The financial system an introduction

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.