Indian Financial System – NISM Series XA Short Notes (Part 2)
Welcome to Part 2 of the PassNISM short notes series for NISM Series XA – Investment Adviser (Level 1). In this post, we cover the Indian Financial System — one of the most foundational and frequently tested topics in the NISM XA exam. You will learn about financial markets, regulators, instruments, and institutions that form the backbone of India's economy.
← Back to Part 1: NISM XA Overview
What is the Indian Financial System?
The Indian Financial System is the set of institutions, markets, instruments, and regulations that enable the flow of funds between savers (surplus units) and borrowers or investors (deficit units). It mobilises savings and channels them into productive investments across the economy.
The financial system consists of four major components:
- Financial Institutions – Banks, NBFCs, insurance companies, mutual funds
- Financial Markets – Capital markets, money markets, forex markets, derivatives markets
- Financial Instruments – Equity shares, bonds, mutual fund units, derivatives
- Financial Regulators – SEBI, RBI, IRDAI, PFRDA, MCA
Key Financial Regulators in India – NISM XA Must Know SEBI – Securities and Exchange Board of India
SEBI was established in 1988 and given statutory powers through the SEBI Act, 1992. It is the primary regulator of India's securities market. SEBI regulates:
- Stock exchanges (NSE, BSE)
- Brokers, sub-brokers, and depository participants
- Mutual funds and portfolio managers
- Investment advisers and research analysts
- Collective investment schemes
SEBI's three core objectives are investor protection, market development, and market regulation.
RBI – Reserve Bank of India
RBI was established under the Reserve Bank of India Act, 1934. It is India's central bank and regulates:
- Commercial banks and cooperative banks
- Non-Banking Financial Companies (NBFCs)
- Monetary policy and interest rates
- Foreign exchange markets (FEMA)
- Government securities (G-Secs)
IRDAI – Insurance Regulatory and Development Authority of India
IRDAI regulates the insurance sector in India. It was established under the IRDAI Act, 1999. It oversees life insurance companies (LIC, HDFC Life, etc.) and general insurance companies.
PFRDA – Pension Fund Regulatory and Development Authority
PFRDA regulates pension products in India, particularly the National Pension System (NPS). It was established under the PFRDA Act, 2013.
MCA – Ministry of Corporate Affairs
The MCA regulates company law matters in India through the Companies Act, 2013. It oversees corporate governance, insolvency (NCLT/NCLAT), and company registration.
Financial Markets in India Money Market
The money market deals with short-term borrowing and lending of funds, typically for a period of one year or less. It provides liquidity to the economy.
Key money market instruments:
- Treasury Bills (T-Bills) – Short-term government securities issued at a discount; maturities of 91 days, 182 days, and 364 days
- Commercial Paper (CP) – Short-term unsecured promissory note issued by creditworthy companies; minimum amount ₹5 lakh
- Certificate of Deposit (CD) – Fixed deposit issued by banks in the form of a certificate; tradable in the secondary market
- Call Money – Overnight or short-term borrowings between banks
- Repo and Reverse Repo – RBI's tool to manage liquidity; the Repo Rate is the rate at which RBI lends to banks; Reverse Repo is the rate at which banks park funds with RBI
- CBLO (Collateralized Borrowing and Lending Obligation) – Short-term instrument used between financial institutions, now replaced by TREPS (Tri-Party Repo)
Capital Market
The capital market deals with long-term securities — both equity and debt — with a maturity of more than one year. It is divided into:
Primary Market
Where new securities are issued for the first time. Examples include IPO (Initial Public Offering), FPO (Follow-on Public Offer), Rights Issue, Private Placement.
Secondary Market
Where previously issued securities are traded among investors. Examples include the NSE and BSE stock exchanges. Price discovery happens here.
Forex Market
The foreign exchange market facilitates currency exchange. In India, it is regulated by RBI under FEMA (Foreign Exchange Management Act, 1999). Exchange rates are determined by demand and supply of currencies.
Derivatives Market
Derivatives are financial instruments whose value is derived from an underlying asset (equity, index, commodity, currency). Types include Futures, Options, Swaps, and Forward Contracts. In India, equity derivatives are traded on NSE (F&O segment).
Types of Financial Instruments
| Instrument | Nature | Risk Level | Returns |
|---|---|---|---|
| Equity Shares | Ownership | High | Variable (Dividend + Capital Gain) |
| Bonds / Debentures | Debt | Low to Medium | Fixed (Interest/Coupon) |
| Mutual Fund Units | Pooled Vehicle | Varies | Variable |
| Government Securities | Sovereign Debt | Negligible | Fixed (Coupon) |
| Treasury Bills | Discount Instrument | Negligible | Implicit (Discount) |
| Derivatives | Risk Management / Speculation | Very High | Variable |
Key Financial Institutions in India Scheduled Commercial Banks
Banks listed in the Second Schedule of the RBI Act. Includes public sector banks (SBI, PNB), private sector banks (HDFC, ICICI), foreign banks, and small finance banks.
Non-Banking Financial Companies (NBFCs)
Companies registered under the Companies Act that provide financial services but do not hold a banking license. Examples: Bajaj Finance, Muthoot Finance. They cannot accept demand deposits.
Depositories
Institutions that hold securities in electronic (dematerialised) form. In India, there are two depositories: NSDL (National Securities Depository Limited) and CDSL (Central Depository Services Limited). Investors access depositories through Depository Participants (DPs) such as brokers or banks.
Stock Exchanges
- NSE (National Stock Exchange) – Largest exchange by volume; uses the NIFTY 50 as benchmark index
- BSE (Bombay Stock Exchange) – Oldest exchange in Asia; uses the SENSEX (S&P BSE SENSEX) with 30 stocks
Clearing Corporations
They guarantee the settlement of trades. Key entity: NSE Clearing Limited (NCL) and Indian Clearing Corporation Limited (ICCL) for BSE.
Important Concepts – Quick Revision
- Gilt = Government Securities (G-Secs) — considered risk-free in India
- LAF (Liquidity Adjustment Facility) = RBI's mechanism to manage short-term liquidity using Repo and Reverse Repo
- SLR (Statutory Liquidity Ratio) = Minimum % of NDTL that banks must maintain in liquid assets (G-Secs, gold, etc.)
- CRR (Cash Reserve Ratio) = Minimum % of NDTL that banks must hold as cash with RBI; earns no interest
- FEMA 1999 = Governs foreign exchange transactions; violations are civil, not criminal (unlike FERA)
- PMLA 2002 = Prevention of Money Laundering Act; applies to all financial intermediaries including Investment Advisers
Indian Financial System – Case Study Type Questions
Q. Mr. Sharma wants to invest ₹50,000 for 3 months in a risk-free instrument. What should he choose?
Answer: A 91-day Treasury Bill is the most suitable option. It is issued by the Government of India, carries no default risk, is highly liquid, and matures in exactly 91 days. Alternatively, a bank FD or short-duration liquid mutual fund can also be considered.
Q. Which regulator would you approach if an insurance company mis-sold a ULIP to you?
Answer: IRDAI (Insurance Regulatory and Development Authority of India) regulates insurance companies, including complaints related to mis-selling of ULIPs and other insurance products.
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