What is a financial System?

A financial system is a network of financial institutions – such as insurance companies, stock exchanges, commercial banks, etc. The financial system of a country plays a dynamic role in economic development by encouraging both savings and investment.  

The system operates at national and global levels. Though they are not the same across the world, the major categories of financial institutions are similar compared to institutions in India. The financial system in India comprises financial institutions, financial markets, financial instruments, and financial services. These institutions are monitored by respective regulatory authorities, namely, the Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI), and the Insurance Regulatory and Development Authority (IRDA).

The following are the four major apparatuses that comprise the Indian financial system.

1. Financial institutions: Financial institutions are also termed as financial intermediaries as they channel funds from those who have excess funds (savers) to those who need funds (borrowers). This intermediation process between savers and borrowers facilitates the efficient distribution of capital and promotes economic growth. Banks and NBFCs are the two crucial financial intermediaries in any financial system. Banks are the traditional types of entities that accept deposits from the public and provide loans to the public, while NBFCs offer various financial services to consumers without a banking license. Banks: The financial sector in India is predominantly a banking sector with commercial banks including the public sector, private sector, Payment Banks, Small Finance Banks, cooperatives, and foreign banks accounting for more than 64% of the total assets held by the financial system. (Read: Transformation of the banking sector in India)

• Non-Banking Financial Companies: A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956. The companies predominantly engaged in financial activity are only getting registered with RBI as NBFCs. In other words,  when a company’s financial assets out of the total assets are more than 50 percent and the company’s gross income from financial assets constitutes more than 50 percent, then such a company is known as predominantly engaged in financial activities. (Read: What is a NBFC?)
• Informal or unorganized financial enterprises: The informal economy consists of activities that have market value but are not formally registered and they are not regulated by any regulated bodies. The informal economy is difficult to measure. This is because activities within it cannot be directly observed, and for the most part, participants in the informal economy do not want to be accounted for. Read: Informal or unorganized financial enterprises)

2.   Financial Market: The Financial market acts as a bridge between savers and investors where funds are mobilized between them. Savers are those who have excess money to invest while investors require money to invest. It helps in capital formation by creating more capital goods like heavy machines, factories, infrastructure, production of more electricity, etc. The Financial system is useful in managing resource allocation. Another important task of the financial system is to manage financial risks inherent in economic activities. It facilitates investment by offering businesses access to capital through equity and debt markets, enabling them to finance growth and investment activities. The financial system enhances liquidity, manages risks, and fosters confidence among investors, encouraging investment and economic activity. (To know more about the financial market read: (Types of Financial Market in India)

The transformations of the following financial markets have created a robust ecosystem in India.

1. Capital market: Capital market is a market for long-term debt and equity shares. A Debt Market is a market where fixed-income securities of various types and features are issued and traded. Debt Markets are, therefore, markets for fixed-income securities issued by the Central and State Governments, Municipal Corporations, banks, and financial institutions. A share may be bought or sold only once listed on the stock exchange. (READ: Transformation of the Capital Market in India
2. Money market: A money market is a place where banks and other financial institutions trade in short-term debt securities such as commercial paper (CP), certificate of deposits (CDs), treasury bills (TBs), and repo in ready-forward contracts (of dated securities, and Treasury Bills). The money market provides a platform for financial institutions to borrow and lend money for a short term of up to one year. (Read: Transformation of the Money market in India
3. Stock market: The stock market trades shares of ownership of public companies.  (To know more read: Stock exchange)
4. Bond market/debt market: The bond market offers an opportunity for companies and the government to secure money to finance a project or investment. (To know more read: Debt instruments and debt market)
5. Foreign exchange market: Foreign exchange is associated with the foreign trade. The traders in the foreign exchange market (Authorized Dealers/brokers) rely on the two basic forms of analysis viz. fundamental analysis and technical analysis. (To know more read: Transformation of the Foreign Exchange Market in India
6. Commodities market: A commodity market is a marketplace where investors trade several commodities like spices, energy, precious metals, and crude oil within a country. Investors can gain exposure to commodities by buying them on the market, investing in companies that produce them, or putting money into futures contracts whose value is derived from the price changes. (To know more, read: Commodities market)
7. Derivatives market: The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. The market can be divided into two, exchange-traded derivatives and that for over-the-counter derivatives. Derivatives act as powerful risk management tools, allowing investors to hedge against price fluctuations and uncertainties. (To know more read ‘derivative market’)

3. Financial instruments, assets, and securities: A financial instrument is any asset that holds capital and may be traded on the market. Not all financial instruments are securities, but all securities are financial instruments. The securities (instruments) are primarily designed to be traded on the secondary markets. (To know more, read: What are financial instruments, assets, and securities?).

4. Financial Services: Financial services refer to services provided by the finance industry. The finance industry consists of a broad range of organisations that deal with the management of money. The Indian financial services industry comprises several key sub-segments. These include, but are not limited to mutual funds, pension funds, insurance companies, stockbrokers, wealth managers, financial advisory companies, and commercial banks- ranging from small domestic players to large multinational companies. The services are provided to a diverse client base- including individuals, private businesses, and public organizations. (Read: Para Banking and financial services provided by Banks)

Related Posts on the Financial Market:

Transformation of Government securities market

Transformation of the Credit market in India

Transformation of Payment Systems in India

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