The financial system: banks and other institutions

Detail

1. What the financial system is

• Financial infrastructure is the network of banks, payment systems, stock markets and other financial institutions (Class 7, Banks and the Magic of Finance).

• It moves money between three groups: households, firms and government.

• It works alongside physical infrastructure such as roads, railways and telecom.

• A physical project, like a highway, needs large funds.

• The financial system collects those funds and sends them to the project.

• Financial sector means the institutions and markets that collect money and decide where it goes. Main parts:

• Commercial banks, which take deposits and give loans
• Investment banks, which help companies raise money by selling shares and bonds
• Stock exchanges, where shares are bought and sold
• Foreign exchange market, where one currency is traded for another

2. Regulators in India

A regulator is a public body that makes rules for a part of the financial sector and supervises the firms in it.

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. Inside the IFSC, it does the jobs that RBI, SEBI, IRDAI and PFRDA do elsewhere [4].
• GIFT City is a multi-services Special Economic Zone (SEZ). It is 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].

3. Financial intermediation

• Financial intermediation means that banks stand between savers and borrowers.
• Savers have extra money. Borrowers need money.

• The bank pools (collects together) many small deposits and lends most of them out as loans.

• NCERT example:

• Navdeep deposits 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 is taken off the saver. Navdeep does not have to judge whether Rima can repay. The bank does that.
• Search costs fall. Savers and borrowers do not have to find each other.

• Many small sums become large loans. Many small deposits add up to loans for big projects.

• How the bank earns (worked example, illustrative):

• A bank pays depositors 6% a year and charges borrowers 10% a year.
• On ₹100 crore of deposits lent out, it earns ₹10 crore and pays out ₹6 crore.

• The spread (the gap between the loan rate and the deposit rate) is 4 percentage points, or ₹4 crore. This pays the bank's costs and gives it profit.

• Joseph Schumpeter said the banker is "not only a middleman". The banker is a "producer" of credit who helps entrepreneurs "transform ideas into reality".

• This links to credit creation. When a bank gives a loan, it creates a new deposit. So banks are part of the money-creating system (section 3 of the parent note).

4. Ancient precedent: temples as banks

• Temples worked like banks in early India.
• They did not take deposits from the public.

• They did lend to artisans, merchants and local governments, including for infrastructure.

• 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.

5. Commercial banks

• Commercial banks take deposits from the public and lend part of them. They are part of the money-creating system.
• Types (detailed structure in the banking-regulation-npas note):
• Public sector banks
• Private sector banks
• Foreign banks
• Regional Rural Banks (RRBs)
• Small finance banks, which lend mainly to small businesses and low-income groups
• Payments banks, which take small deposits and handle payments but cannot give loans

6. Private sector banks

• Private sector banks are majority-owned by private shareholders.
• Timeline:
• 1991: economic reforms opened banking to new private players.
• 1993: RBI guidelines licensed the first new private banks.

• 2016: on-tap licensing began, meaning RBI accepts applications at any time instead of only in rare rounds.

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

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

• The guidelines allow a NOFHC (Non-Operative Financial Holding Company) structure. This is a parent company that holds the bank but does not do banking itself [3].

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

7. Post offices

• Post offices offer small savings schemes:
• National Savings Certificates (NSC)
• Kisan Vikas Patra

• Sukanya Samriddhi (a savings scheme for the girl child)

• Their network reaches remote villages where there may be no bank branch. This matters for financial inclusion (bringing everyone into the formal financial system).

8. Development finance institutions (DFIs)

• A development finance institution (DFI) funds a particular sector with long-term credit.
• How DFIs differ from banks:
• DFIs lend for long periods to sectors whose risks are too high for ordinary commercial banks [6].
• Unlike banks, DFIs do not accept deposits from the public [6].
• They raise money from the market, the government and multilateral institutions such as the World Bank. They are often backed by 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 (roads, irrigation)
EXIM Bank	1982	Export-import finance
NHB	1988	Housing finance
SIDBI	1990	Small industries (MSMEs)
NaBFID	2021	Infrastructure financing

• Refinance means that NABARD does not usually lend directly to farmers. It gives funds to the banks that lend to farmers, which lowers their cost of lending.

9. All-India Financial Institutions (AIFIs)

• NABARD, EXIM Bank, NHB, SIDBI and NaBFID are the RBI-regulated all-India financial institutions [2].
• Legal basis: RBI regulates and supervises AIFIs such as NaBFID under Sections 45L and 45N of the RBI Act, 1934 [2].
• Trap: IFCI (1948) is the first DFI, but it is not one of the five RBI-regulated AIFIs.

10. NaBFID in detail

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

• Developmental: to 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.

Prelims Hooks

• Financial intermediation means banks pool savers' deposits and lend them to borrowers. The saver does not bear the borrower's default risk directly.
• 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. IFCI is not one of them. RBI's power comes from Sections 45L and 45N of the RBI Act, 1934 [2].
• NaBFID was set up under a 2021 Act. It has authorised capital of ₹1 lakh crore, and government holding may fall from 100% to 26% [6].
• IFCI (1948) was India's first DFI. NABARD and EXIM Bank both came in 1982. NHB came in 1988, and SIDBI in 1990.
• 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].
• Payments banks can take deposits but cannot lend. Commercial banks do both.
• Regulator pairs: RBI covers banks, NBFCs and payments. SEBI covers securities, IRDAI insurance and PFRDA pensions.
• In the Kodumbalur inscription (13th century, Tamil Nadu), borrowers from a temple agreed to pay interest. Temples lent money but did not take public deposits.

Mains Points

• Banks vs DFIs for infrastructure (GS-III):
• Banks fund long-term projects with short-term deposits. This creates an asset-liability mismatch.
• That mismatch contributed to the NPA problem of the 2010s.

• NaBFID fixes this by raising long-term money and building 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 do not.

• NABARD's refinance brings credit to farming and village industries.

• Schumpeter's view of banks:

• Banks do more than move savings around. They create credit, which funds new enterprise.

• Easier access to credit therefore supports growth and entrepreneurship (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 is expertise in each sector versus simpler rules and one window for global finance [4].