the financial system an introduction
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The Indian Financial System: An Introduction
IntroductionFinancial system intermideates between
the flow of funds belonging to those who save a part of their income and those who invest in productive assets.
It mobilizes and usefully allocates scarce resources of a country.
A financial system is a complex , well integrated set of sub systems of financial institutions, markets, instruments & services which facilitates the transfer and allocation of funds efficiently & effectively.
Indian Financial System
Indian Financial System
Formal / Organized Financial System
It is characterized by the presence of an organized, institutional and regulated system which caters to the financial needs of the modern spheres of economy.
Informal / Unorganized Financial System
It is an unorganized, non-institutional and non-regulated system dealing with traditional and rural spheres of the economy.
Indian Financial System
Formal Financial System
RegulatorsMoFSEBIRBI
IRDA
Components1. Financial Institutions
2. Financial Markets3. Financial Instruments4. Financial
Services
Informal Financial System
Individual money lenders
Group of persons operating as fundsPartnership firms
Pros and Cons of Informal Financial SystemAdvantages :
◦Low transaction cost◦Minimum default risk◦Transparency of procedures
Disadvantages :◦Wide range of interest rates◦Higher rates of interest◦unregulated
Financial InstitutionsThey are the intermediaries that
mobilize savings and facilitates the allocation of funds in efficient manner.
Classification of Financial Institutions :◦ Banking – Non-Banking◦ Term Finance◦ Specialized◦ Sectoral◦ Investment◦ State - Level
Banking & Non-banking◦ Banking : Creators and purveyors of credit ◦ Non-banking : Only purveyors. E.g.. DFIs,
NBFCs Term Finance
◦ IDBI, ICICI, IFCI, SIDBI, IIBI Specialized
◦ EXIM, TFCI, ICICI Venture, IDFC, NABARD, NHB Sectoral
◦ UTI, LIC, GIC Investment State – Level
◦ State Financial Corporations, State Industrial Development Corporations
Financial MarketTypes
◦Money Market Treasury Bills Call Money Market Notice Money Market Commercial Papers Certificate of Deposit
◦Capital Market Equity Market Debt Market
Segments◦Primary Market◦Secondary Market
Types
Capital Market
Equity Market
Primary Market
Secondary Market
Derivatives Market
Debt Market
Money Market
Treasury Bills
Call Money Market
Commercial Bills
Certificates of Deposits
Money Market It is market for short term debt
instruments.A highly liquid market.E.g. Call money market, certificates of
deposits, commercial paper and treasury bills
Functions :◦ Provide a balancing mechanism to even out
the demand for and supply of short-term funds◦ Provide a focal point for central bank
intervention for influencing liquidity and general level of interest rates in the economy
Capital Market It is a market for long-term securities like
equity or debt. Functions :
◦ Mobilize long term savings to finance long-term investments
◦ Enable quick valuation of financial instruments – both equity and debt
◦ Disseminate information efficiently for enabling participants to develop an informed opinion about investment, disinvestment, reinvestment or holding a particular financial asset.
◦ Provide liquidity with a mechanism enabling the investors to sell financial assets
Link Between Capital Market and Money MarketOften, financial institutions actively
involved in the capital market are also involved in the money market
Funds raised in the money market are used to provide liquidity for long-term investment and redemption of funds raised in the capital market
In the development process of financial markets, the development of the money market typically precedes the development of capital market
Primary Market and Secondary MarketThe primary market creates long-
term instruments for borrowings.The secondary market provides
liquidity through the marketability of these instruments.◦It is also known as stock market.
Link between Primary Market and Secondary MarketA buoyant secondary market is
indispensable for the presence of a vibrant primary capital market
The secondary market provides a basis for the determination of prices of new issues.
Depth of the secondary market depends on the primary market
Bunching of new issues affects prices in the secondary market.
Financial Instruments A financial instrument is a claim against a
person or an institution for payment, at a future date, of a sum of money and/or a periodic payment in the form of interest or dividend.
Many financial instruments are marketable as they are denominated in small amounts and traded in organized markets.
Distinct Features of financial instruments:◦ Marketable◦ Tradable◦ Tailor made
Financial Instruments
Term :Short
MediumLong
Type
Primary / Direct Securities
EquityPreferenceDebts and
Various Combinations
Secondary / Indirect
Securities
Time DepositsMF Units
Insurance Policies
Financial ServicesCategories of financial services:
◦Funds intermediation◦Payment mechanism◦Provision of liquidity◦Risk management ◦Financial engineering – E.g. off-balance sheet
items, development of synthetic securitiesNeed for financial services:
◦Borrowing and Funding◦Lending and investing◦Buying and selling securities◦Payments and settlements
Interaction among Financial System ComponentsInterdependent and interact
continuouslyInteractiveClose linkCompeting with each other
Functions of Financial SystemMobilize and allocate savingsMonitor corporate performanceProvide payment and settlement
system,Optimum allocation of risk –
bearing and reductionDisseminate price-related
informationPortfolio adjustment facility
Key Elements of well functioning Financial SystemStrong legal and regulatory
environmentStable money A central bankA sound banking systemAn information systemA well functioning security
market
Financial System DesignBank Based
◦A few large banks play a dominant role and the stock market is not important
◦E.g. Germany, IndiaMarket Based
◦Financial markets play an important role whole the banking industry is much less concentrated
◦US, UK
Bank Based :◦ Banks play a pivotal role in mobilizing
savings, allocation of capital, overseeing the investment decisions of corporate managers and providing risk management facilities
◦ It is tend to be stronger in countries where governments have a direct hand in industrial development.
Advantages:◦ Close relationship with parties◦ Provides tailor-made contracts◦ No free-rider problem
Disadvantages :◦ Retards innovation and growth◦ Impedes competition
Market Based◦ The securities markets share centre stage with
banks in mobilizing the society’s savings for firms, exerting corporate control and easing risk management
Advantages :◦ Provides attractive terms to both investors and
borrowers◦ Facilitates diversification◦ Allows risk sharing◦ Allows financing of new technologies
Disadvantages :◦ Prone to instability◦ Exposure to market risk◦ Free-rider problem
: Review Questions :1. Explain Financial System. “A financial
system is a well integrated system whose components / parts interact with each other” Explain.
2. Explain the functions and key elements of well functioning financial system.
3. Explain the types of various financial markets and their inter-relationship.
4. “A market-based financial system is preferable over a bank-based system”. Explain and Comment Critically.