Indian Financial System and Capital Market

1. Introduction

The Indian financial system is a complex, interconnected framework that plays a central role in mobilizing savings, supporting economic activities, and promoting capital formation. It consists of financial institutions, financial markets, financial instruments, and financial infrastructure. Over time, the structure has evolved significantly—from a highly regulated, government-directed system to a more market-oriented, technology-driven, resilient financial ecosystem.

This article provides a professional academic analysis of the Indian financial system and the capital market, tracing its evolution, reforms, institutional components, major issues, and growth trends. The explanation is designed for students of commerce, management, economics, and for academic blogs or reference material.

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2. Structure of the Indian Financial System

The Indian financial system can be broadly classified into:

Component	Description
Financial Institutions	Banks, NBFCs, AIFIs, insurance companies, cooperative institutions
Financial Markets	Money market, capital market, foreign exchange market, government securities market
Financial Instruments	Shares, bonds, debentures, derivatives, treasury bills, CDs, CPs
Financial Services	Payment systems, clearing & settlement, fund transfers, brokerage, underwriting

The Reserve Bank of India (RBI) is the apex regulatory authority overseeing large parts of the financial system under the RBI Act, 1934 and Banking Regulation Act, 1949.

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3. Financial Institutions in India

Financial institutions form the backbone of the Indian financial system. They mobilize savings, allocate resources, manage risk, and provide payment and settlement services.

3.1 Scheduled Commercial Banks (SCBs)

SCBs occupy a dominant position, accounting for nearly three-fourths of total assets in the financial system.

Types of SCBs

• Public Sector Banks (PSBs) – Majority government ownership

• Private Sector Banks – 30 banks

• Foreign Banks – 33 banks operating in India

Key Characteristics

• PSBs account for approximately 75% of SCB assets.

• Private banks contribute around 20%, while foreign banks hold 6–7%.

Regional Rural Banks (RRBs)

RRBs are jointly owned by:

• Central Government

• State Government

• Sponsor Bank

They play a crucial role in rural credit delivery.

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3.2 Cooperative Banks

The cooperative banking system has two segments:

Type	Structure	Role
Urban Cooperative Banks (UCBs)	Single-tier (Primary Cooperative Banks)	Serve semi-urban and urban areas
Rural Cooperatives	Multi-tier (State Cooperative Banks, District Central Cooperative Banks, PACs)	Provide rural credit

Challenges include:

• political interference

• weak governance

• multiple regulatory authorities

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3.3 All-India Financial Institutions (AIFIs)

These institutions traditionally provided long-term project finance.

Key AIFIs include:

• IDBI

• IFCI

• SIDBI

• NABARD

• EXIM Bank

• NHB

• IDFC

Most AIFIs have transitioned from development finance institutions to universal/ commercial banking models due to the unsustainability of the traditional DFI model.

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3.4 Non-Banking Financial Companies (NBFCs)

NBFCs represent a highly diversified sector. They include:

• Asset finance companies

• Loan companies

• Investment companies

• Microfinance institutions

• Housing finance companies

• Infrastructure finance companies

• Residuary Non-Banking Companies (RNBCs)

Primary Dealers (PDs) in government securities constitute a systemically important segment of NBFCs.

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4. Pre-Reforms Phase (Before 1991)

Before economic reforms, the Indian financial system exhibited serious structural weaknesses.

Major Issues Before Reforms

• Limited competition due to nationalization

• High intermediation costs

• Low productivity and outdated technology

• Weak prudential norms

• Poor asset quality

• Directed credit programs

• Administered interest rates

• Underdeveloped financial markets

• Overprotected DFIs and insurance sector

The system primarily focused on transferring resources from surplus sectors to deficit sectors—not on efficiency or financial innovation.

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5. Financial Sector Reforms (Post-1991)

Financial reforms in the 1990s were part of broader economic liberalization aimed at improving efficiency, transparency, and competitiveness.

Key Objectives of Reforms

• Strengthen financial institutions

• Promote stable, competitive markets

• Improve regulatory oversight

• Introduce international best practices

• Allow greater market determination of prices

Approach Adopted

Reforms followed a gradual, carefully sequenced, non-disruptive path.

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6. Interest Rate Liberalization

One of the most significant reforms was the shift from administered to market-determined interest rates.

Steps Taken

• Deregulation of money market rates

• Auction-based pricing of government securities

• Freedom to banks to set deposit and lending rates

• Deregulation of corporate bond market rates

At present:

• Only a few categories—such as savings deposits and certain export credits—have partially regulated rates.

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7. Reduction in Statutory Reserve Requirements

India had very high reserve requirements before reforms:

Requirement	Earlier	Current (Approx.)
CRR	Above 10%	~5%
SLR	Above 30%	18–25% range historically; gradually reduced

Lowering CRR and SLR allowed banks to allocate more funds to productive economic activities.

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8. Competition and Efficiency in Banking

To enhance competition:

• New private sector banks were allowed (12 since 1993)

• Foreign banks received more liberal entry

• Government reduced ownership to 51% in PSBs

• FDI in private banks increased to 74%

This led to:

• Improved productivity

• Better customer service

• Technological modernization

• Market-based discipline

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9. Strengthening Regulation and Supervision

Regulatory reforms aligned India with international standards.

Key Measures

• Minimum CRAR of 9% (higher than Basel norm of 8%)

• Investment Fluctuation Reserve (IFR) to absorb interest rate risk

• Enhanced disclosure and transparency

• “Fit and Proper” criteria for directors and major shareholders

• Tighter regulation of NBFCs

• Strengthening of supervisory structures

The Board for Financial Supervision (BFS) was created in 1994 for focused oversight.

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10. Reforms in Cooperative Banks and RRBs

RRBs

• Improved governance

• Deregulated interest rates

• Restructuring of weak banks

Cooperative Banks

• Challenges in democratic structure vs. financial discipline

• Reforms proposed by Government’s Task Force

• Vision document by RBI emphasizing risk-based regulation

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11. Status and Restructuring of AIFIs

• ICICI and IDBI converted into banks

• IFCI moved towards merger

• IIBI faced restructuring

• DFIs shifted to universal banking due to unsustainable business model

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12. Performance of the Indian Financial Sector

Key Improvements

• Lower Non-Performing Assets (NPAs)

• Stronger capital adequacy ratios

• Improved profitability

• Greater competition

Sample Indicator Table

Indicator	2002–03	2003–04
Gross NPAs (SCBs)	8.8%	7.2%
Net NPAs (SCBs)	4.4%	2.9%
CRAR (SCBs)	12.7%	12.9%
Operating Profit %	2.4	2.7

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13. Development of Financial Markets

Reforms targeted the elimination of segmentation and inefficiencies across money, debt, equity, and forex markets.

Key Measures

• Removal of asset pricing restrictions

• New instruments: CP, CDs, repos, FRAs, IRS

• Government securities auction system

• Development of forex markets

• Deregulation of balance sheet restrictions

Better integration across markets improved liquidity and efficiency.

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14. Overview of the Indian Capital Market

The Indian capital market is one of Asia’s oldest and most dynamic.
The Bombay Stock Exchange (BSE) was established in 1875.

The modern capital market includes:

Segment	Instruments
Primary Market	IPOs, FPOs, rights issues, private placement
Secondary Market	Trading of existing securities
Derivatives Market	Index futures, stock futures, options
Debt Market	Government and corporate bonds

Key Regulations

• Companies Act, 1956

• Securities Contracts (Regulation) Act, 1956

• SEBI Act, 1992

SEBI is the primary regulator ensuring transparency, fairness, and investor protection.

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15. Major Reforms in the Capital Market (1990s–Present)

15.1 Strengthening SEBI

• Granted statutory powers in 1992

• Mandate: investor protection + market development

15.2 Free Pricing of Issues

Companies now freely determine:

• Issue size

• Pricing method (fixed price or book-building)

15.3 Enhanced Disclosure Norms

Requirements include:

• Profitability record

• Risk factors

• Promoter holdings

• Use of proceeds

15.4 Modernization of Stock Exchanges

• Replacement of open outcry with electronic trading

• Nearly 8,000 trading terminals across India

• Improved liquidity and price discovery

15.5 Shortened Settlement Cycles

Period	Settlement Cycle
Earlier	T+14
Later	T+5
Now	T+2

15.6 Introduction of Clearing Corporations

Ensures:

• Guaranteed settlement

• Counterparty risk reduction

15.7 Dematerialization (Demat)

• Eliminated paper certificates

• Reduced fraud and delays

• NSDL and CDSL serve as depositories

15.8 Quarterly Financial Results

Mandatory disclosure improved transparency.

15.9 Foreign Institutional Investors (FIIs)

Opened in 1992.
FIIs significantly deepened and globalized Indian markets.

15.10 Corporate Governance Reforms

• Broad-based exchange boards

• Demutualization of stock exchanges

15.11 Derivatives Trading

Introduced in June 2000:

• Index futures

• Index options

• Stock futures

• Stock options

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16. Foreign Institutional Investment (FII)

FIIs play a vital role in India’s equity and debt markets.

16.1 Key Features

• Allowed in equity, corporate debt, government securities

• Full capital convertibility

• Major share in market capitalization

16.2 Investment Limits

Category	Limit
Single FII	Max 10% of company equity
FII + sub-accounts	Max 24% (can be raised to sectoral cap)
FIIs in G-secs	$1.75 billion
FIIs in corporate debt	$500 million

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17. Growth of the Indian Capital Market

Major Growth Indicators

• Rise in market capitalization

• Increase in listed companies

• Higher trading volumes

• Broader investor participation

• Dominance of electronic trading

Statistics

• Over 9,400 listed companies (as of 2004)

• BSE market capitalization: ₹16,860 billion

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18. Recent Trends in Indian Stock Markets

Indian markets have been among the best performing emerging markets.

Key Drivers

• Strong FII inflows

• Corporate earnings growth

• Favorable economic conditions

• Better monsoon performance

• Global market trends

Despite volatility, valuations remained attractive relative to long-term averages.

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19. Payment and Settlement Systems in India

RBI has modernized payment infrastructure to ensure safety and efficiency.

Major Systems Introduced

• RTGS: Real-Time Gross Settlement

• NEFT: Nationwide Funds Transfer

• CFMS: Centralized Funds Management System

• NDS: Negotiated Dealing System

• INFINET: Indian Financial Network

• SFMS: Structured Financial Messaging System

A dedicated Board for Regulation and Supervision of Payment and Settlement Systems (BPSS) oversees governance.

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20. Issues and Challenges in the Indian Financial System

Even with significant progress, challenges remain.

Banking Sector Issues

• Efficient fund deployment

• Asset quality management

• Cost control

• Governance and transparency

• Financial inclusion

• Cybersecurity risks

Capital Market Issues

• Need for stronger corporate governance

• Low retail participation

• Underdeveloped corporate bond market

• High volatility in equity markets

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21. Conclusion

The Indian financial system has undergone profound transformation since the early 1990s. Through systematic reforms, improved regulation, technological advancements, and increased market competition, India has developed a more stable, efficient, and globally integrated financial ecosystem.

The capital markets have modernized to meet international standards, while the banking sector has strengthened through improved governance, capitalization, and risk management practices. Although challenges persist—such as governance issues, financial inclusion gaps, and the need for deeper bond markets—the overall system is significantly more robust than before.

The Indian financial system is now well-positioned to support sustained economic growth, innovation, and global competitiveness.

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