Indian Financial System-An Overview

The American Heritage® Dictionary of the English Language, Fourth Edition defines the term
finance as “the management of money, banking, investments, and credit.” The term "finance" in
our simple understanding is perceived as equivalent to 'Money." It is not exactly money but the
source of providing funds for a particular activity.

FINANCIAL SYSTEM

The economic development of a nation is reflected by the progress of the various economic units,
broadly classified into corporate sector, government and household sector. While performing
their activities, these units will be placed in surplus/deficit/ balanced budgetary situations.
Goldsmith has designated the various economic units into three categories:

• Saving surplus units, that is, those units whose savings are in excess of investments
• Saving deficit units whose investments exceed their savings and
• Neutral units, where savings are equal to investments

In our economy, the deficit areas are the corporate and the government sector and the surplus
area is the household sector. If capital formation is to take place, the savings of the saving
surplus units must be transferred to the saving deficit units. Thus, there arises a need for an
institutional arrangement to facilitate the transfer of resources. This is precisely where the
financial system comes into picture.

The main function of the financial system is the collection of savings and their distribution for
investment, thereby stimulating capital formation and hence, economic development. Finance is a
bridge between the present and the future and whether it is the mobilization of savings or their
efficient, effective and equitable allocation for investment, it is the success with which the financial
system performs its functions that sets the pace for the achievement of broader national objectives.
Van Horne defined the financial system as, “the system to allocate savings efficiently in an
economy to ultimate users either for investment in real assets or for consumption.” It is a

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complex, integrated set of subsystems. These subsystems are financial institutions, markets
and instruments. These are discussed ahead.

Financial institutions
Financial institutions give a physical presence to the system. They provide financial
infrastructure. They encourage savings and make for its optimal allocation. They make one type
of contract with the borrowers and of another type with the lenders. In other words, they perform
the function of financial intermediation. Financial intermediation is a productive activity in
which an institutional unit incurs liabilities on its own account for the purpose of acquiring
financial assets by engaging in financial transactions on the market. A brief account of the main
financial intermediaries in India is given below:

MINISTRY OF
FINANCE

Figure 1- Financial Institutions in India

The Ministry of Finance is at the top of the hierarchy of financial institutions in India. It is an
important ministry within the Government of India. It concerns itself with taxation, financial
Pension,
legislation, financial institutions, capital markets, center and state finances, and the Union
Financial
Provident Banks
Institutions Page 2 of 20

Funds
Budget. As of December 2010, Minister of Finance is Pranab Mukherjee. It comprises five
departments namely Department of Economic Affairs, Department of Expenditure, Department
of Revenue, Department of Disinvestments and Financial Services. It controls various pension
funds, provident funds, term lending institutions (IFCI, ICICI, IDBI), investment institutions
(LIC, GIC, UTI), sectoral (NABARD, NHB, EXIM, TFCI) and state level institutions (SFC,
SIDC). Of these, term lending and state level institutions are of no relevance in the present
scenario. A brief overview of some of these institutions is given below:

• LIC (Life Insurance Corporation) is the largest state-owned life insurance company in
India, and also the country's largest investor. It is fully owned by the Government of
India. It was founded in 1956 with the merger of more than 200 insurance companies and
provident societies. Headquartered in Mumbai, financial and commercial capital of India,
the Life Insurance Corporation of India currently has 8 zonal Offices and 101 divisional
offices located in different parts of India, at least 2048 branches located in different cities
and towns of India along with satellite Offices attached to about some 50 Branches, and
has a network of around 1.2 million agents for soliciting life insurance business from the
public.
• UTI (Unit Trust of India): The establishment of the Unit Trust of India in 1964 was the
culmination of a long overdue need of the capital market in India and reflected the efforts
of the Government to popularize mutual funds to encourage indirect holdings of
securities by the public. The objective of setting up UTI was to enable small investors to
share in industrial prosperity. UTI introduced various unit schemes to suit different
classes of investors.
• GIC: The entire general insurance business in India was nationalized by General
Insurance Business (Nationalisation) Act, 1972 (GIBNA). General Insurance Corporation
of India (GIC) was formed in pursuance of Section 9(1) of GIBNA. It was incorporated
on 22 November 1972 under the Companies Act, 1956 as a private company limited by
shares. GIC was formed for the purpose of superintending, controlling and carrying on
the business of general insurance. As soon as GIC was formed, GOI transferred all the
shares it held of the general insurance companies to GIC. Simultaneously, the
nationalized undertakings were transferred to Indian insurance companies. After a

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 process of mergers among Indian insurance companies, four companies were left as fully
owned subsidiary companies of GIC (1) National Insurance Company Limited, (2) The
New India Assurance Company Limited, (3) The Oriental Insurance Company Limited,
and (4) United India Insurance Company.
• EXIM: Export-Import Bank of India is the premier export finance institution of the
country, set up in 1982 under the Export-Import Bank of India Act 1981. Government of
India launched the institution with a mandate, not just to enhance exports from India, but
to integrate the country’s foreign trade and investment with the overall economic growth.
Since its inception, Exim Bank of India has been both a catalyst and a key player in the
promotion of cross border trade and investment. Commencing operations as a purveyor
of export credit, like other Export Credit Agencies in the world, Exim Bank of India has,
over the period, evolved into an institution that plays a major role in partnering Indian
industries, particularly the Small and Medium Enterprises, in their globalization efforts,
through a wide range of products and services offered at all stages of the business cycle,
starting from import of technology and export product development to export production,
export marketing, pre-shipment and post-shipment and overseas investment.
• TFCI: The Government of India had, pursuant to the recommendations of the National
Committee on Tourism viz Yunus Committee set up under the aegis of Planning
Commission, decided in 1988, to promote a separate All-India Financial Institution for
providing financial assistance to tourism-related activities/projects. In accordance with
the above decision, the IFCI Ltd. along with other All-India Financial/Investment
Institutions and Nationalized Banks promoted a Public Limited Company under the name
of "Tourism Finance Corporation of India Ltd. (TFCI)" to function as a specialized All-
India Development Financial Institution to cater to the financial needs of tourism
industry. TFCI provides financial assistance to enterprises for setting up and/or
development of tourism-related projects, facilities and services, such as: Hotels,
Restaurants, Holiday Resorts, Amusement Parks, Multiplexes and Entertainment Centers,
Education and Sports, Safari Parks, Rope-ways, Cultural Centers, Convention Halls etc
• NABARD: Against the backdrop of the massive credit needs of rural development and
the need to uplift the weaker sections in the rural areas within a given time horizon, the
National Bank for Agriculture and Rural Development was set up. The Reserve Bank had

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 responsibilities to discharge in respect of its many basic functions of central banking in
monetary and credit regulations and was not therefore in a position to devote undivided
attention to the operational details of the emerging complex credit problems. This paved
the way for the establishment of NABARD. The Parliament through the Act 61 of 81
approved its setting up. It was set up with an initial capital of Rs 100 crore, which was
enhanced to Rs 2,000 crore, fully subscribed by the Government of India and the RBI.
• NHB was set up on July 9, 1988 under the National Housing Bank Act, 1987. It is a
wholly owned by Reserve Bank of India, which contributed the entire paid-up capital.
The Head Office of NHB is at New Delhi. NHB has been established to promote a sound,
healthy, viable and cost effective housing finance system to cater to all segments of the
population and to integrate the housing finance system with the overall financial system.

RBI (Reserve Bank of India) is the central banking system of India. The institution started
functioning on 1 April 1935 during the British Raj in accordance with the provisions of the
Reserve Bank of India Act, 1934 and plays an important part in the development strategy of the
government. It is also called the banker of banks or the lender of last resort.
• A commercial bank collects savings primarily in the form of deposits and traditionally
finance working capital requirements. However, in tune with the emerging trends, banks
have entered into term lending business.
• A co-operative bank is a financial entity which belongs to its members, who are at the
same time the owners and the customers of their bank. Co-operative banks are often
created by persons belonging to the same local or professional community or sharing a
common interest. Co-operative banks generally provide their members with a wide range
of banking and financial services. Co-operative banks differ from stockholder banks by
their organization, their goals, their values and their governance. In most countries, they
are supervised and controlled by banking authorities and have to respect prudential
banking regulations, which put them at a level playing field with stockholder banks.
Depending on countries, this control and supervision can be implemented directly by
state entities or delegated to a co-operative federation or central body. Cooperative banks
in India finance rural areas under: Farming, Cattle, Milk and Personal finance.

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 Cooperative banks in India finance urban areas under: Self-employment, Industries,
Small scale units, Home finance, Consumer finance, Personal finance.
• NBFCs (Non Banking Financial Companies) provide a variety of fund based and non
fund based services. Most of their funds are raised in the form of public deposits ranging
one year to seven years of maturity. Depending on the nature and type of services, they
are asset finance companies, housing finance companies, venture capital funds, merchant
banking organizations etc.

SEBI (Securities and Exchange Board of India): The basic functions of the Securities and
Exchange Board of India are to protect the interests of investors in securities and to promote the
development of, and to regulate the securities market. It was established on April 12, 1992 in
accordance with the provisions of the Securities and Exchange Board of India Act, 1992. It
exercises control over the stock exchanges, stock brokers, various investors in the stock markets,
mutual funds, ETFs etc. SEBI has enjoyed success as a regulator by pushing systemic reforms
aggressively and successively (e.g. the quick movement towards making the markets electronic
and paperless rolling settlement on T+2 bases). SEBI has been active in setting up the regulations
as required under law. It has increased the extent and quantity of disclosures to be made by
Indian corporate promoters. More recently, in light of the global meltdown, it liberalized the
takeover code to facilitate investments by removing regulatory strictures. In one such move,
SEBI has increased the application limit for retail investors to Rs 2 lakh, from Rs 1 lakh at
present

IRDA (Insurance Regulatory and Development Authority) is a national agency of the

Government of India, based in Hyderabad. It was formed by an act of Indian Parliament known
as IRDA Act 1999, which was amended in 2002 to incorporate some emerging requirements.
Mission of IRDA as stated in the act is "to protect the interests of the policyholders, to regulate,
promote and ensure orderly growth of the insurance industry and for matters connected therewith
or incidental thereto." It regulates and develops the insurance organizations. Recently, the
Government of India ruled that the Unit Linked Insurance Plans (ULIPs) will be governed by
IRDA, and not the market regulator Securities and Exchange Board of India.

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FINANCIAL MARKETS
Another significant component of the organization of financial system comprises of financial
markets which perform crucial function in the savings investment process. They facilitate the
management of transactions and risks. They help in exchange by causing two or more parties to
meet, communicate and decide on the terms of risk and return. These are the markets where
financial assets are created and transferred. They do not refer to a particular physical location but
are mechanisms enabling participants, the investors and the borrowers, to deal in financial
claims. In the markets, demands and requirements interact to set a price for financial claims.
Financial claims arise out of contractual relationships between borrowers and lenders. They
specify between the two parties certain rights or obligations, the nature of which requires them to
be treated as financial. For instance, a financial claim entitles a creditor to receive a payment, or
payments, from a debtor in circumstances specified in the contract between them. Markets have
to be developed to provide liquidity, transparency and accountability, which essentially aim at
further mobilization of funds. Based on the nature of funds which are their stock in trade, the
financial markets are classified into – money market and capital market.

FI
M

Figure 2- Financial Markets

MONEY Page 7 of 20
Money market deals in financial assets of short term nature, generally less than one year. Funds
are available in this market for periods ranging from a single day up to a year. Essentially, it is a
reservoir of short-term funds. Thus, money market provides a mechanism by which short-term
funds are lent out and borrowed; it is through this market that a large part of the financial
transactions of a country are cleared. This market is dominated mostly by government, banks and
financial institutions. The money market is generally expected to perform following broad
functions:
(i) To provide reasonable access to providers and users of short-term funds to fulfil their borrowing
and investment requirements at an efficient market clearing price.
(ii) To provide a focal point for Central bank intervention for influencing liquidity and general level
of interest rates in the economy.
Money market comprises of a number of sub markets like call market, treasury bills market,
commercial bills market, commercial paper market and so on.
• Call/Notice money is the money borrowed or lent on demand for a very short period.
When money is borrowed on a day and repaid on the next working day, (irrespective of
the number of intervening holidays) is "Call Money". When money is borrowed or lent
for more than a day and up to 14 days, it is "Notice Money".
• Treasury Bills are short term (up to one year) borrowing instruments of the Union
Government. It is a promise by the Government to pay a stated sum after expiry of the
stated period from the date of issue. They are issued at a discount to the face value, and
on maturity the face value is paid to the holder.
• Certificate of Deposit (CD) is a negotiable money market instrument and issued for
funds deposited at a bank or other eligible financial institution for a specified time period.
• Commercial Paper is an unsecured promissory note privately placed with investors at a
discount rate to face value. It is freely negotiable by endorsement and delivery.

Capital market is for long term funds. The transactions taking place in this market will be for
periods over a year. Its focus is on financing of fixed investment in contrast to money market
which is the institutional source of working capital finance. The main participants in the capital
market are mutual funds, insurance organizations, foreign institutional investors, companies and
individuals. The capital market has two segments- Primary and Secondary.

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• Primary market is the new issue market dealing in securities which are not
previously available but are offered to the investors for the first time. Primary market
provides opportunity to issuers of securities, Government as well as corporate, to raise
resources to meet their requirements of investment and/or discharge some obligation. The
issuers create and issue fresh securities in exchange of funds through public issues and/or
as private placement. When securities are exclusively offered to the existing shareholders
it is called ‘Rights Issue’ and when it is issued to selected mature and sophisticated
institutional investors as opposed to general public it is called ‘Private Placement Issues’.
Issuers may issue the securities at face value, or at a discount/premium and these
securities may take a variety of forms such as equity, debt or some hybrid instruments.
The issuers may issue securities in domestic market and /or international market through
ADR/GDR/ECB route.
• Secondary market deals in already issued securities. It performs the essential
function of providing liquidity and marketability to investors. Once the new securities are
issued in the primary market they are traded in the secondary market. The secondary
market operates through two mediums, namely, the over-the-counter (OTC) market and
the exchange-traded market. OTC markets are informal markets where trades are
negotiated. Most of the trades in the government securities are in the OTC market. All the
spot trades where securities are traded for immediate delivery and payment take place in
the OTC market. The other option is to trade using the infrastructure provided by the
stock exchanges. The exchanges in India follow a systematic settlement period. All the
trades taking place over a trading cycle (day=T) are settled together after a certain time
(T+2 day). The trades executed on exchanges are cleared and settled by a clearing
corporation. The clearing corporation acts as a counterparty and guarantees settlement. A
variant of the secondary market is the forward market, where securities are traded for
future delivery and payment. A variant of the forward market is Futures and Options
market. Presently only two exchanges viz., NSE and BSE provide trading in the Futures
& Options. The behaviour of stock exchanges as reflected in the prices of listed securities
has a significant bearing on the level of activity in the primary market. Even the prices of
new issues are influenced by price movement in the secondary markets.

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The Foreign Exchange market popularly called the forex market, deals in multicurrency
requirements, which are met by the exchange of currencies. Depending on the exchange rate that
is applicable, the transfer of funds takes place in this market.

FINANCIAL INSTRUMENTS
Financial instruments are claims against a person or an institution for payment, at a future date,
of a sum of money and/or a periodic payment in the form of interest of dividend. The maturity
and sophistication of the financial system depends on the prevalence of variety of financial
instruments available to meet the needs of heterogeneous investors. They fall into three broad
categories- primary securities, indirect securities and derivatives.

FINA

PRIMARY/DIRECT
Figure 3- Financial instruments

Primary instruments or direct securities are those which are issued directly by the borrowers
to the lenders while indirect securities are issued via a financial intermediary.

EQUITY PREFRERNCE DEBENTURE

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Equity shares, preference shares and the debentures are primary securities. Equity shares are
ownership securities and risk capital. The owners of such securities are residual claimants on
income and assets and participate in the management of the company. Debentures are creditor
ship securities. Their holders are entitled to a specified interest and first claim on the assets of the
security. Preference shares are hybrid securities. The holders of such securities have preference
rights over equity shareholders both in respect of a fixed dividend and return of capital. Also, a
variety of innovative debt instruments have emerged. The holders of participating debentures
participate in excess profits of the company after payment of equity dividend. Third Party
Convertible Debentures include a warrant which entitles the holder to subscribe to equity of
another firm at a preferential (lower than market price). There are convertible debentures
(redeemable at premium) which are issued at a face value with an option to sell the debentures
at a premium. Zero Interest Fully Convertible Debentures carry no coupon rate of interest.
They are automatically converted into shares after the lock in period.

Indirect securities include mutual fund units, security receipts, securitized debt instruments. The
main consideration in case of underlying securities is that there is pooling of funds by a financial
intermediary. They are more suited to interests of investors, particularly small investors due to
convenience, lower risk and expert management. Mutual Funds pool the savings of a number of
investors who share a common financial goal. Each scheme of a mutual fund can have different
character and objectives. Mutual funds issue units to the investors, which represent an equitable
right in the assets of the mutual fund. Security Receipts are bonds issued by Asset
Reconstruction Companies to banks when they buy bad loans from them. Normally, when these
companies buy bad assets from banks, they do not pay cash up front. They buy the stressed
assets through security receipts, which are essentially bonds that can be redeemed later. The
bonds (SR) are issued up to a maximum period of seven years. Securitized debt instruments
are the products of securitization, which in turn is the process of passing debts onto entities that
in turn break them into bonds and sell them. As of 2010, the most common form of securitized
debt is mortgage-backed securities, but moves are being made to securitize other debts, such as
credit cards and student loans. Securitized debts have the benefit of lowering interest rates and
freeing up capital to banks, but they have the drawback of encouraging lending for purposes
other than long-term profit. Securitized debt instruments are created when the original holder

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(like a bank) sells its debt obligation to a third party, called a Special Purpose Vehicle (SPV).
The SPV pays the original lender the balance of the debt sold, which gives it greater liquidity. It
then goes on to divide the debt into bonds, which are then sold on the open market.
Derivative
s are instruments whose value is derived from the value of one/more basic variables called the
underlying asset. They are forwards, futures and options. A forward contract is an agreement
to exchange an asset, for cash, at a pre determined future date today. At the end of the contract,
one can enter into an offsetting transaction by paying difference in price. Future contracts are
similar to forward contracts but are highly standardized traceable contracts unlike the latter. They
are standardized in terms of size, expiry date and all other features. Options establish a contract
between two parties concerning the buying or selling of an asset at a reference price. The buyer
of the option gains the right, but not the obligation, to engage in some specific transaction on the
asset, while the seller incurs the obligation to fulfill the transaction if so requested by the buyer.
An option which conveys the right to buy something is called a call; an option which conveys
the right to sell is called a put.

PHASES IN THE DEVELOPMENT OF INDIAN FINANCIAL SYSTEM

At independence from the British in 1947, India inherited one of the world’s poorest economies.
For about three decades after independence, India grew at an average rate of 3.5% and then
accelerated to an average of about 5.6% since the 1980’s. The growth surge actually started in
the mid-1970s except for a disastrous single year, 1979-80. In 1990-91, India faced a severe
balance of payments crisis ushering in an era of reforms comprising deregulation, liberalization
of the external sector and partial privatization of some of the state sector enterprises. The Indian
Financial System as it exists today has evolved over a period of time. This evolution can be
divided into three stages.

THREE PHASES IN THE EVOLUTION OF INDIAN FINANCIAL SYSTEM

　
I. PRE 1951 ORGANISATION
Before 1951, Indian economy was a traditional economy with low per capita income. The pre

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Independence industrial financing organizations did not participate in long term financing of the
industry. Thus, the industry had minimum access to the savings of the savings-surplus units. It
was due to weak financial system which was incapable of sustaining high rate of industrial
growth basically for the new & innovating enterprises.

II. 1951 to Eighties

Around 1951, Government adopted mixed economy pattern of industrial development. The
organization of financial system during this period evolved in response to the imperatives of
planned economic development. In other words, the distribution of credit & finance was under
Government's control and in accordance with the priorities of the five year plans. The main
elements of the financial organization in planned economic development are –

(1) Public/Government ownership of financial institution: One aspect of the evolution of

Indian Financial system during this stage was the progressive transfer of its important
constituents from private ownership to public control.
• The nationalization of the Reserve Bank of India in 1948 marked the beginning of
transfer of important financial intermediaries to Government control.
• This was followed in 1956 by setting up of State Bank of India by taking over the
Imperial Bank of India. In the same year, 245 life insurance companies were nationalized
and merged together to form the Life Insurance Corporation.
• In the year 1969, fourteen major Indian banks were nationalized to pay attention to the
priority sector. Later, six more were nationalized in 1980.
• Even the general insurance business came under Government control by the
establishment of General Insurance Corporation in 1972.
In addition to this, new institutions sprang up during this phase- the development finance
institutions for long term lending and the Unit Trust of India to promote mutual fund culture.
Thus, the entire institutional structure in a way came under the ownership and control of the
Government.

(2) Fortification of the institutional structure: Another significant element in the evolution of
the Indian financial system during this phase was the strengthening of the institutional structure.

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This was partly due to the modification of the existing institutions but mainly due to addition of
new institutions. The most outstanding development was the setting up of development financial
institutions. Not only did they cater to the long term financing needs of the industry, but also had
a qualitative dimension to them. They encouraged entrepreneurs and small business. They helped
in the development of the backward regions.
• The beginning of the era of developmental banking was marked by the setting up of IFCI
(Industrial Finance Corporation of India) in 1948. It was established to provide
medium and long term finance to the industry were normal banking seemed to be
inadequate.
• In addition to this, at the state level, State Financial Corporations (SFCs) were
established in 1951to promote and assist small and medium enterprises. However, due to
being organized on most orthodox lines, these institutions failed to make an impact.
• In 1955, ICICI (Industrial Credit and Investment Corporation of India) was
established that initiated diversification in development banking by being a pioneer in
underwriting business.
• IDBI (Industrial Development Bank of India) established in 1964 not only provided
finance but also coordinated activities of all the financing institutions.
• Finally another institutional innovation was the setting up of SIDBI (Small Industrial
Development Bank of India) for the development of small and medium enterprises.

Along with the development of new institutions, efforts were made to mould the existing
institutions. There was diversification in the form of financing offered by commercial banks. The
commercial banks which basically provided short term finance for working capital requirement
were encouraged to lend for long term. Also, these banks made an entry in the field of
underwriting of new corporate issues.

The commercial banks were further directed to channelise their resources to the neglected
sectors of the economy. The Government formulated a Credit Guarantee Scheme in
consultation with the RBI to guarantee major part of the advances given by banks to the small
scale industries. In 1964, Export Credit and Guarantee Corporation (ECGC) was set up. It
extended guarantees to the banks for finance given by them to the exporters. For promoting

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agriculture, Agriculture Refinance Corporation Ltd. was set up in 1963 as a subsidiary of the
RBI for providing medium and long term finance to financial institutions.

(3) Protection to investors: Industrial Securities, as a form of savings, were not popular in India
before 1951 as the public did not trust the private businesses. Also, there were no corporate laws
to ensure investor protection. To fill this gap, several legislations were enacted.

Capital Issues (Control) Act, 1947: The Act had its origin during the war in 1943 when the
objective was to channel resources to support the war effort. It was retained with some
modifications as a means of controlling the raising of capital by companies and to ensure that
national resources were channeled into proper lines, i.e., for desirable purposes to serve goals
and priorities of the government, and to protect the interests of investors. Under the Act, any firm
wishing to issue securities had to obtain approval from the Central Government, which also
determined the amount, type and price of the issue. As a part of the liberalization process, the
Act was repealed in 1992 paving way for market determined allocation of resources.

Securities Contracts (Regulation) Act, 1956: It provides for direct and indirect control of
virtually all aspects of securities trading and the running of stock exchanges and aims to prevent
undesirable transactions in securities. It gives Central Government regulatory jurisdiction over
(a) stock exchanges through a process of recognition and continued supervision, (b) contracts in
securities, and (c) listing of securities on stock exchanges. As a condition of recognition, a stock
exchange complies with conditions prescribed by Central Government. Organized trading
activity in securities takes place on a specified recognized stock exchange. The stock exchanges
determine their own listing regulations which have to conform to the minimum listing criteria set
out in the Rules.

Companies Act, 1956: It deals with issue, allotment and transfer of securities and various
aspects relating to company management. It provides for standard of disclosure in public issues
of capital, particularly in the fields of company management and projects, information about
other listed companies under the same management, and management perception of risk factors.

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It also regulates underwriting, the use of premium and discounts on issues, rights and bonus
issues, payment of interest and dividends, supply of annual report and other information.

Monopolies Restrictive Trade Practices Act, 1969: This Act came into force from June 1,
1970 with the following objectives:
a) to ensure that the functioning of the economic system did not result in the
concentration of economic power
b) to control such restrictive and monopolistic trade practices which were injurious to
public health

FERA (Foreign Exchange Management Act): This Act was passed for the conservation of the
foreign exchange resources of the country and the proper utilization thereof in the interests of
the economic development of the country. FERA primarily prohibited all transactions in foreign
exchange, except to the extent permitted by general or specific permission by RBI and violation
of FERA was a criminal offence. However, with the winds of liberalization blowing in the early
1990's, the government realized that possession of forex could no longer be regarded as a crime,
but was an economic offence, for which the more appropriate punishment was a penalty. Thus,
the need of FEMA was felt. The primary difference between FERA and FEMA therefore lies in
the fact that offences under FEMA are not regarded as criminal offences and only invite
penalties, not prosecution and imprisonment. FEMA was passed by Parliament in 1999 and
came into force from 1st June 2000. Similarly, most of the above Acts have been updated in line
with the changing needs.

III. POST Liberalization

New economic policy was introduced in 1991.Development process was shifted from mixed
economics to free market economics & the consequent globalization of the economy. Major
economic policies were changed which had affected structure of the corporate industrial sector in
India. Hence the influence of the Government began to decline over the distribution of finance &
credit. There was capital market oriented developments. Hence, the notable developments during
this phase –

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(1) Privatization of financial institutions: In contrast to the government ownership in the
second phase, steps were taken during this phase to privatize important financial institutions.
IFCI- the pioneer development finance institution was changed into a public company (IFCI
Ltd.). IDBI and IFCI offered their shares to private investors. Private mutual funds were set up.
Similarly, a number of private banks and private insurance companies sprang up. Thus, the state
monopoly over state institutions was dismantled.

(2) Investor Protection: With the development of capital market, there was a need of an
autonomous body to protect the interests of investors and to regulate the market. Consequently,
Securities and Exchange Board of India (SEBI) was set up in April 1988 by an administrative
order and it acquired statutory status in 1992. Since then, it has enjoyed success as a regulator by
pushing systemic reforms aggressively and successively. SEBI prohibits fraudulent and unfair
trade practices, including insider trading. Surveillance cells have been set up in the stock
exchanges for detection of market manipulation, price rigging etc. The stock exchanges have
been demutualised and corporatised. Other reforms are introduction of T+2 rolling settlement
system, application supported by blocked amount (ASBA), credit rating, disclosures in
prospectus, dematerialization of securities etc. To educate the investors, comprehensive
Securities Market Awareness Campaign (SMAC) was launched in January, 2003. The Office of
Investor Assistance and Education (OIAE) of SEBI takes up complaints of the investors with the
concerned entities.

(3) Reorganization of institutional structure: Apart from things mentioned above, the
institutional structure of the Indian Financial System underwent transformation to reflect capital
market orientation in its evolution. There was reorganization of the institutional structure to meet
the changing needs of the environment.
• The DFIs, which once constituted the backbone of the Indian economy, had their
significance declining. The corporate sector started depending upon the capital market for
raising funds. The focus of DFIs shifted to promotion of institutional infrastructure and
organizations like CRISIL (Credit Rating and Information Services of India Ltd.), ICRA
(Information and Credit Rating Agency) were set up. Thus, instead of substituting capital

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 markets, they supplemented them. With their conversion into public limited companies,
these DFIs disappeared from the Indian financial scene.
• By the mid nineties, a geographically wide and functionally diverse banking system
emerged with phenomenal branch expansion in rural and semi urban areas, growth in
deposits, increase in the share of priority sector in total bank lending. However, the
achievement of social goals developed weaknesses in the form of decline in efficiency
and growth of over dues (non performing assets or NPAs). To deal with this, prudential
norms were introduced. These are related to income recognition, asset classification,
provisioning and capital adequacy. Debt Recovery Tribunals were set up under the
Recovery of Debts Due to Banks and Financial Institutions Act, 1993.
• In contrast to the position around mid eighties, where only Unit Trust of India existed, a
number of domestic as well as off shore mutual funds came up.
• Reflecting the imperatives of the evolution of a vibrant, competitive and dynamic
financial system, the NBFC sector in India recorded marked growth in the recent years in
terms of maturity deposits and so on.

CONCLUSION
The questions and challenges that India faces now are therefore
fundamentally different from those that it has wrestled with for decades after
independence. Liberalization and globalization have breathed new life into
the foreign exchange markets while simultaneously besetting them with new
challenges. Commodity trading, particularly trade in commodity futures,
have practically started from scratch to attain scale and attention. The
banking industry has moved from an era of rigid controls and government
interference to a more market-governed system. New private banks have
made their presence felt in a very strong way and several foreign banks have
entered the country. Over the years, microfinance has emerged as an
important element of the Indian financial system increasing its outreach and
providing much-needed financial services to millions of poor Indian
households. But, despite the good economic performance in recent years
India remains a developing country with about a quarter of its massive

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population in acute poverty. With all its sheen and dazzling capital market
performance, the financial system still excludes about 40% of the population,
mostly the rural poor. Thus, there still is, a long way to go.
References
Khan M.Y. Indian Financial System. New Delhi: Tata McGraw Hill
Bhole L.M. Financial Institutions and Markets. New Delhi: Tata McGraw Hill
Dutt &Sundharam Indian Economy. S.Chand & Co.Ltd.,
Allen, Chakrabarti, Sankar.(2007) India’s Financial System
Indian Securities Market- A Review retrieved from www.nseindia.com
Nayak Gautam FERA to FEMA retrieved from http://www.valuenotes.com
OECD Glossary of Financial Terms retrieved from http://stats.oecd.org/glossary/index.htm
www.wikipedia.com
www.bseindia.com
www.nseindia.com
www.rbi.org.in
www.sebi.gov.in
www.tfci.com
www.utimf.com
www.licindia.com
www.eximbankindia.com
www.nhb.org.in’
www.nabard.org.in
www.irda.gov.in

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