Ask NiyaA dynamic and efficient financial system plays a pivotal role in ensuring the efficient allocation of resources from surplus segments to deficit segments of the economy.
The financial system comprises financial markets, financial intermediaries, and various financial instruments.
A thriving economic structure needs a well-developed financial system with multiple intermediaries catering to diverse risk profiles.
The Indian financial sector is characterized by progressive liberal policies, vibrant equity and debt markets, and prudent banking norms.
A sound financial system contributes to increasing output by shifting the economic system towards its production frontier.
This is achieved by transforming total wealth into more productive forms of capital and investment.
It encourages the public and investors to reduce holdings in non-financial assets like precious metals, real estate, and cash, and to instead invest in financial instruments such as bonds, shares, units, and preference shares.
The financial system enables deficit-spending units to undertake greater investment by improving access to capital.
This expansion in capital access increases the overall volume of investments in the economy.
It also reduces the cost of finance and investment risk by offering services such as insurance, hedging, and financial products like remittances, discounting, acceptance, and guarantees.
Beyond stimulating investment, a robust financial system improves allocational efficiency of resources across different investment channels.
This ensures that capital is directed toward the most productive uses in the economy, thus boosting overall economic efficiency.
The capital market is a crucial segment of the financial system, focused on long-term financial assets.
It is broadly classified into two major segments:
(i) Primary Market – where new securities are issued, typically through underwriting mechanisms.
(ii) Secondary Market – where existing securities are traded on platforms like stock exchanges or over-the-counter markets.
The capital market includes various sub-markets:
(i) Stock or equity market
(ii) Debt market
(iii) Derivatives market
(iv) Foreign exchange market
(v) Commodity market
These markets facilitate the buying and selling of diverse financial instruments and services by corporations, financial institutions, governments, and individual investors.
The demand and supply sides of these markets involve participants such as banks, brokers, dealers, lenders, savers, and financial agents, interconnected through laws, contracts, and communication networks.
The fundamental role of the capital market is to channel surplus funds from investors to entities with funding needs.
The Securities and Exchange Board of India (SEBI) regulates the capital market to protect investors and prevent fraud.
India’s capital market reforms began post-1991 balance of payments crisis, with the aim of building a diversified and efficient financial system.
Pre-reform characteristics included:
(i) State-owned banks held 90% of bank assets, primarily funding government borrowing.
(ii) Interest rates were set administratively and credit allocation was government-controlled.
(iii) Capital markets were underdeveloped and fragmented, with stock exchanges operating in favor of members.
(iv) No derivatives market existed and capital controls restricted external borrowing by firms.
The 1997–98 Asian Financial Crisis prompted further financial system strengthening to avoid contagion effects.
Key reform principles included:
(i) Mitigate financial system risks
(ii) Ensure efficient allocation of resources to the real sector
(iii) Enhance global competitiveness of the financial system
(iv) Liberalize the external sector
The overarching objective was to improve resource allocation via operational flexibility, financial viability, and institutional strengthening.
The capital market facilitates the transfer of financial assets from savers to investors, playing a key role in the overall financial system.
It provides liquidity, which refers to the ease with which an asset can be converted to currency without loss of value.
A side benefit of a capital market is that the transaction price offers a market-determined value for assets.
The major functions of capital market include:
(i) Disseminating information efficiently
(ii) Enabling quick valuation of financial instruments
(iii) Providing insurance against market risk and price risk
(iv) Enabling wider participation
(v) Providing operational efficiency through simplified transaction procedures
(vi) Lowering settlement timing and transactional costs
The capital market also fosters integration across sectors and instruments — connecting real and financial sectors, equity and debt, short-term and long-term funds, as well as public and private capital.
It directs the flow of funds through investment, disinvestment, and reinvestment to ensure efficient capital allocation.
Some selective roles of the capital market are:
(i) Mobilisation of Savings: The capital market mobilises idle monetary resources and channels them into productive investments, activating economic potential.
(ii) Acceleration of Capital Formation: Through mobilisation of savings, it contributes to capital formation by making funds available for sectors like agriculture and industry.
(iii) Provision of Investment Avenue: It offers long-term investment options with competitive returns via instruments like bonds, equities, mutual funds, and insurance policies.
(iv) Speed up Economic Growth and Development: By supporting research, infrastructure, and employment generation, it enhances national productivity.
(v) Proper Regulation of Funds: Beyond mobilisation, it ensures qualitative allocation of capital through regulation and strategic direction.
(vi) Service Provision: It offers financial services such as underwriting, consultancy, export finance, and medium to long-term loans to industries.
(vii) Continuous Availability of Funds: As a liquid and active platform, it supports ongoing access to funds for long-term investments through stock exchanges.
Capital market transactions are primarily linked to stock exchanges, ensuring ease of marketability and liquidity for both buyers and sellers.
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