INDIAN FINANCIAL INSTITUTION AND MARKET

UNIT-1 INTRODUCTION TO FINANCIAL SYSTEM

Meaning of Financial system

Financial system refers to a set of complex and closely connected or interlinked financial
institutions or organized and unorganized financial markets, financial instruments, and which
facilitate the transfer of funds.
A financial system consists of institutional arrangements through which financial
surplus in the economy are mobilized from units having surplus funds and it is transferred to
units having financial deficit. Financial system is a total of financial institution, financial
markets, financial services, financial practices and procedures.

Financial dualism:
Financial systems of most developing countries are characterized by co-existence and co-
operation between the formal and informal financial sectors. This co-existence of two sectors is
commonly referred to as “Financial dualism.”

Definition of Financial System:

According to Amit, "Financial system is the integrated form of financial institutions, financial
markets, financial securities and financial services which aims is to circulate the funds in an
economy for economic growth."
According to amctheblogger, "Financial system is the set of interrelated and interconnected
components consisting financial institutions, markets and securities."

Features of Financial system

⊸ It is a set of inter related activities or services
⊸ Services are working together to achieve predetermined goals
⊸ The system allows transfer of money between savers and borrowers
⊸ It is applicable at global, regional and firm level
⊸ It includes financial institutions , markets , instruments, services , practices and transactions
⊸ The main objective is to formulate capital ,investment and profit generation.

Objectives of Financial system

1. To mobilize the resources.
2. To create link between savers and investors.
3. To establish a regular smooth and efficient markets.
4. To create assets for the use of people.
5. To encourage savings and investment.
6. To facilitate economic development of the country.
7. To facilitate for expansion of financial markets.
8. To promote for efficient allocation of financial resources.
9. To make sound decisions based on cash flow and available resources.
10. To establish financial control and clear accounting procedures which ensure that funds are
used for intended purposes.
Functions of Financial System
A good financial system serves in the following ways;

1. Savings Function
Public saving finds their way into the hands of those in production through the financial
system. The funds with the producers result in production of goods and services thereby
increasing society living standards. This is one of the important functions of a financial system is
to link the savers and investors and thereby help in mobilizing and allocating the savings
efficiently and effectively.
2. Liquidity Function
The term liquidity refers to ready cash or money and other financial assets which can be
converted into cash without loss of value and time. It provides liquidity in the market through
which claims against money can be resold by the investors and thereby assets can be converted
into cash at any time. This functions allows for the easy and fast conversion of securities into
cash.
3. Payment Functions
The financial system offers a very convenient mode for payment of goods and services.
Cheque system, credit card system etc are the easiest methods of payments. The cost and time of
transactions are drastically reduced.
4. Risk Functions
The term risk and uncertainty relates to futures which remains unknown for the investors
who expect future incomes through their savings. The mobilized savings are invested into
different productive activities; the investors are exposed to lower risk. This is mainly because of
the benefits or diversification that is available to even small investors.
5. Policy Functions
The government intervenes in the financial system to influence macroeconomic variables
like interest rates or inflation so if country needs more money government would cut rate of
interest through various financial instruments and if inflation is high and too much money is
available in the system, then government would increase the rate of interest.
6. Provides Financial Services
A financial system minimizes situations where the information is an asymmetric and likely
to affect motivations among operators or when one party has the information and the other
parties does not. It provides financial services such as insurance, pension etc and offers portfolio
adjustment facilities.
7. Lowers the Cost of Transactions
A financial system helps in the creation of a financial structure the lowers the cost of
transactions. This has a beneficial influence on the rate of return to savers. It is also reduces cost
of borrowing. Thus, the system generates an impulse among the people to save more.
8. Financial Deepening and Broadening
A well functioning financial system helps in promoting the process of financial deepening
and broadening. Financial deepening refers to an increase of financial assets as a percentage of
the Gross Domestic Product (GDP).Financial broadening refers to building an increasing number
and a variety of participants and instruments.
Other functions are
1. Pooling of Funds,
2. Capital Formation,
3. Facilitates Payment,
4. Provides Liquidity,
5. Short and Long Term Needs,
6. Risk Function,
7. Better Decisions,
8. Finances Government Needs,
9. Economic Development.

Functions of financial system are discussed in brief.

1. Pooling of Funds
In a financial system, the Savings of people are transferred from households to business
organizations. With these production increases and better goods are manufactured, which
increases the standard of living of people.
2. Capital Formation:
Business requires finance. These are made available through banks, households and different
financial institutions. They mobilize savings which leads to Capital Formation.
3. Facilitates Payment: The financial system offers convenient modes of payment for goods and
services. New methods of payments like credit cards, debit cards, cheques, etc. facilitates quick
and easy transactions.
4. Provides Liquidity: In financial system, liquidity means the ability to convert into cash. The
financial market provides the investors the opportunity to liquidate their investments, which are
in instruments like shares, debentures, bonds, etc. Price is determined on the daily basis
according to the operations of the market force of demand and supply.
5. Short and Long Term Needs
The financial market takes into account the various needs of different individuals and
organizations. This facilitates optimum use of finances for productive purposes.
6. Risk Function
The financial markets provide protection against life, health and income risks. Risk Management
is an essential component of a growing economy.
7. Better Decisions
Financial Markets provide information about the market and various financial assets. This helps
the investors to compare different investment options and choose the best one. It helps in
decision making in choosing portfolio allocations of their wealth.
8. Finances Government Needs
Government needs huge amount of money for the development of defense infrastructure. It also
requires finance for social welfare activities, public health, education, etc. This is supplied to
them by financial markets.
9. Economic Development
India is a mixed economy. The Government intervenes in the financial system to influence
macro-economic variables like interest rate or inflation. Thus, credits can be made available to
corporate at a cheaper rate. This leads to economic development of the nation.
 Structure of Indian Financial System or Components of Indian Financial System

The following are the four main components of Indian Financial System:
1. Financial Institutions
2. Financial Markets
3. Financial Instruments
4. Financial Services

Financial Institutions
Financial institutions are the intermediaries which facilitate smooth functioning of the
financial system by making investors and borrowers meet. They mobilize savings of the surplus
units and allocate them in productive activities promising a better rate of return. Financial
institutions also provide services to entities seeking advice on various issues ranging from
restructuring to diversification plans.
Meaning of Financial Institutions
Financial institutions or financial intermediaries are those institutions, which provide financial
services and products which customers needs.
E.g. Customers not having skill to invest in equity market efficiently can invest money in Mutual
Funds and can avail the benefits of capital market. Financial institutions provide all those
financial provide all those financial services, which are available in financial system.
Benefits of Financial Institutions
The following benefits are enjoyed by an individual who invests through financial
intermediaries than involving directly in financial market.
a) Economy of Scale: When financial institutions are carrying out their investments or other
activities in large scale out of pooled funds, they can achieve economy of scale.
 b) Lower Transaction Cost: Because of economy of scale the cost of each transactions is much
lower than what it have been, if that transaction is carried on by individual investors on his own.
c) Diversification: As financial institutions are dealing in huge amounts of pooled funds, they
diversify their investments in such a way that the risk involved would reduce considerably.

Classification of Financial Intermediaries:

1) Capital market intermediaries: Those institutions that provide services only term funds to
individual and companies are called capital market intermediaries e.g. financial corporations,
investing institutions etc.
2) Money market intermediaries: Those institutions who provide only short term funds to
individuals and corporate customers are called money market intermediaries. E.g. Commercial
banks, Co-operative banks
3) Deposit taking organizations: These organizations accept deposits from investors and lend the
same to various entities. Investors are very familiar with these organizations as they deal with
them quite regularly.
4) Contractual savings organizations: These organizations enter long-term contracts with
investors. Typically, the contract involves receiving a series of periodic payments from investors
over a period of time. These companies manage the amount received carefully to adhere to the
terms of the agreement and to meet their part of obligations.
5) Investment type organizations: These companies accept money from investors to manage
money for their behalf. Normally it involves making a pool of investor’s money in investing it in
a portfolio of securities or assets to meet certain common investment objective of the clients.
Example: Mutual funds
6) Fee based intermediaries: These intermediaries do not become a party to the fund transfer
process, but just helps in the transfer. They help in providing information to either party about
availability of funds or need of funds and help in getting a match. They also help investors in
understanding various investment products, understanding risks, analyzing comparative facts and
making suitable choices in case of multiple options. They do not take the transactions on their
own books.
Functions of Financial Intermediaries/Institutions
Traditional Functions:
1) Accepting deposits from those who have it in surplus
2) Lending loans to those who have financial deficit
3) Underwriting of investments in share/debentures etc.
4) Dealing in secondary market activities.
5) Participating in money market instruments.
6) Involving in leasing, hire purchase, venture capital, seed capital.
7) Dealing in foreign exchange market activities.
8) Managing the capital issues.
9) Making arrangements for the placement of capital and debt instruments with investing
institutions.
10) Arrangement of funds from financial institutions for the client’s project.
11) Assisting in the process of getting all government and other clearances.
Modern functions:
1) Rendering project advisory services.
 2) Planning for mergers and acquisitions and assisting for their smooth carry on.
3) Guiding corporate customers in capital restructuring.
4) Acting as trustees to the debenture holders.
5) Structuring the financial collaboration joint venture by identifying suitable partner and
preparing joint venture agreement.
6) Rehabilitating and reconstructing sick companies.
7) Hedging of risks by using swaps and derivatives.
8) Managing portfolio of large public sector corporations.
9) Undertaking risk management services like insurance service, buy back options etc.
10) Advising the clients on best source of funding overall.
11) Guiding the clients in the minimization of the cost of debt.
12) Capital market services such as clearing, registration and transfers, safe custody of
securities, collection of income on securities.
13) Promoting credit rating agencies.
14) Recommending suitable changes in the management structure and management style with
a view of achieving better result.
Classification of Financial Institutions
⊸ The financial institutions are classified into term lending institutions, refinance
institutions, investment institutions and state level institution.
⊸ These are also classified into BANKING AND NON-BANKING institutions:
1. Banking Institutions: this type of institutions which involves in accepting public deposits
and lending the same to the needy customers. This are fundamentally established to earn
profit, secondarily to safeguard the interest of the members. The following are the types of
banking institutions which are running their business in India
Banking Institutions
a) Commercial Banks: these are also called as Business banks. The following are the types of
commercial banks.
 Public sector: type of commercial banks that are nationalized by the government of a
country. In public sector banks, the major stake is held by the government. In India, public
sector banks operate under the guidelines of Reserve Bank of India (RBI), which is the
central bank. Some of the Indian public sector banks are State Bank of India (SBI),
Corporation Bank, Bank of Baroda, Dena Bank, and Punjab National Bank.
 Private sector: a kind of commercial banks in which major part of share capital is held by
private businesses and individuals. These banks are registered as companies with limited
liability. Some of the Indian private sector banks are Vysya Bank, Industrial Credit and
Investment Corporation of India (ICICI) Bank, and Housing Development Finance
Corporation (HDFC) Bank.
 Regional rural banks (RRBs): Regional Rural Banks (RRBs) are Indian Scheduled
Commercial Banks (Government Banks) operating at regional level in different States
of India. They have been created with a view of serving primarily the rural areas of India
with basic banking and financial services. However, RRBs may have branches set up for
urban operations and their area of operation may include urban areas too.

The area of operation of RRBs is limited to the area as notified by Government of India
covering one or more districts in the State. RRBs also perform a variety of different
functions. RRBs perform various functions in following heads:
  Providing banking facilities to rural and semi-urban areas.
 Carrying out government operations like disbursement of wages of MGNREGA
workers, distribution of pensions etc.
 Providing Para-Banking facilities like locker facilities, debit and credit cards, mobile
banking, internet banking, UPI etc.
 Small financial banks.
 Foreign banks: commercial banks that are headquartered in a foreign country but operate
branches in different countries. Some of the foreign banks operating in India are Hong Kong
and Shanghai Banking Corporation (HSBC), Citibank, American Express Bank, Standard &
Chartered Bank, and Grindlay’s Bank. In India, since financial reforms of 1991, there is a
rapid increase in the number of foreign banks. Commercial banks mark significant
importance in the economic development of a country as well as serving the financial
requirements of the general public.
b) Co-operative banks: Cooperative bank is an institution established on the cooperative basis
and dealing in ordinary banking business. Like other banks, the cooperative banks are
founded by collecting funds through shares, accept deposits and grant loans. This are
established to safeguard the interest of its members. These are organized on a cooperative
basis ,accept deposit and lend money to the required members
Non-banking Institutions
⊸ These are financial institutions that provide banking services without meeting the legal
definition of a bank. These are not allowed to accept the deposits from the public not licensed
institutions.
⊸ The y are classified into Organized and Unorganized financial institutions :
 Provident and Pension Fund
 Small savings organization
 Life Insurance Corporation
 General Insurance Corporation
 Unit Trust of India
 Mutual Funds
 Investment Trust etc
FINANCIAL MARKETS
Financial market is a mechanism for the exchange trading of financial products under a policy
framework. It is an institution or arrangement that facilitates the exchange or financial
instruments like shares, debentures, loans etc. Financial market transactions may take place
either at a specific place or location, E.g. Bank, Stock Exchange, or through other mechanisms
i.e., electronic media.
Meaning of Financial market
A financial market is a market in which people and entities can trade financial securities,
commodities, and other fungible items of items of value at low transactions costs and at prices
that reflects supply and demand. Securities include stocks and bonds, and commodities include
precious metals or agricultural goods.
Characteristics of Financial Markets
1. Financial markets are characterized by a large volume of transactions and a speed with which
financial resources move from one market to market to another.
 2. There are various segments of financial markets such as stock markets, bond markets, primary
and secondary segments, where savers themselves decide when and where they should invest
money.
3. There is scope of instant arbitrage among various markets and types of instruments.
4. Financial markets are highly volatile and susceptible to panic and distress selling as
behaviour of a limited group of operators can get generalized.
5. Markets are dominated by financial intermediaries who take investment decisions as well as
risks on behalf of their depositors.
6. Negative externalities are associated with financial markets. A failure in any one segment these
markets may affect many other segments of the market, including the non-financial markets.
7. Domestic financial markets are getting integrated with worldwide financial markets. The failure
and vulnerability in a particular domestic market can have international ‘ramification’. Similarly,
problems in external markets can affect the functioning of domestic markets.
Role of Financial Markets
The role played by financial markets is as follows:
1. Transfer of Resources: Financial markets facilitate the transfer of resources from one person to
another.
2. Growth in income: Financial markets allow lenders earn interest/dividend on their surplus
investible funds, thus contributing to the growth in their income.
3. Productive Usage: Financial markets allow for the productive use of the funds used in financial
systems thus enhancing the income and the gross national production.
4. Capital Formation: Financial markets provide a channel through which new savings flow to aid
capital formation of a country.
5. Price Discovery: Financial markets allow for the determination of the price of the traded financial
asset through the interaction of different set of participants.
6. Sale Mechanism: Financial markets provide a mechanism for selling of a financial asset by an
investors so as to offer the benefits of marketability and liquidity of such assets.
7. Information Availability: The information generated in financial market is useful to various
parties taking part in financial market.
Classification of Financial Markets
Capital Market Money Market
1. Primary Market (New issue Market) 1. Call money market
2. Secondary market (Stock exchange) 2. Treasury Bills
3.Commercial papers
4.Certificate of deposits
5. Repurchase agreement
6.Reverse REPOs
7.Commercial bill market
8.Govt. securities market
9.Inter corporate deposits

A. Capital Market
The capital market is the place where the medium and long term financial needs of business
and other undertakings are met by financial institutions which supply medium and long term
funds resources to borrowers. These institutions may further be classified into investing
institutions and development banks on the basis of the nature of their activities and the financial
mechanism adopted by them. Investing institutions compromise those financial institutions
which garner the savings of the people by offering their own shares and stocks, and which
provide long term funds, especially in the form of direct investment banks in securities and
underwriting capital issues of business enterprises.
Meaning of capital market
Capital market is a place where the medium term and long term financial needs of business and
other undertakings are met by financial institutions which supply medium and long term
resources to borrowers.
Features of Capital Market
1. It deals in long and medium term funds.
2. It consists of primary and secondary markets and special financial institutions.
3. It covers both individual and institutional investors.
4. It makes funds available to industrial and commercial undertakings.
Need and Importance of Capital Market
1. It helps in mobilizing the savings on a large scale
2. It helps in the capital formation in the country
3. It helps in effective distribution of the mobilized funds for balanced development.
4. It provides continues market for long term funds.
Functions of Capital Market
The various functions and significance of capital market are discussed below:
1. Link between Savers and Investors
The capital market functions as a ,link between savers and investors. It plays an important role
in mobilizing the savings and diverting them in productive investment. In this way, capital
market plays a vital role in transferring the financial resources from surplus and wasteful areas to
deficit and productive areas, thus increasing the productivity and prosperity of the country.
2. Encouragement to Savings
With the development of capital market, the banking and non banking institutions provide
facilities, which encourage people to save more. In the less developed countries, in the absence
of a capital market, there are very little savings and those who save often invest their savings in
unproductive and wasteful directions, i.e., in real estate (like land, gold and jewellery) and
conspicuous consumption.
3. Encouragement to Investment
The capital market facilitates lending to the businessmen and the government and thus
encourages investment. It provides facilities through banks and non bank financial institutions.
Various financial assets e.g. shares, securities, bonds etc. include savers to lend to the
government or invest rate falls and investment increases.
4. Promotes Economic Growth
The capital market not only reflects the general condition of the economy, but also smoothens
and accelerates the process of economic growth. Various institutions of the capital market, like
non banking financial intermediaries, allocate the resources rationally in accordance with the
development needs of the country.
5. Stability in Security Prices
The capital market tends to stabilize the values of stocks and securities and thereby reduce the
fluctuations in the prices to the minimum. The process of stabilization is facilitated by providing
capital to the borrowers at a lower interest rate and reducing the speculative and unproductive
activities.
6. Benefits to Investors
The credit market helps the investors, those who have funds to invest in long term financial
assets, in many ways:
a) It brings together the buyers and sellers of sellers of securities and thus ensures the
marketability of investments.
b) It safeguards the interests of the investors by compensating them from the stock exchange
compensating fund in the event in fraud and default.
Classification of Capital market
1. Primary Market
2. Secondary Market
1. Primary Market
It is also called new issues market. In this market, funds are raised by industrial and
commercial enterprises from investors through the issue of shares, debentures and bonds.
The primary market is that part of the capital markets that deals with the issuance of new
securities. Companies, governments or public sector institutions can obtain funding through the
sale of new securities or bond issue. This is typically done through a syndicate of securities
dealers. The process of selling new issues to investors is called underwriting. In the case of a
new stock issue, this sale is an initial public offering (IPO).Dealers earns a commission that is
built into the price of the security offering; through it can be found in the prospectus.
Features of Primary Markets
a) This is the market for new long term capital. The primary market is the market where the
securities are sold for the first time. Therefore it is called the new issue market(NIM).
b) In a primary market, the securities are issued by the company directly to investors.
c) The company receives the money and new security certificates to the investors are directly
issued.
d) Primary issues are used by companies for the purpose if setting up new business or for
expanding or modernizing the existing business.
e) The primary market performs the crucial function of facilitating capital formation in the
economy.
f) The financial assets sold can be only redeemed by the original holder.
Function of Primary Market
1. Organisation: Primary Market deals with the origin of new issue. The proposal is analyzed in
terms of the nature of the security, the size of the issue, timings of the issue and floatation
method of issue.
2. Underwriting: Underwriting is a kind of guarantee undertaken by an institution or firm of
brokers ensuring the marketability of an issue.
3. Distribution: The third function is that of distribution of shares. Distribution means the
function of sale of shares and debentures to the investors. This is performed by brokers and
agents.
4. Household Savings: Companies raise funds in the primary market by issuing initial public
offerings (IPO). These stock offerings authorize a share of ownership in the company to the
extent of the stock value.
5. Global Investments: The primary market enables business expansion and growth for
domestic and foreign companies. International firms issue new stocks-American Depository
Receipts (ADR’s) to the investors in the USA which are listed in American stock exchanges.
6. Sale of Government securities: The government directly issues securities to the public via
primary market to fund public works projects such as the constructions of roads, building,
schools etc. These securities are offered in the form of short term bills, notes that mature in two-
seven years.
Primary market issues can be classified into four types:
1) Initial Public offering (IPO)
2) Follow on Offer (FPO)
3) Rights Issue
4) Private Placement
2. Secondary Market
Secondary market is the market in which existing securities are bought and sold. Existing
securities are bought and sold in the stock exchanges with the help of brokers. The secondary
market is the financial market in which previously issued financial instruments such as stock,
bonds, options, and futures are bought and sold.
Functions of Secondary Market
The securities and other financial assets are traded through the authorized brokers. The functions
of stock exchanges are:
1. Market place for stock: Stock exchange provides a market place for selling and buying of
securities freely by the brokers for their clients.
2. Ready and continuous market: Stock exchanges provide ready and continuous market for
stocks and shares. This provides ready liquidity, price continuity and negotiability to the capital
locked up in securities.
3. Assessment of securities: The stock exchanges ensures correct appraisal of security. The free
play of demand for and supply of securities determines price continuously. The real worth of
securities is evaluated by free play at market force. All the concerned (investors, companies,
brokers) get information about the stock exchange operations through press, radio, television
etc.
4. Stock Exchanges Forecast the Future: Besides providing continuous market, stock exchanges,
render forecasting function. The price movements for securities reflect and forecast the future
happenings in business operations. The impending financial nor services boom or depression is
indicated in advance by stock exchanges. Very prompt signal is given by the stock exchange in
this direction.
5. Mobilization of savings: The stock markets are perfect markets where securities are
standardized, carrying costs are negligible, demand and supply play freely, limitless competitive
activity is in operation etc. which help to mobilize the savings of the people to productive
channels. Besides inducing public to save and invest in securities, the stock market promotes
capital formation and provides necessary funds to the needy industries. Capital formation and
disbursement is an automatic mechanism found in stock exchange.
7. Economic Barometer: Stock exchange indicates the health of the economy. Price trends on a
stock exchange reflect the economic progress and socio political conditions of a country. It
indicates the boom or depression prevailing in the country.
 8. Control of Corporate enterprises: To get the stocks and shares listed o stock exchanges the
companies have to follow certain rules and regulations LISTING means getting the name of the
company registered with the stock exchanges to deal with its securities officially on the
exchange.
9. Speculation: Speculation involves trading a financial instrument involving high risk, in
expectation of significant returns. The motive is to take maximum advantage from fluctuations in
the market. Description: Speculators are prevalent in the markets where price movements of
securities are highly frequent and volatile. These operators hold corporate securities new and old
for a temporary period.
10. Management of public deposit: The Government of India and all state governments are
engaged in planned economic development. Because of this planned growth, governments
require huge capital and they have to float loan, bonds and other securities to get a part of
finance for these projects. These securities are also dealt within the Stock Exchange.

Differences between Capital Market and Money Market

Sl.No. Capital Market Money Market

1. It deals with long term and It deals in short term funds.

medium terms funds.
2. It provides funds for fixed It provides funds for working
capital. capital.
3. It acts as a links between It creates a link between the
investors and industrial and depositors and borrowers.
commercial enterprises.
4. It arranges large amount of It arranges for small amount of
funds. funds.
5. Rate of interest is low. Rate of interest is high.

6. The primary market is that part The secondary market is the

of the capital markets that deals financial market in which
with the issuance of new previously issued financial
securities instruments such as stock, bonds,
options, and futures are bought and
sold.

7. It deals only with new or fresh It deals in existing securities, which

issues made by companies for are already issued by companies.
the first time.
8. No fixed geographical location Need fixed place for trading such as
for primary market. BSE.
9. All companies can enter Only those companies which have
primary market. issued securities in primary market
can enter.
10. Subject to regulations mostly Subject to regulation both from
from SEBI, Stock Exchanges, within and outside the company.
 Companies Act.
11. Creating long term instruments Providing liquidity for those
for savings and investments. instruments which are already
issued by companies.
12. Depth of primary market Depth depends upon the activities
depends on number and the of the primary market.
volume of issue of securities.

Definition of Money Market

1. According to the RESERVE BANK OF INDIA “money market is the centre for dealing,
mainly of short term character, in money assets; it meets the short term requirements of
borrowings and provides liquidity or cash to the lenders. It is the place where short term surplus
investible funds at the disposable of financial and other institutions and individuals are bid by
borrowers’ agent comprising institutions and individuals and also the government itself.”
2. According to Geoffrey, “money market is the collective name given to the various firms and
institutions that deals in the various grades of near money.”
Meaning of money Market
Money market refers to the market where money and highly liquid marketable securities are
bought and sold having a maturity period of one or less than one year. The money markets
constitute a very important segment of the Indian Financial System.
Objectives of Money Market
The following are the important objectives of a money market:
1.To provide a parking place to employ short-term surplus funds.
2.To provide room for overcoming short term deficits.
3.To enable the Central Bank to influence and regulate liquidity in the economic through its
intervention in this market.
4.To provide a reasonable access to the users of short term funds to meet their requirements
quickly, adequately and at reasonable costs.
5.To provide an equilibrium mechanism for ironing out short term surplus and deficits.
6.To provide a focal point for central bank intervention for the influencing liquidity in the economy.

Features of Money Market

1) It is market purely for short term funds or financial assets called near money.
2) It deals with financial assets having a maturity period up to one year only.
3) It deals with only those assets which can be converted into cash readily without loss
and with minimum transaction cost.
4) Generally transactions take place through phone that is oral communication. Relevant
documents and written communications can be exchanged subsequently. There is no formal
place like stock exchanges as in the case of a capital market.
5) Transactions have to be conducted without the help of brokers.
6) The components of a money market are the central bank, Commercial Banks, Non Banking
Financial companies, discount houses and acceptance house. Commercial banks generally play a
dominant role in this market.
 Functions of Money Market
A well developed money market is an essential for a modern economy. Through, historically,
money market has developed as a result of industrial and commercial progress, it also has
important role to play in the process of industrialization and economic development of a country.
1. Financing Trade: Money Market plays crucial role in financing both internal as well as
international trade. Commercial finance is made available to the traders through bills of
exchange, which are discounted by the bill market. The acceptance houses and discount markets
help in financing foreign trade.
2. Financing Industry: Money market contributes to the growth of industries in two ways
(a) Money market helps the industries in securing short term loans to meet their working capital
requirements through the system of the finance bills, commercial papers, etc.
(b) Industries generally need long term loans, which are provided in the capital market.
However, capital market depends upon the nature of and the conditions in the money market.
The short term interest rates of the money market influence the long term interest rates of the
capital market. Thus, money market indirectly helps the industries through its link with and
influence on long term capital market.
3. Profitable Investment: Money Markets enable the commercial banks to use their excess
reserves in profitable investment. The main objective of the commercial banks is to earn income
from its reserves as well as maintain liquidity to meet the uncertain cash demand of the
depositors. I the money market, the excess reserves of the commercial banks are invested in near
money assets which are highly liquid and can be easily converted into cash. Thus, the
commercial banks earn profits without losing liquidity.
4. Self-sufficiency of commercial banks: Developed money market helps the commercial banks
to become self-sufficient in this situation of emergency. When the commercial banks have
scarcity of funds, they need not approach the central banks and borrow at a higher interest rate.
On the other hand, they can meet their requirements by recalling their old short run loan from the
money market.
5. Help to Central Bank: Though the central bank can function and influence the banking
system in the absence of a money market, the existence of a developed money markets
smoothens the functioning and increases the efficiency of the RBI.
6. Money market helps the central bank in two ways: The short term interest rates of the
money market serves as an indicator of the monetary and banking conditions in the countries and
in this way guide the central bank to adopt an appropriate banking policy. The sensitive and
integrated money market helps the central bank to secure quick and widespread influence on the
sub markets, and thus achieve effective implementation of its policy.

Financial Instruments
Financial instruments are monetary contracts between parties. They can be created, traded,
modified and settled. They can be cash (currency), evidence of an ownership interest in an entity
(share), or a contractual right to receive or deliver cash (bond).
Short Term Instruments
1. Call Money Market
Call money market refers to a short term money market, which allows for large financial
institutions such as banks, mutual funds and corporations to borrow and lend money at interbank
 rates. The loans in the call money market are very short, usually lasting no longer than a week
and are often used to help banks meet reserve requirements.
2. Treasury Bills
Treasury bills are short term instruments issued by the RBI on behalf of the government to
tide over short term liquidity shortfalls. This instrument is used by the government to raise short
term funds to bridge seasonal gaps between its receipt (revenue and capital) and expenditure. In
other words T-Bills are short term borrowing instruments of the government of India which
enables investors to park their short term surplus funds while reducing their market risk.
3. Commercial Papers
Commercial papers is an unsecured short term instrument issued by the large banks and
corporations in the form of promissory note, negotiable and transferable by endorsement and
delivery with a fixed maturity period to meet the short term financial requirement. These are in
the form of promissory notes, drafts and certificate of deposits.
4. Certificate of Deposits
Certificates of deposits are unsecured, negotiable, short term instruments in bearer form,
issued by commercial banks and development financial institutions.
The scheme of CD’s was introduced by the RBI as a step towards deregulation of interest rates
on deposits. Under this scheme any commercial banks, co operative banks excluding land
development banks, can issue certificate of deposits for a period of not less than three months
and up to a period of not more than one year.
5. Repurchase Agreement(Repo)
Under this Repo transaction a holder of securities sells them to an investor with an
agreement to repurchase at a predetermined rate and date. It is a temporary sale of debt involving
full transfer of ownership of the securities, which is the assignment of voting and financial rights.
Generally Repo’s are done for period not exceeding 14 days.
6. Reverse repo: it is the exact opposite of repo. Banks purchase government securities from
RBI, and lend money to the banking regulator, thus earning interest.
7. Commercial Bill Market
According to the Indian Negotiable Instruments act,1881, bills of exchange is a written
instrument containing an unconditional order, signed by the maker, directing to pay a certain
amount of money only to a particular person, or to the bearer of the instrument.

3. Financial Instruments/Assets/Securities
Meaning Instruments/Assets/Securities
Financial assets are the intangible assets that receive value due to contractual
transactions.International Accounting Standards define a financial instrument as "any contract that
gives rise to a financial asset of one entity and a financial liability or equity instrument of another
entity".
Monetary contracts between parties Created, traded, modified and settled Cash (currency), share, or
a bond
According to IFRS defines as
⊸ Cash or cash equivalents
⊸ Equity instruments of another entity
⊸ Contractual right to receive cash or another financial asset from another entity or to exchange
financial assets or financial liabilities with another entity under conditions that are potentially
favorable to the entity
⊸ Contract that will or may be settled in the entity’s own equity instruments and is either a non-
derivative for which the entity is or may be obliged to receive variable number of entity’s own
equity instruments, or derivative that will or may be settled other than by exchange of a fixed
amount of cash or another financial asset for a fixed number of entity’s own equity instruments.
Features of financial instruments
⊸ Liquidity, for the quick conversion into cash
⊸ Collateral value, for pledging of instruments for obtaining loan
⊸ Price fluctuations of security
⊸ Tax status
⊸ Transferability, allows easy transfer of instruments
Types of Financial Instruments
⊸ Cash instruments – Instruments whose value is determined directly by the markets. Ex:
loans and deposits, where both borrower and lender have to agree on a transfer.
⊸ Derivative instruments – Value of the contract is derived from underlying assets such as
an asset, index, or interest rate.
⊸ They can be exchange-traded derivatives and over-the-counter (OTC) derivatives.

Classification of Financial Instruments /assets / Securities

Financial Instruments /assets /

Securities
Type based
Term financial securities
securities
Short term securities
Primary Instruments/securities
Mid term securities Secondary instrument/securities
Long term securities Innovative instrument/securities

Term based securities:

1. Short term securities :the sub-category comprises securities with maturity of one year
2. Mid-term securities : this sub-category comprises securities with maturity of one to five
years
3. Long term securities: this sub category comprises securities with maturity longer than those of
short and medium term securities.

Type based securities

⊸ Primary instruments- a financial instrument whose value is not derived from that of another
instrument, but instead is determined directly by the market “. These are issued by non financial
institutions. prices/value are determined by market directly e.g.: preference and equity shares
and debentures
⊸ Secondary instruments- a primary security is an instrument issued directly by the financial
institutions to an investor –when you are investing in a mutual fund you are investing in
secondary security-e.g.: money market, commercial papers , CD’s etc
⊸ Innovative instruments: these are the financial innovative to suit the need of cooperates and
investors group e.g.: derivatives, foreign currency, mortgages etc
4. Financial Services
Financial services are the economic services provided by the finance industry, which
encompasses a broad range of organizations that manage money, including credit unions, banks,
credit card companies, consumer finance companies, stock brokerages, investment funds and
some government sponsored enterprises. Financial services refer to services provided by the
finance industry. The finance industry encompasses a broad range of organizations that deal with
the management of money.
Classification of Financial Services

Financial Services

Fee Based Services Fund Based Services

Issue management, corporate Leasing, Portfolio
counseling, advising on management, housing finance
mergers

1. Fund based services

Bank management sets fees and charges for banking services of ensure that the bank is
adequately compensated for the services it provides. When setting fees and charges, bankers take
into consideration the possible exposure to loss, which may be incurred for providing the
services, the effort required of the bank and the amount of time required the performing the
services properly.
Leasing: it refers to a written agreement between lessor and lessee where lessor allows lessee to
use his property for specified period of time or rent is called lease.
 Lessor: The party who is the owner of the equipment permitting the use of the same
by the other party on payment of a periodical amount.
 Lessee: The party who acquires the right to use equipment for which he pays
periodically.
 Lease Rentals: This refers to the consideration received by the lessor in respect
of a transaction and includes:
(i) Interest on the lessor’s investment;
(ii) Charges borne by the lessor. Such as repairs, maintenance, insurance, etc;
(iii) Depreciation;
(iv) Servicing charges.
a) Factoring: Factoring is a process where a company (client) can sell its accounts receivables to
a third party who is a factor at discount rates and offers immediate cash. This facility is called
as factoring. It is also called as account receivable finance.
o Factoring is a costly source of finance when compared to other sources.
o Bad debts are considered for factoring.
o Factoring companies carries out credit risk analysis before entering into agreement.
o Factoring period is usually 90 days to 150 days
o Based on the financial strength of the debtor the credit worthiness is evaluated.
o A penal charge of 1% to 2% p.m. is charged for delayed payments beyond the approved
credit period.
 Process of Factoring:
• Client makes credit sales with the customer.
• Client gives all details about customer’s account to the factor.
• Factor makes an advance payment against the accounts purchased.
• Factor maintains the customer’s account and follows up for the payment.
• Customer pays the due amount to the factor.
• Factor makes the final payment to the client
b) Bills discounting: Trading or selling bills to financial institution prior to its maturity period
for discount rate is called discounting bill of exchange. The rate of discount depends on the
time left before the bill mature and risk attached to it.
c) Venture capital: it is a way of financing by investor to companies for its start ups and to
promote project which involves high risk and high potential returns. Investor joins
entrepreneurs as co-promoter and share risk and returns.
d) Loan: Loan is oral or written agreement between lender and borrower for temporary transfer
of property ( cash) from lender to borrower where borrower promises to return the same
property or cash along with predetermined interest as per the agreement
e) Housing finance: it is a finance facility provided by housing finance company on acquisition
or construction of houses, renovation of houses which includes acquisitions of development
of land in connection there with.
f) Hire-purchase: this system is a method of selling goods on credit where purchaser is allowed
to purchase goods and allowed him to pay the amount in instalment basis where possession is
with the buyer and the title of the goods transferred from seller to buyer at the end of final
settlement.
Features of Hire purchase:
o Credit purchase
o Installment basis
o possession of time of agreement
o Ownership till last installment
o Right to use goods as a better
o Termination of agreement
o Owner ship of goods after all installments payments
g) Mutual Funds
Definition of Mutual Funds:
The Securities Exchange Board of India (SEBI) defines mutual fund as, “ A fund established
in the form of a trust by a sponsor, to raise money by the trustees, through the sale of units to
the public, under one or more schemes, for investing in securities, in accordance with these
regulations.”
h) Credit financing:
o The resources provided may be financial (e.g. granting of loans), or they may consist of
goods to services (e.g.) consumer credit. Credit encompasses any form of differed payment.
o Credit is extended by a creditor, also known as a lender, to a debtor also known as a
borrower.
o It is the financing ability of individuals or enterprise to obtain financial services, including
credit, deposit, payment, insurance and risk management.

2. Fee based services

 Fund based services include cash credit, overdraft, bill discounting, short-term financing, and
export financing (pre-shipment as well as post-shipment).Fee based facilities include letters of
credit and bank guarantees.
a) Issue management: Management of issues involves marketing of corporate securities like
equity shares, preference shares and debentures.
The issue management may be classified into:
Pre-issue management:
o Issue through prospectus
o Marketing
o Pricing of issues
Post issue management: It consists of collection of application forms and statement of
amount received from the bankers, screening the applications, allotment, share certificates
etc.
b) Underwriting of public issue: It is guarantee given by an underwriter that in the event of
non subscription of shares they have to be subscribed by them. The person who underwrites
the shares or debentures is called underwriter. A company can have either one underwriter or
more than underwriters. The return for underwriting is called ‘Underwriting commission’.
c) Portfolio management: portfolio management is a method of managing and allocating funds
on various best alternatives to reduce the uncertainty. Portfolio refers to diversifying the
available resources into combination of securities inorder to maximise the return and
minimise the risk.
d) Merchant Banking: an organization that underwrites securities for corporations, advices
such clients on mergers and is involved in ownership of commercial ventures.
o Loan syndication: it is the process where large number of lender contributes amount
and grant loans to company or any project and share risk and returns of the same.
o Corporate counselling: it refers to a set of activities performed to ensure the efficient
running of a corporate enterprise and to improve the performance.
o Foreign collaboration: it is an alliance in corporate to carry on agreed task collectively
with the participation of resident and non resident entities.
o Offshore finance: It involves long term foreign currency loans, joint ventures abroad,
financing exports and imports etc..
o Nonresident investment: The services of merchant banks include investment services
to NRI, in terms of identification of investment opportunities, selection of securities,
investment management etc.
e) Credit rating: it is an analysis of the credit risks associated with a financial instrument or a
financial entity.
• It is a rating given to a particular entity based on the credentials and the extent to
which the financial statements of the entity are stabilized in terms of borrowing and
lending that has been done in the past.
• Usually it is in the form of a detailed report based on the financial history or
borrowing or lending and credit worthiness of the entity or the person obtained from
the statements of its assets and liabilities with an aim to determine their ability to meet
the debt obligations.
• It helps in assessment of the solvency of the particular entity.
 f) Stock broking: The function of buying and selling Financial securities such as stocks shares
and bonds through the stock market
o By a dealer (agent)
o On behalf of customer
g) Debt and capital structure:
Financial services guides the company in capital structure
• Capital structure refers to a company’s outstanding debt and equity
• It allows firms to understand Funding or investment strategy used to finance its overall activities
and growth
• To provide an overview of the level of the company’s risk
• The higher the proportion of debt financing a company has, the higher the exposure to risk will
be
Capital structure = debt to equity ratio

Classification of Indian Financial system

The Indian Financial system is broadly classified into two broad groups:
Organized sectors Unorganized Sectors
-Regulators -Money Lenders
-Financial institutions -Local bankers
-Financial markets -Traders
-Financial services -Landlords
-Pawn brokers
-Chits Funds

(A) Organised Financial System

1.Regulators
Market Regulator is a body appointed mostly under an act of parliament to one or several
markets to ensure intergrity. In India, we have specific authorities to regulate each sector to
prevent overlapping.
The main sectors are banking, securities, insurance ang pension. In India, we have the
following regulators:
a)Reserve Bank of India(RBI).
b)Securities and Exchange Board Of India(SEBI).
c)Ministry Of Ministry(MOF)
d)Ministry of Corporate Affairs
e)Insurance Regulatory Authority of India(IRAI)
f)Pension Fund Regulatory and Development Authority(PFRDA)
2.Financial Institutions
Financial Institution is an establishment that focuses on dealing with financial transactions,
such as investments, loans and deposits. Conventionally, financial institutions are composed of
orgagnizations such as banks, trust companies, insurance companies, insurance companies and
investment dealers.Almost everyone has to deal with a financial institution on a regular basis.
Everything from depositing money to taking loans and exchanging currencies must be done
through financial institutions.
Indian Financial institutions are as follows:
 Unorganized Financial System

1. Money Lenders
A moneylender is a person or group who offers small personal loans at high rates of interest.
2. Local Bankers
Local bankers is a person who conducts the business of banking; one who individually, or as a
member of a company, keeps an establishment for the deposit or loan of money, or for traffic in
money, bills of exchange, etc
3. Traders
A trader is a person or entity, in finance, who buys and sells finance instruments such as
stocks, bonds, commodities and derivatives, in the capacity of agent, hedger, and arbitrageur
speculator.
4. Landlords
A landlord is the owner of a house, apartment, condominium, land or real estate which is
rented or leased to an individual or business, who is called a tenant (also a lessee or renter).
When a juristic person is in this position, the term landlord is used. Other terms include lessor
and owner.
5. Pawn Brokers
A pawn brokers is an individual or business (pawnshop or pawn shop) that offers secured loans
to people, with items of personal used as collateral. The word pawn is derived from the latin
word ‘pignus’, for pledge, and the items having been pawned to the broker are themselves called
pledges or pawns, or simply the collateral. ‘
6. Chit Funds
A chit fund is a kind of savings scheme practiced in India. A chit fund company means a
company managing, conducting or supervising, as foremen, agent or in any other capacity, chits
as defined in section 2 of the chit funds act, 1982, According to section2(b) of the chit fund act
1982,”Chit means a transaction whether called chit, chit fund, chitty, kuri or by any other name
by or under which a person enters into an agreement with a specified member of persons where
every one of them shall subscribe a certain sum of money (or a certain quantity of grain instead)
by way of periodical installments over a definite period and that each such subscriber shall, in his
turn, as determined by lot or by auction or by tender or in such other manner as may be specified
in the chit agreement, be entitled to the prize amount”.