Introduction

Financial System is the group of individuals, intermediaries and institutions that can potentially interact or participate in transactions that involve real or financial assets. The word system in financial system implies a set of complex and closely connected or intermixed institutions, agents, practices, markets, transactions etc. in the economy. The financial system is concerned about Money, credit and financethe terms intimately related but different from each other. Money- refers to the current medium of exchange. Credit- is a sum of money to b returned with interest and Finance- is a monetary resource comprising debt and ownership funds of the state, company or person. The financial institutions differ from non-financial business organizations in respect that the former deal in financial assets such as deposits, loans, securities etc. and latter deal in real assets like machinery, equipment, stocks of goods etc. Thus, they act as half-way houses between the primary lenders and the final borrowers. They accept deposits from the public and pay deposit rates to it. The financial intermediaries obtain funds from public and lend these funds to investors. The difference between the lending and the borrowing rates are the profit to the financial intermediaries.

Classification of Financial Institutions

Financial institutions are divided into banking and non-banking ones. The banking institutions have quite a few things in common with the non-banking ones. While the banking system in India comprises the commercial banks and co-operative banks, the non-banking financial institutions include Life Insurance Corporation (LIC), Unit Trust of India (UTI), and Industrial Development Bank of India (IDBI). Financial markets are divided into primary and secondary market which is called direct and indirect markets respectively. Very often financial markets are classified as money market and capital market.

Financial system or financial sector of any country have also been classified into (a) specialized and nonspecialized financial institutions, (b) organized and unorganized financial markets and (c) financial instruments and services which facilitate transfer of funds.

Role of Financial Institutions

Financial institutions are those institutions which were set up mainly by the government for providing medium and long-term financial assistance to industry. As these institutions provide developmental finance, that is, finance for investment in fixed assets, they are also known as development banks or development financial institutions. Financial Institutions were established to meet the long-term financial requirement of such concerns, on economic and social ground. The role of FIs is as follows: 1. Financial intermediaries such as banks, investment companies, mutual funds, credit unions and insurance companies pool resources from various small investors so that they can be able to later lend those funds. 2. Financial intermediaries can substantially reduce transaction costs that can be defined as the time and money spent in performing financial transactions for instance the exchange of assets, goods or services. 3. Because of their large size and expertise, they are able to take advantage of economies of scale. 4. They have an important role in the financial system is because of the inequality of information available between parties. Asymmetric information is fundamental to understanding the need for regulation as it affects the sense of balance that any market needs to remain in a stable situation. 5. Financial intermediaries improve the performance of the economy and are therefore successful elements of the financial system. However, it is important to analyze the new trends that are complicating their position and the factors that are needed to return the confidence to the market and avoid instability of the financial system.

Financial Sector Reforms

India has presently entered a high-growth phase of 8-9 per cent per annum, from an intermediate phase of 6 per cent since the early 1990s. The growth rate of real GDP averaged 8.6 per cent for the four-year period ending 2006-07; if one considers the last two years, the growth rates are even higher at over 9 per cent. There are strong signs that the growth rates will remain at elevated levels for several years to come. This strengthening of economic activity has been supported by higher rates of savings and investment. While the financial sector reforms helped strengthening institutions, developing markets and promoting greater integration with the rest of the world, the recent growth phase suggests that if the present growth rates are to be sustained, the financial sector will have to intermediate larger and increasing volume of funds than is presently the case. It must acquire further sophistication to address the new dimensions of risks. It is widely recognised that financial intermediation is essential to the promotion of both extensive and intensive growth. Efficient intermediation of funds from savers to users enables the productive application of available resources. The greater the efficiency of the

financial system in such resource generation and allocation, the higher is its likely contribution to economic growth. Improved allocative efficiency creates a virtuous cycle of higher real rates of return and increasing savings, resulting, in turn, in higher resource generation. Thus, development of the financial system is essential to sustaining higher economic growth.

Main objectives of Financial Sector Reforms introduced in 1991

(i) (ii) (iii) (iv) (v) (vi) (vii) To develop a market-oriented, competitive, world-integrated and autonomous transparent financial system. To increase the allocative efficiency of available savings and to promote accelerated growth of real sector. To increase the rate of return on real investment. To promote competition by creating level-playing fields and facilitating free entry and exit for institutions and market players. To reduce the levels of resource pre-emption and to improve the effectiveness of directed credit programmes. To build a financial infrastructure relating to supervision, audit, technology and legal matters. To modernize the instruments of monetary control so as to make them more suitable for conduct of monetary policy in a market economy i.e.to increase the reliance on indirect or market incentives based instruments rather than direct or physical instruments of monetary control.

MAJOR REFORMS AFTER 1991 Over the last six years, much has been achieved in addressing many of these problems, but a lot remains to be done. Financial sector reforms encompassed broadly institutions especially banking, development of financial markets, monetary fiscal and external sector management and legal and institutional infrastructure. The following sections review the progress of financial sectors in some key areas.

(1) Systemic and Policy Reforms

Most of the interest rates in the economy deregulated; a beginning made to move towards market rates on government securities and the structure of interest rates greatly simplified. The preemption of banks resources through SLR securities in favour of the government was brought down and the rate of return on SLR securities in maintained by and large at market rates. The SLR on incremental net domestic and time liabilities (NDTL) of banks reduced from 38.5% in 1991-92 to 25% now. The incremental CRR of 10% removed, and the average CRR reduced from 15% in 1991-92 to 10% in 1995-96. Capital adequacy of the banking sector recorded a marked improvement and stood at 12.3 per cent at end-March 2006. This is a far cry from the situation that prevailed in early 1990s. The private sector allowed setting up banks, mutual funds, money market mutual funds, insurance companies etc. The Industrial Development Bank of India Act, 1964 amended to allow IDBI to raise capital up to 49%. The policy permitting foreign banks to open branches liberalized.

Securities and Exchange Board of India (SEBI) made a statutory body in February 1992 and armed with necessary authority and powers for regulation and reform of the capital market.

(2) Banking Reforms Interest rates on deposits and advances of all co-operative banks including urban co-operative
banks deregulated. Similarly interest rates on commercial bank loans above rs.2 lakh controlled. Banks allowed setting their own interest rate on post-shipment export credit in rupees for over 90days. The State Bank of India and other nationalized banks enabled to access the capital market for debt and equity. Banks required making their balance sheets fully transparent and making full disclosures in keeping with International Accounts Standard Committee. Banks given greater freedom to open, shift, and swap branches as also to open extension counters. Bank profitability levels in India have also trended upwards and gross profits stood at 2.0 per cent during 2005-06 (2.2 per cent during 2004-05) and net profits trending at around 1 per cent of assets. Available information suggests that for developed countries, at end-2005, gross profit ratios were of the order of 2.1 per cent for the US and 0.6 per cent for France. The big three- Standard Chartered Bank, Citi and HSBC- will keep a close eye on the unfolding local incorporation norms.

(3) Primary and Secondary Stock Market Reforms A norm of five shareholders for every rs.1 lakh of fresh issues of capital and 10 shareholders for
every rs.1 lakh of offer for sale prescribed as an initial and continuing listing requirement. A ceiling of rs.10 crore imposed on stock market members doing business of financing carry forward transactions. The stock exchanges are being modernized; many of them have introduced electronic trading system; the Bombay Stock Exchange has started its on-line trading system, BOLT. Stock lending schemes without attracting capital gains introduced. Under this scheme, short sellers can borrow securities through an intermediary before making such sales.

(4) Government Securities Market Reforms A 364-day treasury bill (TB) replaced the 182-day TB in 1992-93, and it is being sold fortnightly
auction since April 1992. Maturity period for new issues of central government securities shortened form 20 years and that for state government securities from 15 to 10 years. A scheme fir auction of government securities from RBIs own portfolio as a part of its open market operations announced in March 1995. Reverse repo facility with RBI in government dates securities extended to Discount and Finance House of India (DFHI) and Securities Trading Corporation of India (STCI).

(5) Other Reforms

As the financial sector diversified into new business lines over the past two decades, banks spawned arms to venture into these areas. And today, they have interests in non-bank finance companies (NBFCs), mutual funds, insurance and broking. It is not anymore about just banks,

but bank- plus. This also increases the pressure on banks- they have to feed their subsidiaries need for capital as they grow. It also creates regulatory overlaps as banks arm may alternatively report to the Securities and Exchange Board of India (SEBI) or to the Insurance Regulatory Authority of India (IRDA), or both. It has been in the ethos of SBI to expand the banking business to the remotest parts of India. Thus, the group created to pay special attention to financial inclusion and agriculture in rural regions called as Rural Business Group. ICICI bank claims to be the most technology efficient banks in terms of cost to income. For e.g. it is the only bank in India that has a machine called cash acceptor which credits the money to the account in real time. Branch licenses for foreign banks are largely guided by a World Trade Organization commitment of 1997, under which India needs to issue a dozen branch licenses. The RBI doles out two dozen branch licenses to foreign banks.

Agenda for future

Financial sector being the backbone of the economy of a country must be transparent, efficient and resilient. Efficiency in the financial sector has a significant influence on the growth and development of a country. The financial sector reforms and opening up of the economy has exposed traditionally protected financial institutions and the industry to greater level of competition. Financial inclusion is a key priority. It requires delivery of basic financial services- savings, credit, insurance and payments to the undeserved segments of the economy. In recent years, several policy initiatives and regulatory changes have created an enabling framework for accelerated financial inclusion. While we have made a significant progress, there are few issues highlighted which need significant attention in real terms. Following are the 5 challenges: Firstly, it is addressed both to the micro-prudential and macro-prudential dimensions of financial reform. The micro-prudential framework aimed at making individual financial institutions healthierhas to be set right. The Basel Committee is working on strengthening the bank capital and liquidity framework for this purpose and not let these efforts be diluted by political pressures. Visible progress needs to be made by the time of the November. At the same time, a framework of macroprudential regulation has to be created to deal with systemic risks that reflect interconnectedness and cyclicality. Its successful implementation, however, will depend critically on addressing the flaws in the micro-prudential framework. Secondly, we must look beyond banks to nonbank financial institutions. Reforms need to make the entire financial systemnot only the bankssafer. The reform agenda has so far focused on banks; in the area of nonbanks and the shadow banking system, the risk lies in not acting soon enough. Regulators, policy makers, and standard setters must speed up their work on markets and products, and nonbank financial sectors. Thirdly, we must strike the right balance among three competing objectivessafety, efficiency, and regulatory certainty. We have to move ahead and finalize the core rules governing capital and liquidity. This is essential not just for making the financial system safer but also for providing more certainty to the market. At the same time, the actual calibration of the required levels of capital and liquidity must

proceed cautiously to ensure that, before they are finalized, the impact of the various changes, both individually and collectively, on the financial system and the overall economy have been assessed. Getting the calibration of the steady state impact right will prevent ending up with a system that is either inherently unstable, or that imposes an excessive burden on the financial sector, and ultimately on the economy. Fourthly, regulations must be both nationally appropriate and internationally consistent. There is a danger that the regulatory framework emerging from current discussions will not be adopted evenly. Some countries that were less affected by the crisis may not see the need for implementing some of the new reforms. In a financially globalized world, however, uneven regulations across borders will inevitably lead to a migration of risky activities to those countries with the easiest requirements. This would put their financial systems at risk and, in turn, endanger the global financial system. Last but not least, in addition to regulation, we must reform supervision. A rule is only of value if implemented correctly. The quality of implementation in turn depends on strong supervision. Moreover, there should be improvement in customer service. Banks exist to provide service to customers. With the introduction of technology, there has been a significant change in the way banks operate. The interface with the customers needs to improve. Consumers will increasingly demand enhanced institutional capabilities and service levels from banks. All these issues point to the opportunity that exists for the financial system of the country to continue its high growth trajectory. In the years to come, the Indian financial system will grow not only in size but also in complexity as the forces of competition gain further momentum and as financial markets get more and more integrated. As globalization accelerates, the Indian financial system will also get integrated with the rest of the world. As the task of the banking system expands, there is need to focus on the organizational effectiveness of banks. To achieve improvements in productivity and profitability, corporate planning combined with organizational restructuring become necessary. Equally, governance and financial inclusion will emerge as key issues for India at this stage of socio-economic development.

Conclusion
The financial reform law is oriented to protect consumers, which is good, and cleaning up future spills, which are also good, the process of financial sector reforms is not yet over. To revitalize the financial sector, the Government of India is rightfully planning to introduce second generation financial sector reforms. Thus, if India is growing, everyone will grow. We see a lot of potential and business opportunity. The methods would be different, but the ultimate goal is the same. In the end, its always about the money.