The Indian financial system: structure, regulators and reform

Almost every F&M question sits somewhere on a single map: who saves, who borrows, which institution or market connects them, and who regulates that connection. Candidates who carry that map can place any topic, whether NBFC regulation, the IBC or a new payment system, in context within seconds. Candidates who learn topics in isolation write answers that are accurate but disconnected. This guide gives you the map: the functions, the parts, the regulators and the reforms that shaped India's system, with a worked example on how a bank earns its living.

What a financial system does

A financial system moves resources from those with surplus funds (mostly households) to those who need them (firms, government, other households). Economists list six functions:

1. Mobilising savings from many small savers.
2. Allocating capital to its most productive uses.
3. Payments: a way to settle transactions safely.
4. Risk management: pooling, sharing and transferring risk (insurance, diversification, derivatives).
5. Information: screening borrowers and monitoring them after lending.
6. Corporate governance: lenders and shareholders discipline managers.

Why intermediaries exist

Savers could lend directly to firms, but three frictions stand in the way:

• Information asymmetry: borrowers know more about their own projects. Before lending this causes adverse selection; after lending, moral hazard. Banks specialise in screening and monitoring.
• Transaction costs: one bank assessing a borrower is cheaper than a thousand savers doing so.
• Maturity and liquidity mismatch: savers want to withdraw at short notice; projects need long-term money. A bank performs maturity transformation, funding long loans with short deposits, because not all depositors withdraw at once.

Maturity transformation is also the source of fragility. If depositors all withdraw together, even a solvent bank can fail. That is the reason for deposit insurance, a lender of last resort and prudential regulation, and the reason a central bank exists at the centre of the system.

The components

Institutions in India

• Scheduled commercial banks: public sector, private sector, foreign banks, regional rural banks, small finance banks and payments banks. Payments banks accept deposits but cannot lend.
• Cooperative banks: urban cooperative banks and rural cooperatives (state and district central cooperative banks, primary agricultural credit societies).
• NBFCs: lending, investment, housing finance, microfinance and infrastructure finance companies, now under scale-based regulation by the RBI.
• All-India financial institutions: NABARD (1982), EXIM Bank (1982), NHB (1988), SIDBI (1990) and NaBFID (2021) for infrastructure.
• Insurers, pension funds and mutual funds, which hold long-term savings and are the natural buyers of long-term bonds.

Regulators and their domains

The Financial Stability and Development Council (FSDC), set up in 2010 and chaired by the Finance Minister, coordinates regulators on stability, development and inter-regulatory issues. Its sub-committee is chaired by the RBI Governor.

Bank-based versus market-based systems

India's system has historically been bank-dominated. The infrastructure lending of the 2000s showed the cost: banks funded 15–20-year projects with short-term deposits, and when projects stalled the losses sat on bank balance sheets as NPAs. Deepening the corporate bond market, and the pension and insurance funds that buy long bonds, is therefore a long-standing policy aim. Research on finance and growth suggests that the overall depth of the system matters more than whether it is bank- or market-based; the two complement each other.

From repression to reform

Before 1991 India's system was a case of financial repression: administered interest rates, high statutory pre-emption through CRR and SLR, directed credit and limited competition. It kept government borrowing cheap but lowered efficiency.

The Narasimham Committee reports (1991 and 1998) led to:

• Gradual cuts in CRR and SLR, releasing funds for commercial lending.
• Interest rate deregulation.
• Prudential norms: income recognition, asset classification and provisioning; capital adequacy.
• Entry of new private banks and greater competition.

Later reforms added the IBC (2016), inflation targeting (2016), and digital payments infrastructure. Each is a separate guide; the point for this topic is the direction of travel, from state direction to market signals with prudential regulation.

Worked example: how a bank earns

A bank's main income is the gap between what it earns on loans and investments and what it pays on deposits and borrowings.

A bank has average earning assets of ₹10,000 crore. In a year it earns interest of ₹900 crore and pays interest of ₹550 crore.

1. Net interest income = 900 − 550 = ₹350 crore.
2. Net interest margin (NIM) = 350 ÷ 10,000 = 3.5%.
3. Suppose NPAs rise and ₹1,000 crore of assets stop earning interest. At the average yield of 9% (900 ÷ 10,000), interest earned falls by 9% of 1,000 = ₹90 crore, to ₹810 crore, while interest paid stays at ₹550 crore.
4. New net interest income = 810 − 550 = ₹260 crore; NIM on ₹10,000 crore = 2.6%.

Bad loans hurt twice: through lost income, shown here, and through the provisions the bank must set aside from profit. This is why asset quality dominates bank analysis.

Model answer outline (15 marks)

Question: "India needs a deeper corporate bond market to reduce the burden on banks." Examine.

1. Introduction: India's bank-dominated system; banks' role in long-term finance.
2. The problem: asset–liability mismatch on long loans; concentration of credit risk; the infrastructure NPA episode.
3. Benefits of bond markets: long-term finance from pension and insurance funds; risk spread across investors; market pricing of credit.
4. Constraints: a narrow investor base; issuance concentrated among highly rated firms; thin secondary trading; weak recovery for bondholders in the past.
5. Measures taken: IBC; credit enhancement for lower-rated issuers; electronic bidding platforms; allowing wider investment by pension and insurance funds.
6. Way forward: broaden investors, deepen repo in corporate bonds, standardise issuance, credit enhancement for infrastructure.
7. Conclusion: banks and bond markets are complements; depth in both makes the system safer.

Short model answer (10 marks)

Question: Why do banks need to be more heavily regulated than most firms?

Banks are different from ordinary firms in three ways. First, they fund long-term, illiquid loans with short-term deposits that can be withdrawn on demand. This maturity transformation is useful but fragile: if depositors lose confidence and withdraw together, even a solvent bank can fail.

Second, banks are highly leveraged; most of their funding is other people's money, so shareholders have an incentive to take risks whose losses fall largely on depositors. Deposit insurance reduces runs but adds to this moral hazard.

Third, banks are interconnected through interbank lending and the payment system, so one failure can spread. The costs of a banking crisis fall on the whole economy, through lost credit, not just on the bank's owners.

Regulation responds to each: capital requirements make shareholders bear losses, liquidity ratios limit mismatch, supervision checks risk-taking, and the central bank acts as lender of last resort. In India, the RBI performs these roles under the Banking Regulation Act, 1949 and the RBI Act, 1934.

Practice questions

1. Which regulator supervises housing finance companies since 2019?
   • The RBI.
2. Who chairs the FSDC?
   • The Union Finance Minister.
3. Which type of bank accepts deposits but cannot lend?
   • Payments bank.
4. Net interest income ₹240 crore, earning assets ₹8,000 crore. What is the NIM?
   • 3%.
5. Which committee's reports led to the first banking reforms of the 1990s?
   • The Narasimham Committee (1991 and 1998).
6. Which problem arises when riskier borrowers are more eager to borrow?
   • Adverse selection.

What to do next

• Draw the map from memory: savers, institutions, markets, borrowers, regulators.
• Learn the regulator table with the year of each body.
• Redo the NIM example with ₹2,000 crore of assets turning bad.
• Read the financial markets guide and the financial regulators guide next.