Indian Financial System

28/04/2020 3 By indiafreenotes

The organization of the capital market in India presents a striking contrast to the institutional structure in the industrially advanced countries of the West. The rise of institutional finance for industry abroad has been the result mainly of institutionalization of personal savings through savings media like life insurance, pension and provident funds and unit trusts and so on.

The growth of institutional finance for industry in India has come largely through industrial financing institutions created by the government both at the national and regional levels, collectively referred to as development banks.

In other words, a pronounced feature of the system of industrial financing in India is the heavy domination of its structure by the development banks and the relatively minor role of the normal channels of financing.

As a result, industry has come to rely very heavily on the development banks as far as its financing requirements are concerned. In terms of their massive role development banks have out-grown their supplementary character of suppliers of finance in terms of their conception as ‘gap-fillers’.

It, undoubtedly, redounds to their credit that they have been able to channel sufficient funds into the productive system despite un-favourable conditions in the investment market.

The rigorous, exacting and detailed appraisal that development banks conduct is an integral part of term lending, tones up the quality of projects and ensures efficient use of available resources. Moreover, the evaluation of projects by them is objective and impersonal.

This has led to the availability of funds to varied types of enterprises, in particular new or relatively new firms of industries. The provision of financial facilities to such enterprises is of special significance at the present stage of India’s industrialization.

The relevance of the development banks in the industrial financing system is not merely quantitative; it has overwhelmingly qualitative dimensions in terms of their promotional and innovational function.

With the evolution of a meaningful industrial strategy, the accent in financing by the development banks is geared so that industrial development would sub-serve the basic economic objectives of balanced regional development, growth of new entrepreneurial talents and small enterprises and development of indigenous industrial technology, and thus, contribute to the emergence of a widely-diffused yet viable process of industrialization consistent with the socio-economic objective of State policy.

The development banks, in fact, constitute the backbone of the Indian capital market.

This overwhelming relevance of development banks in India notwithstanding their phenomenal growth and the massive reliance of industry on them in consequence have far-reaching implications in so far as the ability of the market to cope with the future requirements of the accelerated programmes of industrial development is concerned.

The present experience of the supply of industrial capital gives a distorted view of this ability. This ‘distortion’ has, inter alia, two serious dimensions.

The first aspect of this ‘distortion’ relates to the real ability of the financing system to cope with the growing requirements of an expanding corporate sector of private industry resulting from accelerated program of industrial development under the five-year plans.

The relevance of capital markets to economic development is based on mobilization of savings and their distribution to productive enterprises. These two interrelated functions are a sine-qua- none of an efficient capital market.

Judged in these terms development banks play rather partial and limited role and a system of industrial financing so heavily dominated by them as the one in India has certainly failed to grow pari-pasu with the planned growth of industry.

This is because the development banks, as financial intermediaries, are essentially distributive agencies as they derive most of their funds from their sponsors and, to that extent, a divorce between collection of savings and their allocation has come into being.

This is a serious obstacle to the growth of an autonomous financing system in the sense of equilibrium between the demand for, and supply of, capital funds. Attention to this weakness of the Indian capital market was drawn in the following words:-

“A weakness of the present institutional structure with its heavy dependence on special institutions is that the system is not organically linked to the ultimate source of savings and depends a little too much on ad-hoc allocation from the treasury. It will be desirable to forge links between the distributory mechanism, on the one hand, and the normal channels of savings on the other, so that the distributing mechanism becomes increasingly capable of growing autonomously with the needs of the economy on the basis of available savings.”

The domination of the institutional structure of the capital market by development banks in India has created yet another serious ‘distortion’ in the form of financial practices of questionable prudence. Since the development banks provided most of the funds in the form of term loans, there is a preponderance of debt in the financial structure of corporate enterprises.

There is, of course, no doubt that term loans, as a form of financing, reduce the dependence of investment on the erratic stock exchanges and the detailed scrutiny of the loan agreement have the effect of promoting greater financial discipline among the borrowers, on the one hand, and more effective public control over the private enterprise, on the other, but the predominant position of debt capital has made the capital structure of the borrowing concerns lopsided and unbalanced and, on considerations of orthodox canons of corporate financing, highly imprudent.

The sympathetic and flexible attitude of development banks as public financial institutions in case of defaults arising out of temporary difficulties can, of course, permit a greater use of debt than is warranted by the traditional concept of a sound capital structure but it does not justify the unlimited use of debt capital as it is likely to jeopardize the future of the company itself.

The solution to the problem implicit in these distortions obviously lies in securing an organic link between the distributive mechanism and the ultimate pool of the savings of community.