Financial infrastructure

Topic: Banking, Credit Creation and Monetary Policy · NCERT: Class 7, Ch 8 "Banks and the Magic of Finance"

Meaning

Financial infrastructure is the network of banks, payment systems, stock markets and other financial institutions that moves money between three groups: households, firms and government (NCERT Class 7, Banks and the Magic of Finance).

It matters because big projects like highways, railways and telecom (physical infrastructure) need huge funds. The financial system collects many small savings and sends them to these projects. Without it, physical infrastructure cannot be built.

Explanation

How it works: financial intermediation

• Financial intermediation means banks stand between savers (people with extra money) and borrowers (people who need money).
• The bank pools (collects together) many small deposits.

• It lends most of this pool out as loans.

• NCERT example:

• Navdeep puts his spare money in a bank.
• Rima runs a bamboo business. Her friends and family cannot give her all the money she needs.

• The bank lends Rima money from its pool, which includes Navdeep's deposit.

• Why the middleman helps:

• Risk moves away from the saver. Navdeep does not have to judge whether Rima will repay. The bank does that.
• Search costs fall. Savers and borrowers do not have to find each other.
• Small sums become big loans. Many small deposits add up to enough money for large projects.

Worked example: how a bank earns (illustrative)

• A bank pays depositors 6% a year. It charges borrowers 10% a year.
• It lends out ₹100 crore of deposits:
• Interest earned from borrowers = ₹10 crore

• Interest paid to depositors = ₹6 crore

• Spread (the gap between the loan rate and the deposit rate) = 4 percentage points = ₹4 crore.

• This spread pays the bank's costs and gives it profit.

Components: the parts of the financial sector

• Financial sector means the institutions and markets that collect money and decide where it goes. Main parts:
• Commercial banks: take deposits and give loans.
• Investment banks: help companies raise money by selling shares and bonds.
• Stock exchanges: places where shares are bought and sold.
• Foreign exchange market: where one currency is traded for another.

• Payment systems: move money from one person to another.

• Other institutions:

• Post offices: run small savings schemes and reach remote villages.

• Development finance institutions (DFIs): give long-term loans to one sector.

• Regulators: public bodies that make rules for each part and supervise the firms in it.

Banks do more than move money: Schumpeter's view

• Joseph Schumpeter said the banker is "not only a middleman". The banker is a "producer" of credit who helps entrepreneurs "transform ideas into reality".
• The chain:
• A bank gives a loan.
• The loan creates a new deposit.
• So banks do not only pass on old savings. They also create new money, through credit creation.

In India

Regulators

Regulator	What it regulates
RBI (Reserve Bank of India, 1935)	Banks, NBFCs (non-banking financial companies), payment systems, all-India financial institutions
SEBI	Securities markets (shares, bonds, mutual funds)
IRDAI	Insurance
PFRDA	Pensions (e.g. National Pension System)
IFSCA (2020)	The International Financial Services Centre (IFSC) at GIFT City

• IFSCA was created under the International Financial Services Centres Authority Act, 2019. It has worked since April 2020 [4][5].
• It is a unified regulator, meaning one body regulates all financial products, services and institutions inside GIFT IFSC. It does the jobs that RBI, SEBI, IRDAI and PFRDA do elsewhere [4].
• GIFT City is a multi-services Special Economic Zone (SEZ), officially notified as India's IFSC [4].
• IFSC units get a tax holiday on business income for 10 years out of a block of 15 years [4].

Banks

• Types of commercial banks: public sector, private sector, foreign, Regional Rural Banks (RRBs), small finance banks (lend mainly to small businesses and low-income groups) and payments banks (take small deposits and handle payments, but cannot lend).
• Private banks timeline:
• 1991: reforms opened banking to new private players.
• 1993: RBI licensed the first new private banks.

• 2016: on-tap licensing began. This means RBI accepts applications at any time, not only in rare rounds.

• RBI issued the Guidelines for 'on tap' Licensing of Universal Banks in the Private Sector on 1 August 2016, after a draft on 5 May 2016 [3].

• A universal bank offers the full range of services: deposits, loans and other financial services.

• The guidelines allow a NOFHC (Non-Operative Financial Holding Company), which is a parent company that owns the bank but does no banking itself [3].

• Foreign investment of up to 74% is allowed in private sector banks.

Post offices

• They run National Savings Certificates (NSC), Kisan Vikas Patra and Sukanya Samriddhi (a savings scheme for the girl child).
• They reach remote villages with no bank branch. This helps financial inclusion (bringing everyone into the formal financial system).

Development finance institutions (DFIs)

• DFIs give long-term credit to sectors that are too risky for ordinary commercial banks [6].
• They do not accept public deposits. They raise money from the market, the government and multilateral bodies like the World Bank, often with government guarantees [6].

Institution	Year	Role
IFCI	1948	First DFI. Funds industry such as power and textiles
NABARD	1982	Refinances banks that lend for farming, village industries and rural infrastructure
EXIM Bank	1982	Export-import finance
NHB	1988	Housing finance
SIDBI	1990	Small industries (MSMEs)
NaBFID	2021	Infrastructure financing

• Refinance means NABARD usually does not lend straight to farmers. It gives funds to the banks that lend to farmers, so their lending costs less.
• NABARD, EXIM Bank, NHB, SIDBI and NaBFID are the RBI-regulated all-India financial institutions (AIFIs). RBI's power over them comes from Sections 45L and 45N of the RBI Act, 1934 [2].

NaBFID: the newest link between finance and physical infrastructure

• Set up under the National Bank for Financing Infrastructure and Development Act, 2021. The Bill was introduced in the Lok Sabha on 22 March 2021 [6].
• Started in April 2021 as India's fifth AIFI [7].
• Authorised share capital: ₹1 lakh crore [6].
• Ownership: the Centre owns 100% at first. This may later fall to 26% [6].
• Two kinds of goals [6]:
• Financial: lend, invest or attract investment for infrastructure projects wholly or partly in India.

• Developmental: help build the market for bonds, loans and derivatives used in infrastructure financing.

• It supports long-term non-recourse infrastructure finance [7]. In a non-recourse loan, the lender is repaid only from the project's own earnings, not from the sponsor's other assets.

Ancient precedent

• Temples worked like banks in early India. They lent to artisans, merchants and local governments, including for infrastructure. But they did not take deposits from the public.
• Loan contracts were cut on copper plates, for example the Pandya kingdom plates.
• A 13th-century inscription from Kodumbalur (Tamil Nadu) records communities that borrowed from the Tirumudukunramudaiya-Nayanar temple and agreed to pay interest.

Don't confuse with

• Physical infrastructure: roads, railways and telecom. These are real assets. Financial infrastructure is the money network that funds them.
• Development finance institution (DFI) vs commercial bank: a commercial bank takes public deposits. A DFI does not. It raises long-term money from markets, the government and multilateral bodies [6].
• Payments bank vs commercial bank: both take deposits, but a payments bank cannot lend.
• IFSCA vs sector regulators: RBI, SEBI, IRDAI and PFRDA each cover one sector across India. IFSCA covers all sectors, but only inside GIFT IFSC [4].

Prelims Hooks

• Financial infrastructure = the network of banks, payment systems, stock markets and other financial institutions. It moves money between households, firms and government (NCERT Class 7).
• DFIs do not accept public deposits. They raise funds from markets, the government and multilateral bodies [6].
• The five RBI-regulated AIFIs are NABARD, EXIM Bank, NHB, SIDBI and NaBFID. Trap: IFCI (1948) was India's first DFI but is not one of them. RBI's power comes from Sections 45L and 45N of the RBI Act, 1934 [2].
• NaBFID (2021 Act) has authorised capital of ₹1 lakh crore. Government holding may fall from 100% to 26% [6].
• IFSCA is the unified regulator for GIFT IFSC. It was set up under the IFSCA Act, 2019 and has worked since April 2020 [4][5].
• RBI's on-tap licensing guidelines for universal banks in the private sector are dated 1 August 2016 [3].

Mains Points

• Banks vs DFIs for infrastructure (GS-III):
• Banks fund long-term projects with short-term deposits. This is an asset-liability mismatch (the bank's loans are long, but the money it owes depositors can be taken back soon).
• This mismatch added to the NPA problem of the 2010s.

• NaBFID tackles this. It raises long-term money and builds the infrastructure bond market [6][7].

• Financial inclusion needs many channels:

• Post offices, RRBs, small finance banks and payments banks reach people that big commercial banks miss.
• NABARD's refinance brings credit to farming and village industries.

• Schumpeter's point adds to this: banks create credit, so wider access to credit supports new businesses (link to Start-up India and MSME credit through SIDBI).

• Regulatory design:

• India has sector-specific regulators: RBI, SEBI, IRDAI and PFRDA.
• GIFT IFSC has one unified regulator, IFSCA.
• The trade-off: separate regulators bring deep knowledge of each sector. One unified regulator gives simpler rules and a single window for global finance [4].

Related concepts

• Financial sector
• Financial intermediation
• Commercial banks
• Private sector banks
• Development finance institution

Read more

• The financial system: banks and other institutions