Indian Financial System: Components, Markets & Instruments

Posted on Feb 16, 2026 in Business Administration and Management (BAM)

Explain the Financial System: Components & Indian Reference

Explain the financial system in detail. Describe its components and structure with special reference to the Indian financial system.

A financial system is the bedrock of any economy, acting as a complex network that facilitates the flow of funds from those who have surplus capital (savers/lenders) to those who need it for productive purposes (borrowers/investors). The primary goal of a financial system is capital formation. It ensures that money does not sit idle but is instead channeled into businesses, infrastructure, and innovation to drive economic growth.

Core Components of a Financial System

While global systems share commonalities, a standard financial system consists of four pillars:

A. Financial Institutions

These are the intermediaries that bridge the gap between savers and borrowers.

• Banking Institutions: Accept deposits and provide loans (e.g., commercial banks, cooperative banks).
• Non-Banking Financial Institutions (NBFIs): Provide specialized financial services but generally do not hold a full banking license (e.g., insurance companies, mutual funds).

B. Financial Markets

Platforms where financial assets are created and traded.

• Money Market: Deals with short-term funds (maturity of less than one year).
• Capital Market: Deals with long-term funds (equity and debt with maturity over one year).

C. Financial Instruments

The “products” or “contracts” traded in the markets.

• Short-term: Treasury Bills, Commercial Papers, Certificates of Deposit.
• Long-term: Equity shares, debentures, government bonds.

D. Financial Services

The activities that facilitate the smooth movement of funds.

• Fund-based: Leasing, hire purchase, venture capital.
• Fee-based: Merchant banking, credit rating, stockbroking.

Structure of the Indian Financial System

The Indian system is unique due to its dual structure—Organised and Unorganised sectors—and its robust regulatory framework.

The Unorganised Sector

Despite significant modernization, a portion of India’s economy still relies on unregulated channels:

• Money Lenders: Local individuals providing high-interest loans.
• Indigenous Bankers: Traditional family-run firms (e.g., sahukars).
• Chit Funds: Localized community savings and credit groups (though some are moving toward regulation).

Regulatory Framework in India

The Indian system is governed by powerful watchdogs to ensure stability and protect investors:

• Reserve Bank of India (RBI): The “banker’s bank.” It manages the money supply, interest rates (repo rate), and oversees commercial banks.
• Securities and Exchange Board of India (SEBI): Regulates the stock market. It protects small investors and ensures companies do not engage in malpractice.
• Insurance Regulatory and Development Authority (IRDAI): Oversees the insurance sector to ensure fair play and transparency for policyholders.
• Pension Fund Regulatory and Development Authority (PFRDA): Regulates the National Pension System (NPS) and other retirement funds.

The Organised Sector

This sector is highly regulated and follows standardized rules set by the government and apex bodies.

Initial Public Offering (IPO) is the process by which a private company sells its shares to the general public for the first time. This transition from “private” to “public” allows a company to raise significant capital from public investors to fuel growth, pay off debt, or provide an exit for early investors and founders.

Once the IPO is complete, the company’s shares are listed and traded on a stock exchange (like the NSE or BSE in India).

The IPO Process (Step-by-Step)

Launching an IPO is a long and regulated journey that typically takes six to twelve months.

1. Appointment of Underwriters: The company hires investment banks (underwriters) to manage the IPO. They help determine the company’s value and handle legal paperwork.
2. Registration & Filings: The company files a Red Herring Prospectus (RHP) with regulators (like SEBI in India). This document contains the company’s financials, business model, and the risks involved.
3. Roadshows: Company executives travel to meet large institutional investors (mutual funds, insurance companies) to pitch the company and build demand.
4. Pricing: Based on demand generated during roadshows, the company and underwriters set a price band (the range within which investors can bid).
5. Bidding & Launch: The IPO opens for a few days (usually 3–5 days). Retail and institutional investors submit their bids.
6. Allotment & Listing: After bidding closes, shares are allotted to successful bidders. The shares then begin trading on the stock exchange on a specified listing date.

Benefits and Risks

For the Company

• Benefits: Access to massive capital, increased brand visibility, and the ability to use stock as currency for future acquisitions.
• Risks: High flotation costs (legal, banking, and audit fees can be 3–10% of the total raised), loss of control for founders, and intense public/regulatory scrutiny.

Characteristics of Short-Term Financial Instruments

When companies seek short-term financing (typically for a period of less than one year), they use financial instruments designed to bridge cash flow gaps, fund working capital, or seize immediate business opportunities.

These instruments are primarily traded in the money market and share several defining characteristics that distinguish them from long-term capital market tools like shares or debentures.

Core Characteristics

1. Short Tenure (Maturity): These instruments generally have maturities from a few days up to one year. They are intended for temporary financial needs rather than long-term asset building.
2. High Liquidity: Short-term instruments are often referred to as “near-money” or cash equivalents. Because of short duration and active secondary markets, companies can convert these assets into cash quickly with minimal loss in value.
3. Low Risk: Compared to long-term equity or corporate bonds, these instruments carry significantly lower risk. They are usually issued by entities with high credit ratings (large corporations) or the government.
4. Discounted Pricing: Many short-term instruments (like commercial paper and treasury bills) do not pay regular interest. Instead, they are issued at a discount to face value and redeemed at par; the difference represents the yield.
5. Unsecured Nature: While some bank-based short-term loans may require collateral, many market-based instruments like commercial paper are unsecured, backed only by the issuer’s reputation and creditworthiness.

Types of Flotation Costs

In the context of corporate finance, “floating costs” is commonly a typo or synonym for flotation costs. These are the total expenses a company incurs when it issues new securities like stocks or bonds in the market. Because raising capital involves third parties (banks, lawyers, regulators), a company never receives 100% of the money investors pay. The gap between what investors pay and what the company receives is the flotation cost.

1. Direct Flotation Costs

These are explicit, out-of-pocket expenses that are easy to identify and measure.

• Underwriting Fees (Largest Cost): Commission paid to investment banks for managing the issue, finding investors, and taking on the risk of unsold shares. Typically 4% to 7% of the amount raised.
• Legal & Compliance Fees: Paid to lawyers for ensuring the prospectus and issuance process comply with regulators (like SEBI).
• Registration Fees: Paid to government agencies and stock exchanges to list the new securities.
• Audit & Accounting Fees: Paid to auditors to verify and certify the company’s financial statements for investors’ review.
• Printing & Marketing Expenses: Costs for printing the Red Herring Prospectus, brochures, and conducting roadshows.

2. Indirect Flotation Costs

These are hidden costs that do not appear as a bill but still reduce the company’s value.

• Market Pressure (Price Impact): Issuing a large number of new shares can increase supply and cause a slight drop in market price of existing shares.
• Management Time: Significant time spent by the CEO and CFO on fundraising instead of daily operations.
• Underpricing: To ensure the entire issue is sold, companies often set the offer price slightly below expected market price; this is an opportunity cost.

Impact on Cost of Capital

Flotation costs make external financing more expensive than internal financing (retained earnings).

• Cost of New Equity (Re): When calculating the cost of new shares, you must subtract flotation cost from the share price. This increases the required return for investors.

Re = D1 / (P0 (1 – f)) + g

Where: D1 = Expected dividend; P0 = Current price; f = flotation cost (as a percentage); g = growth rate.

Benefits of Commercial Paper

Commercial Paper (CP) is an unsecured money market instrument issued as a promissory note. It serves as an efficient tool for short-term financing, offering advantages to issuers and investors.

1. Benefits for Issuing Companies

• Cost-Effectiveness: CPs typically carry lower interest than commercial bank loans because companies borrow directly from the market and bypass intermediary costs.
• No Collateral Required: As an unsecured instrument, CP does not require pledging assets, leaving company assets free for long-term financing.
• Speed and Simplicity: Issuing CP is faster than obtaining a bank loan; for maturities under 270 days (or 364 days in India), regulatory burden is minimal.
• Operational Flexibility: Companies can tailor maturity (7 days to 1 year) to match cash flow cycles.
• Reputation Building: Successfully issuing and redeeming CP consistently enhances a company’s standing in financial markets.

2. Benefits for Investors

• Higher Yields: CPs usually offer better returns than Treasury Bills or standard savings accounts for the same short-term duration.
• High Liquidity: CPs are transferable and traded in secondary markets, so investors can sell before maturity if needed.
• Portfolio Diversification: Adds high-quality corporate debt to a portfolio of government securities and bank deposits.
• Lower Risk (for High Ratings): Only companies with high credit ratings (like A1+) are allowed to issue CP in India, lowering default risk statistically despite being unsecured.

3. Benefits to the Indian Financial System

• Financial Disintermediation: Reduces reliance of corporations on the banking system, spreading risk across more investors.
• Market Transparency: Mandatory credit ratings from agencies (like CRISIL or ICRA) promote transparency and disciplined reporting among corporates.
• Liquidity Management: Provides an additional channel for the RBI and the market to manage short-term liquidity.

Capital Market (Long-Term)

The capital market funds projects and growth for periods exceeding one year.

Purpose: Raise capital for long-term growth such as factories, research, or infrastructure.

Risk: Higher than money market due to long-term market fluctuations.

Liquidity: Moderate — shares can be sold on exchanges but prices vary.

Primary Market: Where new securities (like IPOs) are issued for the first time.

Secondary Market: Where already issued shares are traded (e.g., BSE or NSE).

Money Market (Short-Term)

The money market deals with funds borrowed or lent for a very short period—usually one day to one year.

Purpose: Manage daily cash flow (liquidity) and working capital for businesses and government.

Risk: Very low, as instruments are backed by highly creditworthy entities.

Liquidity: Extremely high; assets convert to cash almost instantly.

Indian Specific Instruments:

• Treasury Bills (T-Bills): Issued by the RBI on behalf of the government for 91, 182, or 364 days.
• Commercial Paper (CP): Short-term unsecured notes issued by large companies.
• Call Money: Loans between banks for 1 to 14 days to meet reserve needs.
• Certificates of Deposit (CD): Issued by banks to raise bulk funds.

Instruments of Credit Control

Instruments of credit control are the tools used by a central bank (like the RBI) to regulate credit flow and money supply. These instruments are broadly divided into quantitative (general) and qualitative (selective) categories.

Quantitative (General) Instruments

These tools control the total volume of credit in the banking system and affect the entire economy.

• Bank Rate: The official interest rate at which the central bank lends long-term funds to commercial banks.
• Repo Rate: The rate at which the central bank lends short-term money to banks against government securities; primary tool for daily liquidity management.
• Reverse Repo Rate: The rate banks receive for parking excess funds with the central bank.
• Cash Reserve Ratio (CRR): Percentage of deposits banks must keep with the central bank as cash.
• Statutory Liquidity Ratio (SLR): Percentage of deposits banks must maintain in liquid assets within themselves.
• Open Market Operations (OMO): Buying and selling government securities to inject or absorb liquidity.

Qualitative (Selective) Instruments

These tools target the direction or quality of credit to encourage priority sectors or discourage speculative activities.

• Margin Requirements: The difference between collateral value and loan amount; raising margins restricts borrowing against assets.
• Credit Rationing: Setting ceilings or limits on credit to specific industries or sectors.
• Moral Suasion: Persuasion and advice from the central bank to banking heads to follow certain credit policies.
• Direct Action: Punitive steps against non-compliant banks, such as fines or refusal to lend.
• Regulation of Consumer Credit: Controlling down payment and installment rules for consumer loans to influence spending.

Mutual Funds in India

A mutual fund pools money from many investors to purchase a diversified portfolio of securities like stocks, bonds, and money market instruments. Each investor owns units representing a portion of the fund’s holdings. In India, the mutual fund industry saw significant growth, with Assets Under Management (AUM) reaching ₹80.8 lakh crore in November 2025 (as reported).

How a Mutual Fund Works

Pooling: Thousands of investors contribute money (as low as ₹500 via a SIP).

Management: A professional fund manager from an Asset Management Company (AMC) decides where to invest based on the fund’s objective.

Returns: Income (dividends or interest) and capital appreciation are passed back to investors after deducting a small management fee (expense ratio).

NAV: The value of one unit is the net asset value (NAV), updated daily based on the market value of underlying assets.

The Three-Tier Structure (India)

SEBI mandates a strict three-tier organizational structure to protect investors:

• The Sponsor: The promoter who starts the fund (e.g., SBI, HDFC).
• The Trust & Trustees: Watchdogs who ensure the fund is managed in unit-holders’ best interest.
• Asset Management Company (AMC): The operational arm that employs fund managers to make investment decisions.

Chit Funds in India

A chit fund is an Indian financial tool combining features of both savings and borrowing. It operates as a rotating savings and credit association (ROSCA) where members contribute a fixed amount monthly into a common pool, and one member receives the pool each month through an auction or a draw.

Chit funds remain popular in semi-urban and rural India for managing lump-sum needs like weddings, medical emergencies, or business expansion.

Types of Chit Funds

• State-Run Chit Funds: Managed by state governments or PSUs; considered the safest (examples: KSFE, MSIL).
• Private Registered Chit Funds: Run by private companies but registered under the Chit Funds Act, 1982 (examples: Margadarsi Chits, Shriram Chits, Gokulam Chits).

Regulation: The Chit Funds Act, 1982

Key regulations include:

• Mandatory Registration: Every chit group must be registered with the State Registrar of Chits.
• Security Deposit: The foreman must deposit a security amount (equal to the chit value) with the registrar before the first auction.
• Commission Limit: The foreman’s commission is capped (typically 5%, with some states allowing up to 7%).
• Ceiling on Discount: The maximum discount a member can bid is usually capped at 30–40% to prevent predatory borrowing.

Difference Between Primary and Secondary Markets

The fundamental difference is who is selling the security and who receives the money. In the primary market, a company sells new shares directly to investors. In the secondary market, investors trade those shares among themselves. Think of buying a new phone directly from the store (primary market) versus buying a used phone from an individual (secondary market).

The Primary Market (Where Shares Are Created)

Companies use this market to raise capital for projects, debt repayment, or expansion.

Major Methods of Raising Capital

• Initial Public Offering (IPO): The first time a private company sells shares to the public.
• Follow-on Public Offer (FPO): When an already-listed company issues additional new shares.
• Rights Issue: Offering new shares to existing shareholders at a discount.
• Private Placement: Selling shares to a select group of large investors instead of the general public.

The Secondary Market (Where Shares Are Traded)

After an IPO, shares get listed on a stock exchange like the NSE or BSE. The secondary market allows investors to buy and sell these listed securities.

Key Features:

• Liquidity: Convert shares into cash by selling to another buyer.
• Price Discovery: Prices change continuously based on news, earnings, and supply-demand.
• No Company Involvement: Trades occur among investors; the issuing company does not receive money from secondary market sales.

Types of Secondary Markets:

• Stock Exchanges: Regulated platforms like NYSE or NSE.
• Over-the-Counter (OTC): Decentralized trading between parties (common for certain bonds and derivatives).

Function of IDBI

The IDBI (Industrial Development Bank of India) transformed from a government-owned development institution to a full-service universal bank. Because of this history, its functions are often categorized into its original developmental role and its modern commercial banking role.

As of 2025, IDBI Bank is classified as a private sector bank for regulatory purposes (after LIC acquired a controlling stake in 2019), though it still maintains a strong focus on industrial growth and government welfare schemes.

Modern Commercial Banking Functions

• Retail Banking: Savings accounts, fixed deposits (FDs), and various loan products (home, auto, education, personal loans).
• Corporate Banking: Project finance, term loans, working capital, and trade finance for large industrial clients.
• MSME & Agri Banking: Specialized lending for micro, small, and medium enterprises and farmers (including schemes like Kisan Credit Card).
• Treasury Operations: Manages the bank’s investments in government securities, bonds, and foreign exchange trading.

The Indian financial system in 2025 is a sophisticated, dual-layered framework designed to mobilize savings and allocate capital to productive sectors. It serves as the bridge between “surplus units” (savers) and “deficit units” (borrowers), ensuring economic stability and growth.

The Organized (Formal) Sector

This is the heavily regulated segment of the economy, governed by central authorities to ensure transparency and protect participants.

A. Regulatory Bodies (The Watchdogs)

• Reserve Bank of India (RBI): Regulates banks, NBFCs, and the money market; manages monetary policy and digital currency (CBDC).
• Securities and Exchange Board of India (SEBI): Oversees capital markets, mutual funds, and stockbrokers.
• Insurance Regulatory and Development Authority (IRDAI): Governs the insurance sector.
• Pension Fund Regulatory and Development Authority (PFRDA): Manages pension schemes like the NPS.

B. Financial Institutions

• Banking Institutions: Public sector banks (e.g., SBI), private banks (e.g., ICICI), regional rural banks (RRBs), payment banks, and small finance banks.
• Non-Banking Financial Companies (NBFCs): Provide credit and financial services (like gold loans or vehicle finance) but do not hold full banking licenses.
• Specialized Institutions: Development banks like NABARD (agriculture) and SIDBI (MSMEs).

C. Financial Markets

• Money Market: Deals with short-term funds (up to 1 year) and includes T-Bills and commercial paper.
• Capital Market: Focuses on long-term funds (more than 1 year), divided into primary and secondary markets.

D. Financial Instruments

• Equity & Bonds: Shares, debentures, and government securities.
• Insurance & Mutual Funds: Units and policies that pool risk and investment.
• Digital Assets: UPI transactions and central bank digital currency (e-Rupee).

The Unorganized (Informal) Sector

Despite the massive digital push, this sector still exists, primarily serving rural or underbanked populations:

• Money Lenders: Local individuals providing high-interest loans.
• Indigenous Bankers: Traditional family-run firms (e.g., sahukars).
• Unregistered Chit Funds: Neighborhood groups pooling money outside formal regulation (high risk).