FINANCIAL SYSTEM AND ITS COMPONENTS

INDIAN FINANCIAL SYSTEM

By: Dr. Silony GuptaAssistant Professor, Department of

MBA,Quantum School of Management,

Roorkee, Uttarakhand

FINANCIAL SYSTEM “Financial system", implies a set of complex and

closely connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the economy”.

is the system that allows the transfer of money between savers (and investors) and borrowers.

is the set of Financial Intermediaries, Financial Markets and Financial Assets.

helps in the formation of capital. meets the short term and long term capital

needs of households, corporate houses, Govt. and foreigners.

its responsibility is to mobilize the savings in the form of money and invest them in the productive manner.

FLOW OF FUNDS IN THE FINANCIAL SYSTEM

FUNCTIONS OF THE FINANCIAL SYSTEM To link the savers & investors. To inspire the operators to monitor the

performance of the investment. To achieve optimum allocation of risk

bearing. It makes available price - related

information. It helps in promoting the process of

financial deepening and broadening

ORGANIZATION / STRUCTURE OF FINANCIAL SYSTEM

Financial system

Financial Intermediaries

Financial Markets

Financial Assets

FINANCIAL INTERMEDIARIES

Come in between the ultimate borrowers and ultimate lenders

provide key financial services such as merchant banking, leasing, credit rating, factoring etc.

Services provided by them are: Convenience( maturity and divisibility), Lower Risk(diversification), Expert Management and Economies of Scale.

TYPES OF FINANCIAL INTERMEDIARIES

Financial Intermediaries

Banks NBFCsMutual Funds

Insurance Organizati

ons

TYPES OF FINANCIAL INTERMEDIARIES

1. COMMERCIAL BANKS

Collect savings primarily in the form of deposits and traditionally finance working capital requirement of corporates

With the emerging needs of economic and financial system banks have entered in to:

Term lending business particularly in the infrastructure sector,

Capital market directly and indirectly, Retail finance such as housing finance,

consumer finance…… Enlarged geographical and functional

coverage

2. NON-BANKING FINANCE COMPANIES (NBFC)

A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 engaged in the business of loans and advances, acquisition of shares/stocks/ bonds/debentures/securities issued by Government or local authority or other marketable securities of a like nature, leasing, hire-purchase, insurance business, etc.

Provide variety of fund/asset-based and non-fund based/advisory services.

Their funds are raised in the form of public deposits ranging between 1 to 7 years maturity.

Depending upon the nature and type of service provided, they are categorised into:

Asset finance companies Housing finance companies Venture capital funds Merchant banking organisations Credit rating agencies Factoring and forfaiting organisations Housing finance companies Stock brokering firms Depositories

3. MUTUAL FUNDS A mutual fund is a company that pools money

from many investors and invests in well diversified portfolio of sound investment.

issues securities (units) to the investors (unit holders) in accordance with the quantum of money invested by them.

profit shared by the investors in proportion to their investments.

set up in the form of trust and has a sponsor, trustee, asset management company and custodian

advantages in terms of convenience, lower risk, expert management and reduced transaction cost.

MUTUAL FUND OPERATION FLOW CHART

4. INSURANCE ORGANIZATIONS

They invest the savings of their policy holders in exchange promise them a specified sum at a later stage or upon the happening of a certain event.

Provide the combination of savings and protection

Through the contractual payment of premium creates the desire in people to save.

FINANCIAL MARKET

It is a place where funds from surplus units are transferred to deficit units.

It is a market for creation and exchange of financial assets

They are not the source of finance but link between savers and investors.

Corporations, financial institutions, individuals and governments trade in financial products on this market either directly or indirectly.

Financial Market

Money Market

Capital/ Securities Market

Secondary/ Stock Market

Primary Market

COMPONENTS OF FINANCIAL MARKET

MONEY MARKET A market for dealing in monetary assets of short

term nature, less than one year. enables raising up of short term funds for

meeting temporary shortage of fund and obligations and temporary deployment of excess fund.

Major participant are: RBI and Commercial Banks Major objectives: equilibrium mechanism for evening out short

term surpluses and deficits focal point for influencing liquidity in economy access to users of short term funds at reasonable

cost

COMPONENTS OF MONEY MARKET

Money Market

Call

Market

T-bills Market

Bills Market

CP Market

CD Market

Repo

Market

CAPITAL MARKET

A market for long term funds focus on financing of fixed investments main participants are mutual funds,

insurance organizations, foreign institutional investors, corporate and individuals.

two segments: Primary market and secondary market

PRIMARY/NEW ISSUE MARKET A market for new issues i.e. a market for

fresh capital. provides the channel for sale of new

securities, not previously available. provides opportunity to issuers of

securities; government as well as corporates.

to raise resources to meet their requirements of investment and/or discharge some obligation.

does not have any organizational setup performs triple-service function:

origination, underwriting and distribution.

SECONDARY MARKET/STOCK MARKET

A market for old/existing securities. a place where buyers and sellers of securities

can enter into transactions to purchase and sell shares, bonds, debentures etc.

enables corporates, entrepreneurs to raise resources for their companies and business ventures through public issues.

has physical existence vital functions are: nexus between savings and investments liquidity to investors continuous price formation

FINANCIAL INSTRUMENTS : THE COMMODITIES THAT ARE TRADED IN FINANCIAL MARKET ARE FINANCIAL ASSETS/SECURITIES OR INSTRUMENTS

Financial Instruments

Primary Securities

Indirect Securities Derivatives

PRIMARY SECURITIES

Securities issued by the non-financial economic units

Equity Shares: An equity share are the ownership securities. They bear the risk and enjoy the rewards of ownership.

Preference Shares: Holders enjoy preferential right as to: (a) payment of dividend at a fixed rate during the life time of the Company; and (b) the return of capital on winding up of the Company

Debentures: An creditorship security. Holders are entitled to predetermined interest and claim on the assets of the company.

Innovative Debt instruments: A variety of debt innovative instruments emerges with the growth of financial system to make them more attractive.

Participative Debentures: participate in the excess profits of the company after the payment of dividend.

Convertible debentures with options: Third party convertible debentures:

entitle the holder to subscribe to the equity of another firm at a preferential price.

Convertible debenture redeemable at premium: issued at face value with option to sell at premium.

Debt equity swap: offers to swap debentures for equity.

Zero coupon convertible notes : convertible in to shares and all the accrued /unpaid interest is forgone.

Warrants: entitles the holder to purchase specified number of shares at a stated price before a stated date. Issued with shares or debentures.

Secured premium notes with detachable warrants:

redeemable after lock-in period warrants entitle the holder to receive shares after

the SPN is fully paid no interest during lock-in period option to sell back SPN to company at par after lock-

in. no interest/ premium on redemption if option

exercised right to receive principal+interest in instalments, in

case of redemption after expiry of the term detachables required to be converted in to shares

within specified period.

Non -Convertible debenture with detachable equity warrants: option to buy a specified no. of share at a specified price and time.

Zero interest Fully Convertible debentures: carries no interest and convertible in to shares after lock-in period.

Secured zero interest partly convertible debentures with detachable and separately tradable warrants:

Having two parts Part A convertible at a fixed amount on the date of

allotment Part B redeemable at par after specified period

from date of allotment. Carries warrants of equity shares at a price to be

determined by company

Fully convertible debentures with interest(optional):

No interest for short period After that option to apply for equities at

premium without paying for premium. Interest is made from first conversion

date to the second/final conversion date

INDIRECT SECURITIES/FINANCIAL ASSETS: Issued by financial intermediaries. such as units of mutual funds, policies of

insurance companies, deposits of banks, etc.

Better suited to small investors Benefits of pooling of funds by

intermediaries Convenience, lower risk and expert

management.

DERIVATIVES

Derivative is a product whose value is derived from the value of one or more basic variables called base, in a contractual manner

The underlying asset can be equity/forex or any other assets.

The Securities Contracts (Regulation) Act, 1956 (SCIA) defined derivative to include-

1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.

2. A contract which derives its value from the prices, or index of prices, of underlying securities.

Derivatives

Forward Contract

Indirect Securities

Options

FORWARD CONTRACT

is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price.

At the end offsetting is done by paying the difference in the price.

FUTURE CONTRACT

is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price.

They are special types of forward contracts which are standardized exchange-traded contracts.

OPTIONS Contracts that give the buyer the right to

buy or sell securities at a predetermined price within/at the end of a specified period.

Two types - calls and puts. Calls give the buyer the right but not the

obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.

Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.