Introduction to Indian Financial System

Indian Financial System Introduction

• A Financial System plays a vital role in the economic growth of a country• It intermediates between those who have surplus funds and those who need them• It is a complex, well integrated set of sub-systems of financial institutions, markets, instruments and services which facilitates the transfer and allocation of funds efficiently and effectively

Indian Financial System - Introduction

• Formal and informal Financial Sectors• Formal – Organized, institutional and regulated

system• Informal – Unorganized, flexible, low transaction

cost, minimal default risk, higher rate of interest• Interpenetration exists between formal and informal

systems in terms of operation, participation and nature of activities which in turn have led to their coexistence. Priority should be accorded to development of efficient formal financial system

Indian Financial System - Introduction

• Control – Formal financial system is controlled by Ministry of Finance, RBI, SEBI,IRDA and other regulatory bodies

• Informal financial system • Consists of moneylenders, group of persons

such as partnership firms, funds or associations, pawn brokers etc function under a system of their own rules

Indian Financial System - Introduction

• Formal Financial System• Institutions, Markets, Instruments and Services• Financial Institutions – Banking and Non- Banking. Banks

can accept deposits and give loans whereas Non-Banking Companies can give only loans unless specifically permitted by RBI to accept deposits. Development FIs, NBFCs, HFCs are major institutional purveyors of credit. Other specialized finance institutions are EXIM Bank, TFCI, IFDC, NABARD, NHB etc

• State Level FIs are SFCs, SIDC. Post reform there has been tremendous change in role and activity

Indian Financial System - Introduction

• Financial Markets• Mechanism enabling participants to deal in

financial claims. Markets provide a facility in which demand and supply interact to set a price for such claims

• Organized markets in India are Money market and Capital Market. Money Market is for short term securities and Capital Market is for long term securities which are those having maturity period of one or more years

Indian Financial System - Introduction

• Financial Markets are classified as Primary and Secondary markets

• Primary markets deal with new issues• Secondary markets deal with outstanding or

existing securities. There are two components – OTC market and Exchange traded market. Govt. securities market is OTC market where it is spot trade. In Exchange traded market, trading takes place over a trading cycle in stock exchanges.

Indian Financial System - Introduction

• Financial Instruments• Different Financial Instruments can be designed to

suit the risk and return preferences of different classes of investors

• Savings and Investments are linked through a wide variety of complex financial instruments known as “securities”. Securities are defined in the Securities Contracts Regulation Act (SCRA), as including shares, scripts, stocks, bonds, debentures or other marketable securities of a similar nature

Indian Financial System - Introduction

• Financial Securities are Financial Instruments that are negotiable and tradeable. They may be primary or secondary securities. Primary/Direct are directly issued by ultimate borrowers to ultimate savers such as shares, debentures. Secondary/Indirect are those that are issued by financial intermediaries to ultimate borrowers like Bank deposits, Mutual fund units, insurance policies etc

Indian Financial System - Introduction

• Financial Instruments differ in terms of marketability, liquidity, reversibility, type of options, return, risk and transaction costs. Financial instruments help financial markets and financial intermediaries to perform the important role of channelizing funds from lenders to borrowers.

Indian Financial System - Introduction

• Financial Instruments• It 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.

• FIs represent paper wealth shares, de mat shares, debentures, bonds and notes.

• FIs are marketable

Indian Financial System - Introduction

• Financial Services are those that help in:• Borrowing• Funding• Lending• Investing• Buying• Selling • Enabling payments and settlements• Managing Risk exposures in financial markets

Indian Financial System - Introduction

• Intermediating services link the saver and borrower which in turn leads to capital formation

• Liquidity is essential for smooth functioning of a financial system. It is enhanced through trading in securities

• Liquidity is provided by brokers who act as dealers by assisting sellers and buyers and also market makers who provide buy and sell quotes

Indian Financial System - Introduction

• The producers of financial services are financial intermediaries such as banks, insurance companies, mutual funds and stock exchanges. They provide key financial services such as merchant banking, leasing, hire purchase and credit rating. These services bridge the gap between lack of knowledge on the part of investors and the increasing sophistication of financial instruments & markets

Indian Financial System - Introduction

• Financial Services are vital for creating of firms, industrial expansion and economic growth

• Before investors lend money, they need to be reassured that it is safe to exchange securities for funds.

• The financial regulators provide this reassurance. The regulator regulates the conduct of issuers of securities and the intermediaries to protect the interests of investors in securities and increases their confidence in markets.

Indian Financial System - Introduction

• RBI regulates the Money market• SEBI regulates the Capital market• Securities Market is regulated by DEA, DCA, RBI and

SEBI• A high-level committee on capital and financial

markets coordinates the activities of these agencies• Intermediation among the above components• Interdependent – All four coordinate continuously• Interactive – leads to development of a smoothly

functional system

Indian Financial System - Introduction

• Close Links – with the financial markets in economy

• Competing with each other – Financial Intermediaries rely on financial markets to raise funds whenever the need arises. This increases the competition between financial markets and financial intermediaries for attracting investors and borrowers

Indian Financial System - Introduction

• Functions of a Financial System• Link Savers and Investors• Help in mobilizing and allocating the savings efficiently and

effectively• Monitor Corporate Performance• Provide payment and settlement systems• Optimum allocation of risk-bearing and reduction• Disseminate price related information• Offer portfolio adjustment facility• Lower the cost of transactions• Promote the process of financial deepening and broadening

Indian Financial System - Introduction

• Key element of a Financial System• Strong legal and regulatory environment• Stable money• Sound public finances and public debt

management• A Central Bank• Sound banking system• Information system• Well functioning securities market

Indian Financial System - Introduction

• Financial System Designs• Bank based – bank dominated system where

few large banks play a dominant role and stock market is not important (Germany)

• Market based – Financial markets play an important role while the banking industry is much less concentrated (US)

Indian Financial System - Introduction

• Nature and Role of Financial Institutions (Intermediaries) and Financial Markets

• Liability, Asset and size transformation• Maturity transformation• Risk transformation

Indian Financial System – Introduction

• Financial Intermediaries• Liability, asset and size transformation consisting of

mobilization of funds and their allocation by providing large loans on the basis of numerous small deposits

• Maturity transformation by offering the savers tailor-made short-term claims or liquid deposits and so offering borrowers long-term loans matching the cash flows generated by their investment

• Risk transformation by transforming and reducing the risk involved in direct lending by acquiring diversified portfolios

Indian Financial System - Introduction

• Financial Markets• These are a mechanism for the exchange

trading of financial products under a policy framework.

• Money market – a market for short term debt instruments

• Capital market – a market for long term equity and debt instruments

Indian Financial System - Introduction

• Segments • Primary – a market for new issues• Secondary – a market for trading outstanding

or existing securities

Indian Financial System - Introduction

• Functions of Money Markets• To serve as an equilibrating force that redistributes cash

balances in accordance with liquidity needs of the participants

• To form a basis for the management of liquidity and money in the economy by monetary authorities and

• To provide reasonable access to the users of short-term money for meeting their requirements at realistic prices

• As it facilitates conduct of monetary policy, it is a very important segment of financial system

Indian Financial System - Introduction

• Functions of Capital Markets• Mobilize long-term savings to finance long-term

investments• Provide risk capital in the form of equity or quasi-equity

entrepreneurs• Encourage broader ownership of productive assets• Provide liquidity with a mechanism enabling the investor to

sell financial assets• Lower the costs of transactions and information and • Improve the efficiency of capital allocation through a

competitive pricing mechanism

Indian Financial System - Introduction

• Money market and capital market• There is strong link between money market and

capital market• Financial institutions involved in capital market are

also involved in the money market• Funds raised in money market are used to provide

liquidity for long-term investment and redemption of funds in capital market

• Development of money market precedes the development of capital market

Indian Financial System - Introduction

• Link between Primary Capital Market and Secondary Capital Market

• Primary market is for new issues but volume, pricing and timing of new issues are influenced by returns in the stock market. Secondary market is for existing securities. A buoyant secondary market in turn induces investors to buy new issues if they think that is a good decision.

Indian Financial System - Introduction

• A 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 secondary market

Indian Financial System - Introduction

• Characteristics of Financial Markets• Large volume of transactions and the speed with

which financial resources move from one market to another

• Various segments – stock markets, bond markets- primary and secondary segments, where savers themselves decide when and where they should invest

• Scope for instant arbitrage among various markets and types of instruments

Indian Financial System - Introduction

• Highly volatile and susceptible to panic and distress selling as the behaviour of a limited group of operators can get generalized

• Dominated by financial intermediaries who take investment decisions as well as risks on behalf of their depositors

• Negative externalities are associated with financial markets. A failure in any one segment of these markets may affect other segments, including non-financial markets

• Domestic financial markets are getting integrated with worldwide financial markets. The failure and vulnerability in a particular domestic market can have international ramifications. Problems in external markets can effect the functioning of domestic markets.

Indian Financial System - Introduction

• Functions of Financial Markets

• Enabling economic units to exercise their time preference• Separation, distribution, diversification and reduction of

risk• Efficient payment mechanism• Providing information about companies. This spurs

investors to make inquiries themselves and keep track of the companies’ activities with a view to trading in their stock efficiently

• Transformation of financial claims to suit the preferences of both savers and borrowers