FINANCIAL SYSTEM

Prof. N K JainJamia Hamdard

FINANCIAL SYSTEM

� The core function of the financial system is to facilitate the allocation and deployment of economic resources, both across the time and space, in an uncertain environment.

� The Financial system is changing due to innovation. Innovation may be by creating new products which serve an existing need or by using existing technology to serve new needs.

FINANCIAL SYSTEM

FINANCIALSYSTEM

FinancialInstitutions

FinancialMarkets

FinancialServices

FinancialInstruments

Six Core Functions of Financial System

� Provides a payment system for the exchange of goods and services.

� Provides a mechanism for the pooling of funds.� Provides a way to transfer economic resources through

time and across geographic regions and industries.� Provides a way to manage uncertainty and control risk.� Provides price information that helps coordinate

decentralised decision-making in various sectors of the economy.

� Provides a way to deal with the asymmetric-information problems when one party to a financial transaction has information that the other party does not.

FINANCIAL INSTITUTIONS

FINANCIALINSTITUTIONS

Regulatory Intermediaries Non-intermediaries Others

� Financial institutions change their structure over time and across geographical subdivisions to perform the functions of financial system more efficiently.

Classification of Financial Institutions

Transparent Translucent OpaqueGovt. Bond Unit Trusts FinanceMarket CompaniesStock Market Mutual Funds Insurance

CompaniesFutures and Pension Funds CommercialOptions Markets Banks

Financial Markets

Financial Markets

Capital Markets Money Markets

UnorganisedOrganised

SecondaryPrimary

Financial Markets

� The essential difference between money market and capital markets is based on the maturity of claims.

� Money market deals in short-term instruments i.e. maturity of less than one year e.g. Treasury Bill Market, Call Money Market and Commercial Bill Market.

� Capital market deals in longer maturity instruments e.g. Stock Markets and Government Bonds Markets

Capital Markets

� The capital markets comprises cash-flow cycle in which household savings are channeled into capital investment by firms and then returned to households via dividends, security repurchases and interest payments for consumption and recycling as new savings.

� Financial markets tend to be efficient institutional alternatives to intermediaries when the products have standardised terms, can serve a large number of customers and are easy to be understood by large number of customers.

� Intermediaries are better suited for low volume products.

Financial Services

Financial Services

Banks Mutual Funds

InvestmentCommercial

Non-acturialLife

Insurance

Property

Financial Instruments

Financial Instruments

Primary

Long TermMedium Term

Secondary

Short Term

Trade

� The Financial system makes it easy to trade.� People trade because they differ in what they have and

in what they want. The basis of trade is diversity. It makes room for specialisation.

� Trading makes ample economic sense. � Lending is also a form of trade. One gives up purchasing

power now in exchange for purchasing power in the future.

� Some people have purchasing power now but want purchasing power later.

� Others expect to have purchasing power later but want purchasing power now.

SAVINGS AND WEALTH

� Life-Cycle Pattern of saving: It refers to pattern of borrowing and repayment, saving and dis-saving, over a lifetime.

� Turning Wealth into Income: owners of wealth do not wish to exercise the purchasing power immediately

� Precautionary Reserve: assets held as protection against fluctuations in income or spending.

� Savers and holders of wealth are potential lenders.� Potential borrowers are businesses and households.

They need purchasing power now to invest for a long period.

SAVINGS AND WEALTH� Business Investment: All businesses make substantial

outlays before they start any earnings. Investment in fixed capital and working capital are both productive. They add to future income stream.

� Thus investment involve a timing problem. Without the purchasing power now, future rewards cannot be obtained.

� Household Investment: Investment in higher education, purchase of a house or a car either increase future cash flows or provide a stream of consumption services over time.

� Households face the same timing problem in making investment as do businesses.

GAINS IN TRADING OF BORROWING AND LENDING

� Savers and wealth-holders wish to trade current purchasing power in the future.

� Businesses and households need purchasing power now to finance investments.

� Borrowers gain because they expect to earn much more than the interest they may be required to pay on borrowings.

� Lenders gain because they get a better return than they could achieve otherwise.

Trade in Risk� Businesses and households face a variety of risks. Trade can

reduce the economic burden of these risks substantially. � Two principal form of risk mitigation

� insurance and forward transactionINSURANCE

� Insurance is particularly useful in case of accidents, illness and natural disasters.

� Reciprocal Insurance: An agreement whereby those facing a particular risk agree to share their losses. e.g. mutual aid and gift exchange

� External Insurance: An agreement whereby those who do not face a particular risk agree to share the losses of those who do.

� Insurance softens the blow of the loss. The benefit is more than the cost of the insurance.

Trade in Risk

� FORWARD TRANSACTIONS� This may be broadly referred to price risk � The

risk of an adverse change in market prices.� Price risk can be mitigated through forward

transaction. It is a transaction in which two parties agree in advance on the terms of trade to be carried out at a specified future time.

� The people who are willing to take other side of the trade may be either a hedger or speculator.

� Not all trade in risk is driven by the desire to reduce risk e.g. �Gambling and Lotteries�.

Difficulties Encountered in Lending

� A lender gives up purchasing power today in exchange for a promise of payment tomorrow. The borrower may not keep his promise.

� Lending is made after evaluating the potential reward against chance of loss due to default.

� A lender seeks information about the borrower before committing his funds:

� It is difficult for an individual to gather, analyse and evaluate the information for its reliability.

� Even after the screening if one decides to go ahead with lending, the transaction has to be recorded as an agreement. It may be difficult and expensive for an individual to do all this.

� Loan covenant safeguards the interest of the lender and restricts the borrower�s behaviour in various ways.

� Liquidity: Lender wishes that the loan to be as liquid as possible while a borrower wishes commitment of funds over a long period.

Summary of the Problems of Lending

� The cost of acquiring and processing information

� The cost of negotiating and writing a contract

� The incentive problems inherent in all lending arrangements

� The cost of establishing safeguards and of monitoring borrower compliance (transaction costs)

� Conflicting interests over liquidity

THE PROBLEMS OF TRADE IN RISK

� INSURANCE� Moral hazard: leads to tendency among the

insured to take more risk because they have insurance.

� Adverse selection: is due to tendency of worse risk to buy insurance and better risks not to.

� FORWARD TRANSACTIONS� Replacement risk is that a counter party to a

forward transaction will default and have to be replaced.

Innovation in Financial System

� Money: The first innovation in a financial system. It eliminated the inefficiencies associated with a barter system. It has facilitated in enlargement of markets over space and time.

� Warehouse bank: is a bank that keeps depositors� cash in storage. They allow depositors to make payments by transferring title to deposited cash rather than by transferring the cash itself. There is a one-to-one correspondence between deposits and cash in the banks� vault.

� Check: is an order to a bank to make payment from a deposit.

� Clearing: is collection process for checks drawn on one bank are offset against checks drawn on another.

Fractional-reserve Banking� It is a bank that holds reserves of cash equal to only a fraction of its

deposit liabilities. � A loan creates deposit for a borrower � This creation of deposits through lending changes the nature of

bank and bank deposit . � A deposit becomes no more of currency but it becomes a promise

by the bank to pay on demand a certain sum of rupees. � It is a claim on bank�s assets in general, rather than on any

particular sum of cash in vault. � This cash in vault becomes a general reserve which is a fraction of

the amount of deposits. � Commercial bank liabilities usually include several types of non

deposit sources of funds while their loans are broader in range comprising consumer, commercial and real estate loans

Indirect Lending and Financial Intermediaries

� Direct lending is lending by ultimate lender to ultimate borrower with no intermediary.

� Financial intermediary is an institution that borrows by issuing its own securities and relends the funds it raises.

� This process is also known as indirect lending.

Indirect Lending and Financial Intermediaries

� Cost of making loans by a bank is much less than direct lending due to following reasons:

� INFORMATIONAL ADVANTAGES� POOLING TO MAKE LARGE LOANS� GAINS FROM SPECIALISATION� ADVANTAGE OF A CONTINUING

RELATIONSHIP� DIVERSIFICATION REDUCES DEFAULT RISK� LIQUIDITY