Indian Financial System: Structure, Functions and Institutions for RBI Grade B Finance

Last updated: 2026-11-13 · MockMentor

"Structure and Functions of Financial Institutions" is the first line of the Financial System unit in the RBI Grade B Phase 2 Finance syllabus. It is the foundation for almost every other Finance chapter: once you know how savings move from households to businesses and government, and which institution sits where, topics such as banking, markets and regulation fall into place. Questions range from the components of the financial system to descriptive questions on its role in growth and its weak spots.

In one line: the financial system is the network of institutions, markets, instruments and services that collects savings and channels them into productive investment, under the watch of RBI, SEBI, IRDAI, PFRDA and IFSCA.

Basic concepts

• Financial system: the set of institutions, markets, instruments, services and rules through which money flows from those who have surplus funds (savers) to those who need funds (borrowers and investors).
• Surplus and deficit units: households usually save more than they spend and are surplus units; firms and the government usually spend more than they save and are deficit units.
• Financial intermediation: the process in which an institution such as a bank takes money from savers and lends it to borrowers, taking on the risk and the work of checking borrowers.
• Disintermediation: savers and borrowers dealing directly through markets, for example a company raising money by selling bonds instead of taking a bank loan.
• Financial deepening: the growth of financial assets, credit and markets relative to the size of the economy, usually measured as a ratio to gross domestic product (GDP).
• Financial instrument: a contract that represents a claim on money, such as a deposit, a share, a bond or an insurance policy.

Why in News?

1. In October 2026, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) raised the repo rate by 25 basis points to 5.50% and moved its stance to "calibrated tightening", as inflation rose after a long benign phase.
2. RBI's final directions on capital for credit risk under the Basel III standardised approach, issued in April 2026, and its final expected credit loss (ECL) provisioning norms, issued in July 2026, will both apply from 1 April 2027.
3. The Financial Inclusion Index (FI-Index) of RBI rose to 70.0 for the year ended March 2026, driven mainly by greater use of formal financial services.
4. The Income-tax Act, 2025 came into force on 1 April 2026, replacing the Income-tax Act, 1961, with simpler language and a single "tax year" in place of the old previous year and assessment year.

Functions of the financial system

A sound financial system does much more than move money. Its main functions are:

1. Mobilising savings: it gives households safe and convenient places to keep their money, such as bank deposits, small savings schemes, mutual funds, insurance and pension funds.
2. Allocating capital: it directs savings to the projects that offer the best return for the risk taken. Banks screen borrowers; markets price shares and bonds.
3. Payments and settlement: it lets people and firms pay one another quickly and safely, through cash, cheques, cards, the Unified Payments Interface (UPI), National Electronic Funds Transfer (NEFT) and Real Time Gross Settlement (RTGS).
4. Pooling and sharing risk: insurance, derivatives and diversified funds spread risks across many people, so that no single person bears a large loss alone.
5. Providing liquidity: markets let investors turn long-term assets such as shares into cash quickly, which encourages them to invest in the first place.
6. Price discovery and information: market prices of shares, bonds and currencies carry information about the economy and the health of companies.
7. Monitoring and governance: lenders and shareholders watch how borrowers and managers use money, which improves corporate behaviour.
8. Supporting policy: monetary policy works through the financial system. A change in the repo rate reaches the economy only through banks and markets.

Why it matters for growth

Economists from Schumpeter to the modern growth literature have shown that a deeper financial system helps growth, because it raises the saving rate, lowers the cost of capital and directs money to more productive uses. India's experience fits this pattern: the spread of bank branches after nationalisation, the capital market reforms of the 1990s and the digital public infrastructure of the last decade each widened the flow of funds. The reverse also holds. A weak financial system, such as India's banks during the twin balance sheet problem of 2015 to 2018, holds back investment for years.

Components of the financial system

The financial system has five building blocks. They work together and the lines between them often blur.

Financial institutions

Banking institutions

Banks accept deposits that can be withdrawn on demand or by cheque, and use them to give loans. This deposit-taking role is what sets them apart and is the reason they are the most closely regulated part of the system. India's banking system includes:

• Scheduled commercial banks: public sector banks, private sector banks, foreign banks, regional rural banks, small finance banks and payments banks.
• Cooperative banks: urban cooperative banks, state cooperative banks and district central cooperative banks.
• Local area banks, of which very few remain.

Banks hold the largest share of financial assets in India. The detailed structure is covered in the banking system chapter.

Non-banking financial institutions

These institutions lend or invest but either do not take public deposits or take them under tight limits.

Formal and informal sectors

The formal sector is regulated and includes all the institutions above. The informal sector includes moneylenders, traders, landlords, chit funds that are not registered, and pawnbrokers. It charges high interest rates and offers no protection to borrowers. Shrinking the informal sector, especially in rural areas, has been a policy aim since the All India Rural Credit Survey of 1954, and the All India Debt and Investment Surveys show that its share in rural household debt has fallen over the decades but has not disappeared.

Financial markets

Financial markets can be grouped in several ways.

The money market, bond market, equity market and foreign exchange market each have their own chapter in this section.

Financial instruments

Instruments can be classified as:

• Primary or direct securities: issued directly by the user of funds to the saver, such as shares and debentures issued by a company.
• Secondary or indirect securities: issued by intermediaries, such as bank deposits, mutual fund units and insurance policies. The intermediary then invests in primary securities.
• By maturity: short term (treasury bills, commercial paper, certificates of deposit), medium term and long term (government bonds, shares).
• By nature of return: fixed return (bonds, deposits) and variable return (shares).
• Hybrid instruments: convertible debentures, preference shares and Additional Tier 1 (AT1) bonds, which share features of debt and equity.

A good instrument balances three things that investors care about: return, risk and liquidity. A savings account is liquid and safe but pays little; an equity share may pay much more but carries market risk.

Financial services

Financial services are the support activities that make the system work:

Regulators and the regulatory structure

India follows a sector-based model, in which each part of the system has its own regulator, coordinated by a council.

The Financial Stability and Development Council (FSDC), chaired by the Union Finance Minister, coordinates among regulators, and its sub-committee is chaired by the RBI Governor. The chapter on financial regulators covers each body in detail.

Evolution of the Indian financial system

Indicators of the financial system

The depth and health of the system are judged through indicators such as:

• Credit to GDP ratio: bank and total credit to the private sector as a share of GDP. India's ratio is lower than in China and most advanced economies, which suggests room to grow.
• Market capitalisation to GDP: the value of listed companies relative to GDP; India's ratio has been above 100% in recent years.
• Gross non-performing assets (GNPA) ratio: the share of bad loans in total loans; Indian banks' GNPA ratio fell from over 11% in 2018 to around 2% to 2.5%, a multi-year low.
• Capital to risk-weighted assets ratio (CRAR): banks' capital as a share of their risk-weighted assets; well above the regulatory minimum for the system as a whole.
• Financial inclusion measures: the FI-Index, accounts per adult and digital payment use.

Strengths of the Indian financial system

• A well-capitalised and profitable banking system after the clean-up of 2015 to 2020.
• Deep and well-run equity markets, with fast settlement (T+1) and a large and rising base of retail investors.
• World-leading digital payments through UPI, and digital public infrastructure such as Aadhaar, e-KYC (electronic know your customer), DigiLocker and the Account Aggregator framework.
• Strong regulators with a record of acting early, for example on unsecured consumer credit in 2023.
• Large foreign exchange reserves, which protect against sudden capital outflows.

Weaknesses and challenges

• Bank dominance: the corporate bond market is shallow, so firms depend heavily on banks, and banks carry most of the risk.
• Low credit penetration: many small firms and households still lack access to formal credit, and the MSME (micro, small and medium enterprises) credit gap remains large.
• Long-term finance: infrastructure needs long-term money, but banks raise short-term deposits, which creates a mismatch.
• Governance: frauds and governance failures in some banks, NBFCs and cooperative banks (such as the IL&FS default in 2018 and the PMC Bank case in 2019) show the cost of weak oversight.
• Household savings shifting: households have moved money from bank deposits to markets, which raises funding costs for banks.
• New risks: cyber attacks, fraud through digital channels, unregulated lending apps, climate risk and the rise of crypto assets and stablecoins.
• Interconnectedness: banks, NBFCs and mutual funds are linked through lending and investment, so stress in one can spread to others.

Way forward

1. Deepen the corporate bond market through better credit enhancement, easier rules for issuers and wider participation by insurance and pension funds.
2. Build long-term financing institutions such as NaBFID and strengthen the market for infrastructure investment trusts.
3. Use digital public infrastructure for credit, for example cash-flow based lending through the Account Aggregator framework and the Unified Lending Interface.
4. Keep supervision ahead of risks, including through the ECL framework, stress testing and close watch on NBFCs and fintech lenders.
5. Improve financial literacy and consumer protection, in line with the National Strategy for Financial Inclusion 2025 to 2030.
6. Prepare for climate-related financial risks through disclosure and stress testing.

Possible exam and interview questions

1. Explain the structure of the Indian financial system and the role of each of its components. How has it changed since 1991? (620 words)
2. "A well-developed financial system is a precondition for economic growth." Discuss with reference to India. (420 words)
3. Distinguish between financial intermediation and disintermediation. Why has disintermediation increased in India in recent years?
4. What are the main weaknesses of the Indian financial system, and what reforms would address them?
5. Interview: Should India move from many sector regulators to a single unified financial regulator?

Related reading: functions of RBI, financial regulators in India, and Indian money and financial markets.

More in Finance

• Functions of RBI
• Banking System
• Banking Reforms
• Financial Institutions
• Financial Regulators

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