Module 1

FINANCIAL SYSTEM

Introduction
Finance plays an important role in the
process of economic development. The
economic development of any country
depends on the financial system of that
country. It acts as an intermediary for
inflow and outflow of funds. It mobilizes
the funds of the nation and channelizes the
fund for productive purposes.It includes its
banks, securities exchanges, pension
funds, insurers, central bank and national
regulators. All of these provide a
framework for carrying out economic
transactions and help to channel savings
into investment.

MEANING AND DEFINITION

A financial system may be defined as a set
of institutions, instruments and markets,
which encourage savings and channelize
them to their effective use. The system
consists of savers, intermediaries, markets
and users of savings.

ROLE AND SIGNIFICANCE OF FINANCIAL

SYSTEM IN ECONOMIC DEVELOPMENT OF
A COUNTRY
 It serves as a link between savers and
borrowers to mobilize savings and
channelize it into productive purpose.
  It provides detailed information to
inventors, borrowers, individuals etc.
 It promotes the capital formation by
mobilizing scattered savings.
 It provides a payment mechanism for
the exchange of goods and services.
 It provides a mechanism for
transferring resources all over the
world.

SIGNIFICANCE OF FINANCIAL SYSTEM

1. Well developed and well functioned
financial market is required to create a
balanced financial system.
2. It is required to mobilize savings and
channelize to productive resources in the
form of investment.
3.It helps to meet the capital requirements
of a firm.
4. It plays an important role by providing
funds for the growth of infrastructure
industries.
5. It helps in the promotion of both
domestic and foreign trade.
6. It will generate more employment
opportunities in the country
7. Financial system ensures balanced
growth throughout the country

Functions of the financial system

1. Providing Liquidity
The financial system provides money and
monetary assets which can be easily
converted into cash without any loss of
value.
2.Mobilization of Savings
The savings is to be mobilized and
channelized for the productive purposes.
FINANCIAL CONCEPTS
A)Financial Assets
B)Financial Intermediaries
C) Financial markets
D)Financial rates of returns
E)Financial instruments
A) Financial Assets
Financial assets are cash and other assets
that convert directly into known amounts
of cash. The three basic categories of
financial assets are cash, marketable
securities, and receivables.
Classification of Financial Assets
1) Primary or direct assets
These are the financial claim against real
sector units created by themselves for
raising funds to finance their deficient
spending. They are the ultimate
borrowers. E.g., bills, bonds, equities etc.
2) Secondary or indirect assets : These are
financial claims issued by financial
institutions against themselves to raise
funds from the public. These assets are
the obligations of financial institutions.
E.g.. bank deposits, life insurance policies,
UTI units etc.
Other classification of financial assets
1)Marketable assets: It can be transferred
from person to person without much
difficulty. Eg: shares, government
securities, bonds etc.
2)Non marketable assets: These are the
financial assets which cannot be
transferred easily. example : Banks
deposits, Provident funds etc.
3)Cash assets: Money assets consist of
coins and currency notes and created
money.
4)Debt assets: organization issues debt
assets for raising their debt capital by way
of issuing debentures or bonds, raising
long term loans etc.
5)Stock asset: Corporate issue stocks for
the purpose of raising their fixed capital.
There are mainly two types of stocks such
as preference and equity stock.
B) FINANCIAL MARKETS
A financial market is a market in which
financial assets are traded(buying and
selling). It facilitate borrowing and lending
by facilitating the sale by newly issued
financial assets.
It deals with the financial assets of
different types such as cheques, bills,
bonds etc. The main participants in the
financial markets are financial institutions,
agents, brokers etc.

Functions of Financial Markets

1. Borrowing and Lending: Financial
markets permit the transfer of funds from
one agent to another for either investment
or consumption purposes.
2. Price Determination: Financial markets
provide means by which prices are set
both for newly issued financial assets and
for the existing stock of financial assets.
3. Information Aggregation and
Coordination: Financial markets act as
collectors and aggregators of information
about financial asset values and the flow of
funds from lenders to borrowers.
4. Risk Sharing: Financial markets allow a
transfer of risk from those who undertake
investments to those who provide funds
for those investments.
5. Liquidity: Financial markets provide the
holders of financial assets with a chance to
resell or liquidate these assets.
6. Efficiency: Financial markets reduce
transaction costs and information costs.
TYPES or CLASSIFICATION OF FINANCIAL
MARKETS
1. Money market
2. Capital market
3. Financial guarantee market
4. Financial mortgage market
5. Foreign Exchange market
6. Commodity market
7. Debt market
1.Money Market
It is a market for short-term funds
normally up to one year. It deals with
relatively liquid and quickly marketable
assets like short term government
securities, treasury bills of exchange etc.
2. Capital Markets
It is the market for the issue and trading of
long-term securities. where the term to
maturity of the instrument is more than 10
years.
3. Financial Mortgages Market
Financial Mortgages market is market
through which mortgage loans are granted
to individual customers. Mortgage loans
are granted against immovable property
like real estate.
4. Financial Guarantees Market
It is the centre where finance is provided
against the guarantee of a reputed person
in the financial circle. If the principal
debtor makes default in payment the
amount can be recovered from the surety
or guarantor.It includes:
a. Personal guarantee: It is the guarantee
given by the individual to obtain loans
from cooperative banks, or stands as a
surety for chit funds etc.
b. Government guarantee: The
government stands as a guarantor for
public sector enterprises to obtain finance
from the financial institutions.
c. Institutional guarantee: It is the
guarantee provided by the institutions like
LIC, statutory financial institutions,
specialized financial institutions etc.
5. Foreign Exchange Market
Foreign exchange market is an institutional
arrangement for the sale and purchase of
foreign currencies.

6. Commodity market
It is the market where a wide range of
products, such as base metals, precious
metals, crude oil, energy and soft
commodities like palm oil, coffee etc. are
traded. It includes direct physical trading
and derivatives trading. In spot trading
buying and selling of goods are done for
cash and immediate delivery of goods is
done. In derivative trading, the price is set
now, but delivery and payment of goods
will be happened for a future date.
7. Debt market
 Debt market is a market where different
types of debt instruments are traded. Debt
instruments like debentures and bonds are
traded in debt markets.

C) Financial instruments or financial

securities
Financial insturument or security is a legal
evidence of a deposit or claim for a specific
sum of money. These are the documents,
which represent financial claims on assets.
Basic Features of Financial Instruments
1. Transferability: It can be transferred
easily.
2. Minimum transaction cost: The
transaction cost should be the lowest.
3. Ready market: These securities can be
bought and sold frequently.
4.Liquidity: These securities possess
liquidity. Liquidity denotes the ability of
the investment to convert as cash .
5.Security value: It can be used for raising
loans by pledging them as security.
6.Tax status: The investment made in some
securities will be exempted for payment of
tax.
7.Prevalence of uncertainty: The
uncertainty is with regard to the payment
of principal or interest or dividend on
securities.
8.Rate of return: Selection of a security
depends upon the rate of interest or
dividend offered for it.
9.Facilitates future trading: These
instruments facilitate future trading which
helps to cover risks arising out of price
fluctuations, interest rate fluctuations etc.
10.Maturity period: The securities based
on the maturity period such as short term,
medium term or long-term securities.

Classification of Financial Securities

a)Primary securities
These are the securities which are issued
by the ultimate users of the capital to the
final investors. Shares and debentures
issued to the public directly come under
this category.
b)Secondary securities
These are the securities issued by financial
intermediaries to the ultimate savers. It is
also called derivatives which are based on
the original primary issues. Examples of
derivatives are futures, options, etc.
D) FINANCIAL INTERMEDIARIES OR
INSTITUTIONS
Financial intermediaries or institutions are
those organizations which act as
intermediaries in financial market. They
borrow funds or accept deposits from
those who are willing to give their current
purchasing power and lend to or buy
securities from those who require the
funds to meet the current requirements. It
includes Banks, Investment Companies,
Insurance Companies, etc.
classification
1)Banks and non-banking financial
intermediaries:
It include insurance companies, Provident
fund organizations etc.
2)Capital market intermediaries:
They meet the long term financial
requirements of individuals and corporate.
3)Money Market intermediaries:
They provide short-term funds to
individuals and corporate,
E) FINANCIAL SERVICES
Financial service is the term used to
describe those organizations that deal with
the management of money. They provide
money and investment related services.
Financial services include banking,
insurance, stock broking etc.
Types/ classification of financial services
1. Fee based/ advisory services.
2. Fund/asset based services

Fee based / Advisory services: it includes

(a) Merchant banking (b) Stock broking and
(c) Credit rating
Fund based services : It consists of (a)
Factoring (b) Venture capital financing (c)
mutual funds (d) Housing finance (f) lease
financing (g) Hire purchase financing (h)
Insurance services and (J) bill discounting
MERCHANT BANKING
Merchant banking involves rendering
services of non banking nature to the
industrial and business houses. It provides
a wide range of services under one roof
like financial, technical, managerial etc.
The services provided by merchant banker
includes:
1. They manage market and underwrite
new issues.
2. They provide project promotion services
and project finance.
3. Organisation of credit and other
facilities.
4. Leasing including project leasing.
5. They will provide corporate services.
6. They will provide investment advisory
services.
7. It will provide bought out deals.
8. It will provide venture capital.
9. It will provide mutual funds and offshore
funds.
10.It will provide assistance for technical
and financial collaboration and joint
ventures.
Stock Broking
Stock broking is a professional activity of
buying and selling of stocks and shares for
clients. Stock brokers are the members of
the recognized stock exchanges. They buy,
sell or deal in securities.
Credit Rating
Credit Rating is essentially a symbolic
indicator of the relative grading of the
investment or credit qualities of financial
instruments. It reflects the relative ability
of the issuers of such instruments to meet
the servicing obligations as and when they
arise. CRISIL is the most important rating
agency in India.
Factoring Service
Factor is a financial institution which
manages the collection of accounts
receivables of the business firm and bears
the credit risk associated with it. In
factoring there are three main parties such
as client (seller), the customer (buyer) and
factor. The factor undertakes the risk of
bad debt and maintains sales ledger on
behalf of the client.
VENTURE CAPITAL FINANCING
Venture capital is an equity investment in
a high risk project related to some
innovations or new technological
developments pondered by a company.
Venture capital assistance is given to those
enterprises where the risk element is
comparatively high due to the involvement
of a relatively new technology which is
untried or the entrepreneur is a new one
and not wealthy though otherwise
qualified.
Lease financing
It is a contractual agreement
between the owner of the
asset(lessor) who grants the
other party(lessee) the right to
use the asset in return for a
periodic payment (lease
rentals).
FINANCIAL RATES OF RETURN
It is the rate of return expressed as a
percentage of the amount invested.

ELEMENTS IN THE INDIAN FINANCIAL

SYSTEM
1.Financial assets
2.Financial institutions
3.Financial services
4.Financial markets
Well diversified structure of Financial
institutions
i. Financial institutions
ii. Non-Banking Financial Companies
iii. Mutual funds
Iv. Introduction of the on line trading
v. Growth of service sector

WEAKNESS OF THE INDIAN FINANCIAL

SYSTEM
1. Lack of institutional investors: The
disinvestments and privatization
programme has also been inhibited by the
lack of institutional investors in the private
sector. The introduction of private sector
insurance companies and pension funds
will help to remove some of these
difficulties in the capital market.
2. Lack of coordination between different
financial intermediaries: The Government
indirectly hold a controlling interest on
financial intermediaries through
Government owned or sponsored
institutions. Due to its multiplicity, there is
lack of coordination of these institutions .
3. Lack of emergence of financial
corporations: The Indian regulatory system
should enable the development of
financial corporations. It will be necessary
for Indian institutions for competing
efficiently with the much larger
international financial sector companies.
4. Dominance of monopolies: Some
financial institutions have created
monopolistic market structures financial
system. These large structures have
weakness in respect of management
competency, lack of coordination etc.
5. Lack of integration of the segments of
the financial system: The different sectors
of the financial system like capital market,
money market, bullion markets etc are not
properly coordinated and integrated for
the benefits of the financial system.
6. Dominance of development banks: It
also occupies a dominant place in the
capital market. The industrial financing is
done through these development banks by
the government. But it is noted that they
are not able to mobilize the savings of the
people, which is a necessity for the growth
of the financial system.
7. Dominance of the public sector firms:
The domination of public sector finance
firms inhibits the market for corporate
control and the development of widely
held, board managed, professionally run
companies.
8. Market irregularities: The securities
markets have experienced a steady stream
of episodes of market irregularities. Even
though the market design on the stock
markets has made major progress, there
are continuing concerns about the speed
and effectiveness with which fraudulent
activities are detected and punished.
9. Neglect for small and new enterprises:
Small and new enterprises are not able to
raise funds at an easy term and cost. It will
retard the development of the financial
system.

10.Problems with multiple regulators in

India: With multiple regulators in India ,
there are varying regulatory requirements
which often leads to regulatory arbitrage.
Demonetization
Demonetization is an act of
canceling the legal tender
status of a currency unit in
circulation. The aim of
demonetization was to control
corruption, counterfeiting the
use of high denomination notes
for illegal activities, and
especially the increase of black
money generated by income
that has not been paid to the
tax authorities.