international market. India currently follows a market-determined exchange rate regime. This came into being in March 1993. This regime allows the market to determine the exchange rates.

The Indian financial sector has made significant strides in its digital journey, driven by government initiatives, technological innovation, and changing consumer behavior. This transformation has not only improved access to financial services but also increased its efficiency and transparency. The Payment and Settlement System (PSS) Act, 2007 provides for the regulation and supervision of payment systems in India. It designates the Reserve Bank of India (Reserve Bank) as the authority for that purpose and all related matters. The rapid developments in Payment Systems and technology have led to the implementation of major reforms of payment systems to expedite the processing of payments, reduce the risk and uncertainty associated with noncash payments, facilitate the adoption of indirect monetary policy instruments, and foster financial market development. Now there are over 45 varieties of digital payment systems, digital enablers, and payment options available to consumers in India. To know about them (Read: 45 TYPES OF DIGITAL PAYMENT OPTIONS AVAILABLE TO CONSUMERS IN INDIA)

In brief, the major changes to trade policy in the post-1991 period are a simplification of procedures to promote free trade, removal of quantitative restrictions, a substantial reduction in the tariff rates, liberal inflows of private capital, a shift towards market-determined exchange rate, a focus on export growth, digitalisation of payment system and entering into regional trade agreements.

Related posts

R