Indian Financial Institutions and Markets Unit 1 Basis of Financial System

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INDIAN FINANCIAL INSTITUTIONS AND MARKETS

Unit 1
BASIS OF FINANCIAL SYSTEM

Finance is defined as the management of money and includes activities such as investing,
borrowing, lending, budgeting, saving, and forecasting. Finance not only focuses on raising
funds by the business enterprise but also its effective usage in an organisation.

A financial system may be defined as a set of institutions, instruments, and markets which


promote savings and channels them to their most efficient use. It consists of individuals (savers),
intermediaries, markets and users of savings (investors).

According to Van Horne, “Financial system allocates savings efficiently in an economy to


ultimate users either for investment in real assets or for consumption”.

According to Robinson, the primary function of the system is “to provide a link between
savings and investment for the creation of new wealth and to permit portfolio adjustment in the
composition of the existing wealth.

Financial dualism means the co-existence of organised and unorganised money market in the
Less developed countries/ developing countries.

Given below are the features of the Indian Financial system:


 It plays a vital role in the economic development of the country as it encourages both
savings and investment
 It helps in mobilising and allocating one’s savings
 It facilitates the expansion of financial institutions and markets
 Plays a key role in capital formation
 It helps forms a link between the investor and the one saving
 It is also concerned with the Provision of funds

OBJECTIVES OF FINANCIAL SYSTEM (5 marks)


1. Facilitate Payment
The financial system facilitates payment through banks and any other financial institution.
Anything we buy or sale requires the transection of money. That is done by the financial system

2. It creates link between Saver And Investor


The financial system provides a place where saver and investor meet. Saver saves money and
investors invest it in different types of stocks to get profit on it.

3. Helps in Capital Formation


For capital formation, there should be a good financial system that provides the finance timely
and in an appropriate amount.
4. To Ensure Safety On Investment
The financial system has different institutions for the proper supervision of the financial market
that controls the market. So, the safety of the investment can be done.

5. Helps In the Growth of The Economy


Proper mobilization of funds and proper control in the financial market helps the business to
grow and motivate investors to invest. That helps in the growth of the economy.

6. Other objectives:
 To establish financial control and clear accounting procedures which ensure that funds are
used for intended purposes.
ROLE/ IMPORTANCE OF FINANCIAL SYSTEM IN THE ECONOMIC
DEVELOPMENT OF A COUNTRY. (6/ 15 marks)

1. Savings-investment relationship
To attain economic development, a country needs more investment and
production. This can happen only when there is a facility for savings. As, such
savings are channelized to productive resources in the form of investment. Here,
the role of financial institutions is important, since they induce the public to save
by offering attractive interest rates. These savings are channelized by lending to
various business concerns which are involved in production and distribution.

2. Financial systems help in growth of capital market


Any business requires two types of capital namely, fixed capital and working
capital. Fixed capital is used for investment in fixed assets, like plant and
machinery. While working capital is used for the day-to-day running of business. It
is also used for purchase of raw materials and converting them into finished
products.

 Fixed capital is raised through capital market by the issue of debentures and


shares. Public and other financial institutions invest in them in order to get a
good return with minimized risks.
 For working capital, we have money market, where short-term loans could
be raised by the businessmen through the issue of various credit instruments
such as bills, promissory notes, etc.
3. Foreign exchange market enables exporters and importers to receive and raise
funds for settling transactions. It also enables banks to borrow from and lend to
different types of customers in various foreign currencies. The market also
provides opportunities for the banks to invest their short term idle funds to earn
profits. Even governments are benefited as they can meet their foreign
exchange requirements through this market.

4. Financial system helps in Infrastructure and Growth


Economic development of any country depends on the infrastructure facility
available in the country. In the absence of key industries like coal, power and oil,
development of other industries will be hampered. It is here that the financial
services play a crucial role by providing funds for the growth of infrastructure
industries. Private sector will find it difficult to raise the huge capital needed for
setting up infrastructure industries. For a long time, infrastructure industries were
started only by the government in India. But now, with the policy of economic
liberalization, more private sector industries have come forward to start
infrastructure industry. The Development Banks and the Merchant banks help in
raising capital for these industries.

5. Financial system helps in development of Trade


The financial system helps in the promotion of both domestic and foreign trade.
The financial institutions finance traders and the financial market helps in
discounting financial instruments such as bills. Foreign trade is promoted due to
per-shipment and post-shipment finance by commercial banks. They also issue
Letter of Credit in favour of the importer. Thus, the precious foreign exchange is
earned by the country because of the presence of financial system.

6. Employment Growth is boosted by financial system


The presence of financial system will generate more employment opportunities in
the country. The money market which is a part of financial system provides
working capital to the businessmen and manufacturers due to which production
increases, resulting in generating more employment opportunities. With
competition picking up in various sectors, the service sector such as sales,
marketing, advertisement, etc., also pick up, leading to more employment
opportunities.

7. Venture Capital
There are various reasons for lack of growth of venture capital companies in India.
The economic development of a country will be rapid when more ventures are
promoted which require modern technology and venture capital.
Venture capital cannot be provided by individual companies as it involves more
risks. It is only through financial system, more financial institutions will contribute
a part of their investable funds for the promotion of new ventures. Thus, financial
system enables the creation of venture capital.

8. Financial system ensures Balanced growth


Economic development requires a balanced growth which means growth in all the
sectors simultaneously. Primary sector, secondary sector and tertiary sector require
adequate funds for their growth. The financial system in the country will be geared
up by the authorities in such a way that the available funds will be distributed to all
the sectors in such a manner, that there will be a balanced growth in industries,
agriculture and service sectors.

9. Financial system’s role in Balanced regional development


Through the financial system, backward areas could be developed by providing
various concessions or sops. This ensures a balanced development throughout the
country and this will mitigate political or any other kind of disturbances in the
country. It will also check migration of rural population towards towns and cities.

10. Role of financial system in attracting foreign capital


Financial system promotes capital market. A dynamic capital market is capable of
attracting funds both from domestic and abroad. With more capital, investment
will expand and this will speed up the economic development of a country.

11. Financial system helps in Uniform interest rates


The financial system is capable of bringing a uniform interest rate throughout the
country by which there will be balanced movement of funds between centres
which will ensure availability of capital for all kinds of industries.

12. Financial system role in Electronic development:


Due to the development of technology and the introduction of computers in the
financial system, the transactions have increased manifold bringing in changes for
the all-round development of the country. The promotion of World Trade
Organization (WTO) has further improved international trade and the financial
system in all its member countries.
LIMITATIONS OR WEAKNESSES OF INDIAN FINANCIAL SYSTEM
The measures taken by the government over the years to develop a strong financial
system has definitely resulted in a considerable amount of consistency and growth
in the economy. However, some of the weaknesses or limitations of Indian
Financial System are that are still to be addressed are:
1. Lack of coordination between different financial institutions
2. Monopolistic market structures
3. Dominance of development banks in industrial financing
4. Inactive and erratic capital market
5. Imprudent & immoral financial practice.

STRUCTURE/ COMPONENTS/ CONSTITUENTS OF INDIAN


FINANCIAL SYSTEM (6/ 15 marks)

The following are the four major components that comprise the Indian Financial
System:

1. Financial Institutions
2. Financial Markets
3. Financial Instruments/ Assets/ Securities
4. Financial Services.

1. Financial Institutions
The Financial Institutions act as a mediator between the investor and the borrower.
The investor’s savings are mobilised either directly or indirectly via the Financial
Markets. 
The financial institutions can further be divided into two types:

 Banking Institutions or Depository Institutions – This includes banks and


other credit unions which collect money from the public against interest
provided on the deposits made and lend that money to the ones in need
 Non-Banking Institutions or Non-Depository Institutions – Insurance,
mutual funds and brokerage companies fall under this category. They cannot
ask for monetary deposits but sell financial products to their customers.

2. Financial Assets
The products which are traded in the Financial Markets are called the Financial
Assets. Based on the different requirements and needs of the credit seeker, the
securities in the market also differ from each other. 

Features or characteristics of financial instruments:


 Liquidity- financial assets can be easily and quickly converted to cash.
 Marketing- It facilitates easy trading on the markets. They have a ready
markets
 Collateral value- Financial assets can be pledged for getting loans
 Transferability- those transferred to one person to another
 Maturity period- these kinds of assets have maturity period short or medium
or long term basis.
 Transaction cost- financial instruments involve buying and selling cost like
brokerage fees, Bank charges etc..,
 Risk- chances of physical damage of certificates, online fraud, Payment of
dividend is uncertain.
 Future Trading- these instruments facilitate future trading so as to cover risks
arising out of price fluctuations, interest rate fluctuations etc.
Classification of financial instruments

1. Term based classification:

 Short term securities: these includes with maturity of one year or less.
 Medium term securities: these includes with maturity from 1 to 5 year.
 Long term securities: these includes with maturity of more than 5 years.

2. Type based classification:

 Primary securities: like Equity shares, preference shares & Debentures and
used for to raise fixed capital by the business or institutions only in the primary
market.

 Secondary securities: like Mutual funds, certificate of deposits, Commercial


papers etc.., and used for to raise working capital by the Investors only in the
secondary market.

 Innovative instruments: these are those only to suit the need of corporates or
Investors group. For example: Derivatives, loans, insurance, foreign currency
mortgages and so on.

3. Financial Services/ Intermediation


(Note; for explanation of each point refer to PPT notes)

 Banking Services – Any small or big service provided by banks like granting a
loan, depositing money, issuing debit/credit cards, opening accounts, etc. 
 Insurance Services – Services like issuing of insurance, selling policies,
insurance undertaking and brokerages, Reinsurance etc. are all a part of the
Insurance services
 Investment Services – It mostly includes asset management, Hedge fund
Management etc.
 Foreign Exchange Services – Exchange of currency, foreign exchange, etc.
are a part of the Foreign exchange services
The main aim of the financial services is to assist a person with selling, borrowing
or purchasing securities, allowing payments and settlements and lending and
investing. 

4. Financial Markets
The marketplace where buyers and sellers interact with each other and participate
in the trading of money, bonds, shares and other assets is called a financial
market. 
These organised markets can be further classified into two they are:
a) Capital market
The capital market is a market for financial assets which have a long or indefinite
maturity. Generally, it deals with long term securities which have a maturity
period of above one year.
It can be further subdivided into two. They are:
 Primary market or New issue market
Primary Market Primary market is a market for new issues or new financial claims.
Hence, it is also called New Issue market. The primary market deals with those
securities which are issued to the public for the first time.
 Secondary Market
Secondary market is a market for secondary sale of securities. In other words,
securities which have already passed through the new issue market are traded in
this market. Generally, such securities are quoted the Stock Exchange and it
provides a continuous and regular market to buying and selling of securities.

b) Money market is a market for dealing with financial assets and securities
which have a maturity period of up to one year. In other words, it is a market
for purely short term funds. The money market includes the following types:

 Treasury Bills – Also known as T-Bills, These are Government bonds or debt
securities with maturity of less than a year. Buying a T-Bill means lending
money to the Government.
 Certificate of Deposits – It is a dematerialised form (Electronically generated)
for funds deposited in the bank for a specific period of time.
 Commercial Paper – It is an unsecured short-term debt instrument issued by
corporations.

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