The financial sector plays the role of an intermediary by ensuring smooth flow of resources from those who have surplus funds to those who have a shortage of funds. It is the role of the financial sector to ensure that the savings of the household sector reaches the firms, which need the resources for investment.
Investments can be made by not only firms, but also households and the government. On the savers side financial market provides savers, various types of investments to choose from based on their risk appetite as well as their expectations of return and liquidity of their savings. The financing system also helps in allocation of savings to those in need of funds mainly the firms.
The second important role of the financial system is that of risk management. Every business enterprise involves risk. The financial institutions provide a framework for evaluating these risks.
Banks are traditional financial institutions that do the job of financial intermediation between the savers and investors. Acceptance of deposit from the public and lending to the investor has remained the core activity of the banking system. Apart from this they act as a financial intermediary by providing services such as dematerialization, underwriting of financial instruments (shares and debentures). In India, many banks are offering value added services like foreign exchange transactions, merchant bank and remittance services. They also help create liquidity through their fractional reserve system.
Besides the commercial banking segment, another segment in the financial system, known as Non Banking Financial Companies plays a crucial role in facilitating transfer of funds from the surplus to the deficit segment in the economy. A Non-Banking Financial Company is engaged in the business of loans and advances, acquisition of shares/stock/bonds/debentures/securities issued by Government or local authority or other securities like marketable nature, leasing, hire-purchase, insurance business and chit business. NBFCs contribute to the financial system because they tend to finance riskier projects than those that are financed by the banks. Because of their relative organizational flexibility leading to a better response mechanism, they are often able to provide tailor-made services relatively faster than banks and other financial institutions. NBFCs also play a role in diversifying the financial sector and thereby improving the financial system.
A mutual fund as a financial intermediary combines or pools investors’ savings for collective investment in a diversified portfolio made up of equities, debts, short-term money market instruments, and/ or other securities. A mutual fund will have a fund manager who trades the pooled money on a regular basis. The net proceeds or losses are then typically distributed to the investors periodically.
Mutual funds are meant to serve the interest of several small investors who may not have the time, experience, expertise or means of managing their investment portfolio directly on a regular basis. They are useful for investors because they get advantage of a professional fund manager, better diversification of portfolio, improved liquidity of their assets and convenience. Returns on investment in Mutual Funds are also exempt from long term capital gains taxes.
Insurance agencies are another set of important financial institutions that play an major role by mobilizing savings and supplying long-term capital to the financial sector. Insurance companies cater to various forms of insurance including life insurance, health insurance, crop insurance and general insurance. The insurance agencies help mobilize resources by developing a contractual saving portfolio for small investors. These agencies generate and mobilize funds by providing the small investors a low risk saving instrument with insurance and tax benefits.
The equity market In India has two segments: the primary market and the secondary market. The primary market is the new issue market where companies list their stocks for the first time for purpose of raising capital, whereas the secondary market consists of pre issued stocks that are traded amongst investors. These two markets have a direct link because the stocks purchased in primary market can later be traded in the secondary market. The stock market provides investors with an array of assets with varying degree of risk, return and liquidity which induces demand in the market leading to higher savings amongst investors for investment purposes.
The debt market can be broadly divided into government securities markets and the corporate debt market. Governments issue securities with maturities ranging from less than a year to a very long-term stretching up to 30 years. Typically, debt instruments with short-term maturities up to one year (called Treasury Bills) form a part of the money market and facilitate the Government’s cash management operations, while government securities with maturities of more than a year (called Bonds) facilitate its medium to long-term financing requirements.
Treasury bills are the instrument bought and sold in the money market, which enables the managers of public debt to raise resources in a cost effective way. Whereas, Bonds are the instrument of the Government Securities Market, that allows the government to fund its fiscal deficit by borrowing money through the sale of government securities.
The corporate bond market can play a critical role in supporting economic development as it supplements the banking system to meet the requirements of the corporate sector for long-term capital investment and asset creation. RBI and SEBI have taken a number of measures to promote the corporate debt market. Size of the corporate debt market is small in India. Notably, the FIIs have been allowed to invest in this market. Within the corporate debt market, the private placement market is gradually becoming important. In the private placement market, resources are raised through arrangers (merchant banking intermediaries) who place securities with a small number of financial institutions, banks, mutual funds and high net-worth individuals.
The spot market is a cash-for-delivery market where securities are traded for cash and delivered immediately. These securities also have a derivative market mainly used for hedging price risk. Currently, two types of derivatives are traded in NSE, namely options and futures. These derivatives can be based on equity prices, stock market indices, exchange rate and interest rate (futures).
Financial and Market Regulators
Regulatory institutions play an important role in making sure that market doesn’t deviate from legal framework. A small deviation by a single financial institution could lead to systemic risk. Following are the financial regulatory institutions in India - RBI, SEBI, IRDA, PFRDA, FMC etc.
The Reserve Bank of India (RBI) is the central bank of India. RBI controls and supervises banks and financial institutions, including non-banking finance companies.
Functions pertaining to banks such as establishment (licensing), branch expansion, liquidity of their assets, management, methods of working, amalgamation, reconstruction and liquidation come under purview of RBI.
RBI conducts periodic inspections of banks by calling for returns and follow-ups.
Other functions of RBI are as follows:
• Issue Currency
• Controls money supply and credit
• Manages foreign exchange reserves
• Serves as banker to the Government - Receipt and payment of money on behalf of the Government and various other operations.
• Serves as Bankers Bank - RBI mandates banks to deposit some part of cash with it. It also lends money to banks for short periods and provides them with centralized clearing and cheap and quick remittance facilities
The Securities and Exchange Board of India (SEBI) is an autonomous body which regulates securities market in India. SEBI is empowered with statutory powers to:
- Protect the Interests of investors in securities,
- Promote the development of the securities market, and
- Regulate the securities market.
-SEBI has the power to enquire, audit, inspect and adjudicate offences under the SEBI Act. SEBI can register and regulate all market intermediaries and can penalize them in case of violations of Rules and Regulations made under the act.
Insurance Regulatory and Development Authority (IRDA) is an autonomous body and regulates the business of insurance and re-insurance. Listed below are the duties, powers and functions of IRDA:
To regulate, promote and ensure orderly growth of the insurance business and reinsurance business.
- Protection of the interests of the policy holders in matters concerning assigning of policy, nomination by policy holders, insurable interest, settlement of insurance claim, surrender value of policy and other terms and conditions of contracts of insurance;
- Promoting efficiency in the conduct of insurance business;
- Promoting and regulating professional organizations connected with the insurance and re-insurance business;
- Regulating investment of funds by insurance companies;
- Adjudication of disputes between insurers and intermediaries or insurance
Pension Fund Regulatory and Development Authority (PFRDA oversees the functions of Pension Fund Managers. PFRDA is the result of a reform that was to set up to design a proper regulatory framework.
The role of Pension Fund Regulatory and Development Authority (PFRDA) is to consolidate the initiatives taken so far regarding the full New Pension System and expanding the reach of the distribution network of NPS.
The NPS architecture allows a subscriber to monitor his/ her investments and returns under NPS, the choice of Pension Fund Manager (PFM) and the investment option would also rest with the subscriber. The design allows the subscriber to switch his/her investment options as well as pension funds.
Forward Markets Commission (FMC) used to be commodities futures market regulator in India. FMC is overseen by the Ministry of Finance. Commodity exchanges like the National Commodity & Derivatives Exchange Limited (NCDEX) and Multi Commodity Exchange of India Limited (MCX) came under purview of FMC.
On 28 September 2015 the FMC was merged with the Securities and Exchange Board of India (SEBI)
Stock Exchanges in India act as a mediator to exchange securities in between buyers and sellers. They act as a free market for securities where prices are determined by the forces of supply and demand.
Companies get listed on stock exchange and their shares are traded every day pertaining to rules and regulations.
In India, there are numerous stock exchanges among which the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) are the leading ones.
The stock exchanges offers a wide range of products including equity shares, Currencies, commodities, Exchange Traded Funds (ETF), mutual funds and Derivatives etc.