Unit-I

An Overview of Financial System

 Introduction to Financial System
► The economic scene in the post independence period has seen
a sea change, the end result being that the economy has made
enormous progress in diverse fields. There has been a
quantitative expansion as well as diversification of economic
activities.
► The financial system is possibly the most important
institutional and functional vehicle for economic
transformation. Finance is a bridge between the present and
the future and whether it be the mobilization of savings or
their efficient, effective and equitable allocation for
investment, it is the success with which the financial system
performs its functions that sets the pace for the achievement
of broader national objectives.
Significance and Definition
► The term financial system is a set of inter-related
activities/services working together to achieve some
predetermined purpose or goal. It includes different
markets, the institutions, instruments, services and
mechanisms which influence the generation of savings,
investment capital formation and growth.
► Van Horne defined the “Financial system as the purpose of
financial markets to allocate savings efficiently in an economy
to ultimate users either for investment in real assets or for
consumption”.

► Christy has opined that the objective of the financial system is

to "supply funds to various sectors and activities of the
economy in ways that promote the fullest possible utilization of
resources without the destabilizing consequence of price level
changes or unnecessary interference with individual desires."
► According to Robinson, the primary function of the
Financial 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."

From the above definitions, it may be said that the primary

function of the financial system is the mobilization of savings,
their distribution for industrial investment and stimulating capital
formation to accelerate the process of economic growth.
► A financial system is an economic arrangement wherein
financial institutions facilitate the transfer of funds and
assets between borrowers, lenders, and investors. Its goal
is to efficiently distribute economic resources to promote
economic growth and generate a return on investment
(ROI) for market participants.
Contd…
► The Financial System of any country is also known as Financial Sector. It
consists of individuals,Companies,Markets and Government that are
involved in the activities of exchanging Financial Assets( are those liquid
assets that gets its value from a cotractual rights or ownership claim)
► Financial system assists to mobilize the savings of the country to sectors that
can make productive utilization of them.
► Financial system is a system that allows the exchange of funds between
financial market participants such as Lenders ,Investors and Borrowers.
The economic development of the country depends upon a well
–developed Financial system. It offers a mechanism through which
savings are transformed into investments.
The Financial system is related with 3 terms:
1. Money : It is the current medium of exchange or means of payment.
2.Credit: it a sum of money to be refunded generally with interest , it defines
to a debt of economic unit.
3.Finance : it refers to the monetary resources including ownership securities
and debt.
❖ Financial System can be explained at the global, regional or
firm specific level.
► The market participants may include investment banks, stock
exchanges, insurance companies, individual investors, and other
institutions. It functions at corporate, national, and international
levels and is governed by various rules dictating the eligibility
of participants and the use of funds for different purposes. Aside
from financial institutions, financial markets, financial
instruments , and financial services are the components of the
financial system.
Role/ functions of financial system
► It serves as a link between savers and investors
► It channelizes the flow of savings into productive channels
► It assists in the selection of projects to be financed
► It provides a payment mechanism for exchange of goods and
services
► It provides a mechanism for transfer of resources across
geographical boundaries
► It provides a mechanism for managing and controlling the risk
involved in mobilizing savings and allocating credit
► It promotes the process of capital formation
► It helps in lowering the cost of transactions and increasing returns
► It provides detailed information to all the operators and players in
the market such as individuals ,business houses , government etc
Structure of Financial System
The structure of the financial system is also known as
Components or Constituents of the financial system.

The four Components of the financial system are as follows:

1)Financial Institutions,
2)Financial Markets
3)Financial Instruments
4)Financial Services.
 FINANCIAL
SYSTEM

Financia
Financial Financia
Financia l
Institutio l
l Instrume
ns Services
Markets nts
Financial Institutions

► Financial Institutions mobilize the savings of the surplus units

and allocate them in productive activities promising a better
rate of return. Hence they act as middlemen (Intermediary)
between savers and borrowers.
 Types of financial institutions
Following are the types of Financial Institutions in India:
► Banking Institutions: Indian Banking industry is subject to be
controlled by RBI. All banks in India are governed by Indian
Banking Regulation Act of 1949.The main legislation governing
commercial banks in India is the Banking Regulation Act 1949.

The Indian Banking institutions can be classified into:

► Organised sector

► Unorganised sector
 Organised sector

It consists of the following:

► Commercial banks: Their primary functions are Accepting deposits

and Granting short term and medium term loans for all productive
activities.

► Cooperative Banks: Rural credit societies are primarily agricultural in

nature while urban credit societies are non agricultural in nature. For
providing medium to long term loans for agriculture specialised
cooperative Banks have been set up.

► Regional Rural Banks: RRB's were set up by state governments and

sponsoring commercial banks to provide banking services and credit to
small farmers,entrepreneurs in rural areas.They were set up with a view
to provide credit to weaker sections and to develop the rural economy.
► Industrial Banks: They provide short term, medium
term and long term loans only to industry.

► Exchange Banks: They specialize in financing the

credit needs of exporters and importers.

► Foreign Banks: They are banks which have their

headquarters in another country( home country) but
have their branches in India( Host country)
Unorganised sector:
► Indigenous bankers also act as financial intermediaries.They are local
bankers.The geographical area covered by Indigenous bankers are much
higher than the commercial banks.They are found in all parts of the
country although their names style of functioning and the functions
performed by them differ.They may accept deposits and lend money but
mostly use large funds of their own.

► On the other hand moneylenders are not bankers .Their only function is
lending money out of their own funds .Their clients are weaker sections
of the society.Their loans are highly exploitative in nature as they charge
very high rate of interest.Their operations are entirely unregulated.

► Indigenous bankers provide loans directly to trade and industry and

indirectly to agriculture through money lenders.
 Non Banking institutions:
► Non Banking institutions are classified as Organised sector and Unorganised
sector:
I) Organised non Banking financial institutions means IDBI,IFCI,ICICI,IRDC
,SFC,SIDC,NABARD,Land Development banks etc.
► They provide medium term and long term credit to only the industrial sector
and also take up activities for economic development.
► Investment institutions like LIC,GIC,UTI,Mutual funds mobilise savings of
people through various schemes and invest their funds in corporate and
government securities.
ii) Unorganised Non- Banking Financial Institutions:
► They include Non Banking financial companies like leasing ,hire purchase,
consumer finance,housing finance companies, loan companies,
factoring,merchant banking companies,credit rating companies etc.NBFCs
mobilise public funds and provide loanable funds.
►
Financial Markets
► Financial market may be defined as ‘a transmission mechanism
between investors (or lenders) and the borrowers (or users)
through which transfer of funds is facilitated’.

► It consists of individual investors, financial institutions and other

intermediaries who are linked by a formal trading rules and
communication network for trading the various financial assets
and credit instruments.
Functions of financial market.
It provides facilities for interaction between the investors and
the borrowers.

It facilitate creation and allocation of credit and liquidity

To serve as intermediaries for mobilising savings

It provides pricing information resulting from the interaction

between buyers and sellers in the market when they trade the
financial assets.
To assist the process of balanced economic growth

It provides security to dealings in financial assets.

To provide financial convenience

To cater to the credit needs of the business houses

It ensures liquidity by providing a mechanism for an investor to sell
the financial assets.

It ensures low cost of transactions and information.

 TYPES OF FINANCIAL MARKETS
A financial market consists of two major segments:
(a) Money Market
(b) Capital Market.

The money market deals in short-term credit, whereas the capital

market handles the medium term and long-term credit.
MONEY MARKET
The money market is a market for short-term funds, which deals in
financial assets whose period of maturity is up to one year. It
should be noted that money market does not deal in cash or money
as such but simply provides a market for credit instruments such
as bills of exchange, promissory notes, commercial paper, treasury
bills, etc. These financial instruments are close substitute of
money. These instruments help the business units, other
organisations and the Government to borrow the funds to meet
their short-term requirement.
Money market does not imply to any specific market place. Rather it refers to
the whole networks of financial institutions dealing in short-term funds, which
provides an outlet to lenders and a source of supply for such funds to borrowers.
Most of the money market transactions are taken place on telephone, fax or
Internet. The Indian money market consists of Reserve Bank of India,
Commercial banks, Co-operative banks, and other specialised financial
institutions. The Reserve Bank of India is the leader of the money market in
India. Some Non-Banking Financial Companies (NBFCs) and financial
institutions like LIC, GIC, UTI, etc. also operate in the Indian money market.
Capital Market

► A capital market is a place that allows the trading of

funding instruments such as shares, debentures, debt
instruments, bonds, ETFs, etc. It is a source for raising
funds for individuals, firms, and governments. The
securities exchanged here would typically be a long-term
investment with over a year lock-in period.
► A capital market is where individuals and firms borrow
funds using shares, bonds, debentures, debt instruments,
etc. The most common example is a stock exchange such
as NASDAQ(National Association of Securities Dealers
Automated Quotations), trading shares from different
companies amongst investors.
Capital Market may be defined as a market dealing in medium and
long-term funds. It is an institutional arrangement for borrowing
medium and long-term funds and which provides facilities for
marketing and trading of securities. So it constitutes all long-term
borrowings from banks and financial institutions, borrowings from
foreign markets and raising of capital by issue various securities
such as shares debentures, bonds, etc
Types of capital markets

They are of two types –

• Primary market – deals with fresh stocks.
• Secondary market – trading with old securities.
► The market where securities are traded known as Securities
market. It consists of two different segments namely primary
and secondary market. The primary market deals with new or
fresh issue of securities and is, therefore, also known as new
issue market; whereas the secondary market provides a place
for purchase and sale of existing securities and is often termed
as stock market or stock exchange.
 What Is a Financial Instrument?
► Financial instruments are assets that can be traded, or they can
also be seen as packages of capital that may be traded. Most
types of financial instruments provide efficient flow and transfer
of capital all throughout the world's investors. These assets can
be cash, a contractual right to deliver or receive cash or another
type of financial instrument, or evidence of one's ownership of
an entity.
Meaning of Financial Instruments

► Financial instruments can be real or virtual documents

representing a legal agreement involving any kind of monetary
value. Equity-based financial instruments represent ownership
of an asset. Debt-based financial instruments represent a loan
made by an investor to the owner of the asset.

► Foreign exchange instruments comprise a third, unique type of

financial instrument. Different subcategories of each
instrument type exist, such as preferred share
equity(Preference shares) and common share equity.
Types of Financial Instruments

Financial instruments may be divided into

two types:

► Cash instruments

► Derivative Instruments
Cash Instruments

► The values of cash instruments are directly influenced and

determined by the markets. These can be securities that are
easily transferable.
► Cash instruments may also be deposits and loans agreed upon
by borrowers and lenders.
Derivative Instruments
► The value and characteristics of derivative instruments are based on
the vehicle’s underlying components, such as assets, interest rates, or
indices.

► An equity options contract, for example, is a derivative because it

derives its value from the underlying stock. The option gives the
right, but not the obligation, to buy or sell the stock at a specified
price and by a certain date. As the price of the stock rises and falls,
so too does the value of the option although not necessarily by the
same percentage.
► There can be over-the-counter (OTC) derivatives or exchange-traded
derivatives. OTC is a market or process whereby securities–that are
not listed on formal exchanges–are priced and traded.
Types of Financial Instruments

► Financial instruments may also be divided according to an asset

class, which depends on whether they are debt-based or
equity-based.
Debt-Based Financial
Instruments
► Short-term debt-based financial instruments last for one year or
less. Securities of this kind come in the form of T-bills and
commercial paper. Cash of this kind can be deposits and
certificates of deposit (CDs).
► Exchange-traded derivatives under short-term, debt-based
financial instruments can be short-term interest rate
futures. OTC derivatives are forward rate agreements
► Long-term debt-based financial instruments last for more than a
year. Under securities, these are bonds. Cash equivalents are
loans. Exchange-traded derivatives are bond futures and options
on bond futures.
► Equity-Based Financial Instruments: Securities under
equity-based financial instruments are stocks. Exchange-traded
derivatives in this category include stock options and equity
futures.
 Financial services
► Financial services are the economic services provided by
the finance industry, which encompasses a broad range
of businesses that manage money, including credit
unions,banks, creditcard companies, insurance companies,
accountancy companies, consumer
finance companies, stock brokerages, investment funds,
individual asset managers, and
some government-sponsored enterprises
Meaning of Financial Services
► In general, all types of activities which are of financial nature may
be regarded as financial services.
► In a broad sense, the term financial services means mobilisation
and allocation of savings.
Thus, it includes all activities involved in the transformation of
savings into investment. Financial services refer to services provided
by the finance industry. The finance industry consists of a broad
range of organisations that deal with the management of money.
These organisations include banks, credit card companies, insurance
companies, consumer finance companies, stock brokers, investment
funds and some government sponsored enterprises.
Financial services may be defined as the products and services
offered by financial institutions for the facilitation of various
financial transactions and other related activities.
Financial services can also be called financial intermediation.
Financial intermediation is a process by which funds are mobilized
from a large number of savers and make them available to all those
who are in need of it and particularly to corporate customers. There
are various institutions which render financial services. Some of the
institutions are banks, investment companies, accounting firms,
financial institutions, merchant banks, leasing companies, venture
capital companies, factoring companies, mutual funds etc. These
institutions provide variety of services to corporate enterprises. Such
services are called financial services. Thus, services rendered by
financial service organizations to industrial enterprises and to
ultimate consumer markets are called financial services. These are
the services and facilities required for the smooth operation of the
financial markets. In short, services provided by financial
intermediaries are called financial services.
 Functions of Financial Services
1. Facilitating transactions (exchange of goods and services) in the
economy.
2. Mobilizing savings (for which the outlets would otherwise be
much more limited).
3. Allocating capital funds (notably to finance productive
investment).
4. Monitoring managers (so that the funds allocated will be spent as
envisaged).
5. Transforming risk (reducing it through aggregation and enabling
it to be carried by those more willing to bear it).
Characteristics or Nature of Financial
Services
► From the following characteristics of financial services, we can
understand their nature:
1. Intangibility: Financial services are intangible. Therefore, they cannot
be standardized or reproduced in the same form. The institutions
supplying the financial services should have a better image and
confidence of the customers. Otherwise, they may not succeed. They
have to focus on quality and innovation of their services. Then only they
can build credibility and gain the trust of the customers.
2. Inseparability: Both production and supply of financial services have to
be performed simultaneously. Hence, there should be perfect
understanding between the financial service institutions and its
customers.
3. Perishability: Like other services, financial services also require a match
between demand and supply. Services cannot be stored. They have to be
supplied when customers need them.
4. Variability: In order to cater a variety of financial and related needs
of different customers in different areas, financial service organisations
have to offer a wide range of products and services. This means the
financial services have to be tailor-made to the requirements of
customers. The service institutions differentiate their services to
develop their individual identity.
5. Dominance of human element: financial services are labour
intensive. quality financial products. Financial services are dominated
by human element. Thus, It requires competent and skilled personnel to
market the quality financial products.

6. Information based: Financial service industry is an information

based industry. It involves creation, dissemination and use of
information. Information is an essential component in the production of
financial services
❖ Importance of Financial Services :
The successful functioning of any financial system depends upon the range
of financial services offered by financial service organisations. The
importance of financial services may be understood from the following
points:
1. Economic growth: The financial service industry mobilises the savings
of the people, and channels them into productive investments by
providing various services to people in general and corporate
enterprises in particular. In short, the economic growth of any country
depends upon these savings and investments.
2. Promotion of savings: The financial service industry mobilises the
savings of the people by providing transformation services. It provides
liability, asset and size transformation service by providing huge loan
from small deposits collected from a large number of people. In this
way financial service industry promotes savings.
3. Capital formation: Financial service industry facilitates capital
formation by rendering various capital market intermediary services.
Capital formation is the very basis for economic growth.
4.Creation of employment opportunities: The financial service
industry creates and provides employment opportunities to millions of
people all over the world.
5. Contribution to GNP: Recently the contribution of financial
services to GNP has been increasing year after year in almost countries.
6. Provision of liquidity: The financial service industry promotes
liquidity in the financial system by allocating and reallocating savings
and investment into various avenues of economic activity. It facilitates
easy conversion of financial assets into liquid cash.
 KINDS OF FINANCIAL
SERVICES

FUND BASED NON-FUND OR FEE

SERVICES BASED SERVICES
 The financial services can be broadly classified into two:
(a) fund based services
(b) non-fund services (or fee-based services)

Fund based Services : The fund based or asset based services include
the following:
1. Underwriting
2. Dealing in secondary market activities
3. Participating in money market instruments like CPs, CDs etc.
4. Equipment leasing or lease financing
5. Hire purchase
6. Venture capital
7. Bill discounting.
8. Insurance services
9. Factoring
10. Forfeiting
11. Housing finance
12. Mutual fund
A. Asset/Fund Based Services

1. Equipment leasing/Lease financing: A lease is an agreement

under which a firm acquires a right to make use of a capital asset
like machinery etc. on payment of an agreed fee called lease
rentals. The person (or the company) which acquires the right is
known as lessee. He does not get the ownership of the asset. He
acquires only the right to use the asset. The person (or the
company) who gives the right is known as lessor.

2. Hire purchase and consumer credit: Hire purchase is an

alternative to leasing. Hire purchase is a transaction where goods are
purchased and sold on the condition that payment is made in
instalments. The buyer gets only possession of goods. He does not get
ownership. He gets ownership only after the payment of the last
instalment. If the buyer fails to pay any instalment, the seller can
repossess the goods. Each instalment includes interest also.
3. Bill discounting: Discounting of bill is an attractive fund based financial
service provided by the finance companies. In the case of time bill (payable
after a specified period), the holder need not wait till maturity or due date. If
he is in need of money, he can discount the bill with his banker. After
deducting a certain amount (discount), the banker credits the net amount in
the customer’s account. Thus, the bank purchases the bill and credits the
customer’s account with the amount of the bill less discount. On the due date,
the drawee makes payment to the banker. If he fails to make payment, the
banker will recover the amount from the customer who has discounted the
bill. In short, discounting of bill means giving loans on the basis of the
security of a bill of exchange.

4. Venture capital: Venture capital simply refers to capital which is

available for financing the new business ventures. It involves lending finance
to the growing companies. It is the investment in a highly risky project with
the objective of earning a high rate of return. In short, venture capital means
long term risk capital in the form of equity finance.
5. Housing finance: Housing finance simply refers to providing finance for
house building. It emerged as a fund based financial service in India with the
establishment of National Housing Bank (NHB) by the RBI in 1988. It is an
apex housing finance institution in the country. Till now, a number of
specialised financial institutions/companies have entered in the filed of
housing finance. Some of the institutions are HDFC, LIC Housing Finance,
Citi Home, Ind Bank Housing etc

6. Insurance services: Insurance is a contract between two parties. One

party is the insured and the other party is the insurer. Insured is the person
whose life or property is insured with the insurer. That is, the person whose
risk is insured is called insured. Insurer is the insurance company to whom
risk is transferred by the insured. That is, the person who insures the risk of
insured is called insurer. Thus insurance is a contract between insurer and
insured. It is a contract in which the insurance company undertakes to
indemnify the insured on the happening of certain event for a payment of
consideration. It is a contract between the insurer and insured under which the
insurer undertakes to compensate the insured for the loss arising from the risk
insured against.
According to Mc Gill, “Insurance is a process in which uncertainties are made
certain”. In the words of Jon Megi, “Insurance is a plan wherein persons
collectively share the losses of risks”. Thus, insurance is a device by which a loss
likely to be caused by uncertain event is spread over a large number of persons
who are exposed to it and who voluntarily join themselves against such an event.
The document which contains all the terms and conditions of insurance (i.e. the
written contract) is called the ‘insurance policy’. The amount for which the
insurance policy is taken is called ‘sum assured’. The consideration in return for
which the insurer agrees to make good the loss is known as ‘insurance premium’.
This premium is to be paid regularly by the insured. It may be paid monthly,
quarterly, half yearly or yearly.

7. Factoring: Factoring is an arrangement under which the factor purchases the

account receivables (arising out of credit sale of goods/services) and makes
immediate cash payment to the supplier or creditor. Thus, it is an arrangement in
which the account receivables of a firm (client) are purchased by a financial
institution or banker. Thus, the factor provides finance to the client (supplier) in
respect of account receivables. The factor undertakes the responsibility of
collecting the account receivables. The financial institution (factor) undertakes the
risk. For this type of service as well as for the interest, the factor charges a fee for
the intervening period. This fee or charge is called factorage.
8. Forfaiting: Forfaiting is a form of financing of receivables relating to
international trade. It is a non-recourse purchase by a banker or any other
financial institution of receivables arising from export of goods and services.
The exporter surrenders his right to the forfaiter to receive future payment
from the buyer to whom goods have been supplied. Forfaiting is a technique
that helps the exporter sells his goods on credit and yet receives the cash well
before the due date. In short, forfaiting is a technique by which a forfaitor
(financing agency) discounts an export bill and pay ready cash to the
exporter. The exporter need not bother about collection of export bill. He can
just concentrate on export trade.

9. Mutual fund: Mutual funds are financial intermediaries which mobilise

savings from the people and invest them in a mix of corporate and
government securities. The mutual fund operators actively manage this
portfolio of securities and earn income through dividend, interest and capital
gains. The incomes are eventually passed on to mutual fund shareholders.
Non-Fund Based/Fee Based Financial
Services
1.Merchant banking: Merchant banking is basically a service banking,
concerned with providing non-fund based services of arranging funds rather
than providing them. The merchant banker merely acts as an intermediary. Its
main job is to transfer capital from those who own it to those who need it.
Today, merchant banker acts as an institution which understands the
requirements of the promoters on the one hand and financial institutions,
banks, stock exchange and money markets on the other. SEBI (Merchant
Bankers) Rule, 1992 has defined a merchant banker as, “any person who is
engaged in the business of issue management either by making arrangements
regarding selling, buying or subscribing to securities or acting as manager,
consultant, advisor, or rendering corporate advisory services in relation to such
issue management”.
2. Credit rating: Credit rating means giving an expert opinion by a
rating agency on the relative willingness and ability of the issuer of a
debt instrument to meet the financial obligations in time and in full. It
measures the relative risk of an issuer’s ability and willingness to
repay both interest and principal over the period of the rated
instrument. It is a judgement about a firm’s financial and business
prospects. In short, credit rating means assessing the creditworthiness
of a company by an independent organisation.

3. Stock broking: Now stock broking has emerged as a

professional advisory service. Stock broker is a member of a
recognized stock exchange. He buys, sells, or deals in
shares/securities. It is compulsory for each stock broker to get
himself/herself registered with SEBI in order to act as a broker. As a
member of a stock exchange, he will have to abide by its rules,
regulations and bylaws.
4. Custodial services: In simple words, the services provided by
a custodian are known as custodial services (custodian services).
Custodian is an institution or a person who is handed over securities
by the security owners for safe custody. Custodian is a caretaker of a
public property or securities. Custodians are intermediaries between
companies and clients (i.e. security holders) and institutions (financial
institutions and mutual funds). There is an arrangement and
agreement between custodian and real owners of securities or
properties to act as custodians of those who hand over it. The duty of
a custodian is to keep the securities or documents under safe custody.
The work of custodian is very risky and costly in nature. For
rendering these services, he gets a remuneration called custodial
charges. Thus custodial service is the service of keeping the securities
safe for and on behalf of somebody else for a remuneration called
custodial charges.
5. Loan syndication: Loan syndication is an arrangement where a group of
banks participate to provide funds for a single loan. In a loan syndication, a
group of banks comprising 10 to 30 banks participate to provide funds
wherein one of the banks is the lead manager. This lead bank is decided by the
corporate enterprises, depending on confidence in the lead manager. A single
bank cannot give a huge loan. Hence a number of banks join together and
form a syndicate. This is known as loan syndication. Thus, loan syndication is
very similar to consortium financing.
6. Securitisation (of debt): Loans given to customers are assets for the
bank. They are called loan assets. Unlike investment assets, loan assets are not
tradable and transferable. Thus loan assets are not liquid. The problem is how
to make the loan of a bank liquid. This problem can be solved by transforming
the loans into marketable securities. Now loans become liquid. They get the
characteristic of marketability. This is done through the process of
securitization. Securitisation is a financial innovation. It is conversion of
existing or future cash flows into marketable securities that can be sold to
investors. It is the process by which financial assets such as loan receivables,
credit card balances, hire purchase debtors, lease receivables, trade debtors
etc. are transformed into securities.
Thus, any asset with predictable cash flows can be securitised.
Securitisation is defined as a process of transformation of illiquid
asset into security which may be traded later in the opening market. In
short, securitization is the transformation of illiquid, non- marketable
assets into securities which are liquid and marketable assets. It is a
process of transformation of assets of a lending institution into
negotiable instruments. Securitisation is different from factoring.
Factoring involves transfer of debts without transforming debts into
marketable securities. But securitisation always involves
transformation of illiquid assets into liquid assets that can be sold to
investors.
Challenges faced by the financial service sector.
► Financial service sector has to face lot of challenges in its way to
fulfil the ever growing financial demand of the economy. Some of
the important challenges are listed below:
1. Lack of qualified personnel in the financial service sector.
2. Lack of investor awareness about the various financial services.
3. Lack of transparency in the disclosure requirements and
accounting practices relating to financial services.
4. Lack of specialisation in different financial services
(specialisation only in one or two services).
5. Lack of adequate data to take financial service related decisions.
6. Lack of efficient risk management system in the financial service
sector
 Indian financial system-an overview
❑ A country depends on economic growth and development
to a large extent.
❑ It depends on the efficiency of a developed financial
system .
❑ Growth of financial sector is an indicator of an economic
development of a country.
❑ Financial system has undergone massive changes in its
structure with the help of liberalisation/deregulation and
globalisation of the Indian economy.
❑ The changes in the financial system can be studied into
three stages.
1. Before independence
2. After independence
3. After 1990
STAGE I-BEFORE INDEPENDENCE

The pre independence financial system was characterised

by the following
• The system was unorganised
• Capital stock exchange had very few industrial securities
being traded in securities market
• There was no separate issuing institution(which provides
payment services for clients by issuing payment
instruments such as debit and credit card.)
• Participation of financial intermediaries had almost been
nil in long term financing of industries.
• Industry’s access to outside savings was also restricted.
 STAGE II-AFTER INDEPENDENCE (1948-90)
• Post independence period stressed on planned economic
development.
• Under the directive principles of state policy, a scheme of planned
economic development was evolved in 1951 by the directive
principles of state policy a view to achieve the broad economic and
social objective of the state.
• Indian constitution also laid stress on the securing economic
growth with social justice.
• Five year plans were introduced.
• Both public and private sector were to play an important role in the
economy to achieve industrial growth an development.
• Number of developments took place in the financial system which
are listed below.
• Transfer of ownership from private to public sector was the main
motive during the second phase after independence. As well setting
up of new institution in the public sector was also the main motive.
• Nationalisation of RBI
The beginning of the transfer of ownership from private to
government control took place when RBI was nationalised through
Reserve bank (transfer of public ownership) Act 1948,the entire
share where acquired by central government.
• Setting up of State Bank of India
1st Five year plan launched in 1951 aimed at the development of
rural area.
It suggested the setting up of State Bank by taking over the
imperial bank of India under the state bank of India act 1935,
giving reserve bank of India 92% of the issued capital of the bank.
• Nationalisation of Life Insurance business
One of the milestone in the economic development of the nation
was the nationalisation of 245 life insurance companies in 1956. As
a result life insurance corporation of India existence on 1st
September 1956 as a statutory institution incorporated under the
LIC act 1956.
• Nationalisation of Commercial Banks
14 Commercial Banks with a deposit base of Rs 50 crores or more were
nationalised
Again in 1980 six more private sector banks were nationalised bringing
up the total number of banks nationalised to twenty.

• Nationalisation of general insurance business

General insurance business was set up in 1972 by passing the general
insurance business act 1972

• Setting up of financial institutions

1. Development finance institution
2. Investing institutions
3. Changing roles of commercial banks
 STAGE III AFTER 1990’s
• Entry of private sector
• Changing role of development finance institution (DFIs)
• Emergence of Non banking financial companies (NBFC’s)
• Growth of mutual funds industry
• Securities and exchange board of India
• Development of secondary markets/ stock markets
 What Is a Financial Asset?
A financial asset is a liquid asset that gets its value from a contractual right or
ownership claim. Cash, stocks, bonds, mutual funds, and bank deposits are all are
examples of financial assets. Unlike land, property, commodities, or other tangible
physical assets, financial assets do not necessarily have inherent physical worth or
even a physical form. Rather, their value reflects factors of supply and demand in
the marketplace in which they trade, as well as the degree of risk they carry.
► A financial asset is a liquid asset that represents—and derives value from—a
claim of ownership of an entity or contractual rights to future payments from an
entity.
► A financial asset's worth may be based on an underlying tangible or real asset,
but market supply and demand influence its value as well.
► Stocks, bonds, cash, CDs, and bank deposits are examples of financial assets.
• What are physical assets ?
Physical assets are those which we can touch, feel and see. Real estate,
commodities and gold are examples of physical assets.

Advantages of Financial Assets over Physical Assets

1) Liquidity-When it comes to withdrawing money from the investment,
financial assets score over physical assets. Financial assets can be easily
converted into cash in a short span of time. Fixed deposits can be liquidated,
mutual funds can be redeemed easily and money gets credited into bank
account in 1-3 working days.
On the other hand, selling real estate is not easy as it may take months and
years to find the right buyer. Gold can be easily liquidated but it is ingrained
in human behaviour that selling gold is a sign of financial distress. It is
generally observed that people tend to cling to gold and do not sell it until it
is the last resort.
2) Transparency-Financial assets are more transparent in terms of their
valuation and charges involved. Their current value can be checked and
tracked on the daily basis.
In the case of real estate, it is difficult to know the correct value of the
property. Similar houses in the same area fetch different prices. Also, only
after the deal has finally happened between the buyer and the seller, one can
know the actual value of an asset.
Even in case of gold, whether it is in form of jewellery or coins and bars, the
actual value is known only once it is sold. Specially in case of jewellery, the
purchase price and the selling price can be significantly different due to
deduction of making charges and materials used other than pure gold.
3)Divisibility -One of the many advantages of financial assets is their
flexibility to be liquidated fully or partially, as per the requirement of an
investor.
Physical asset like real estate cannot be sold in parts. Also, real estate usually
involve large amount and has to be sold in whole, no matter how small the
requirement of an investor is.
4) Taxation – Prior knowledge of the exact value of a financial asset makes it
is easy to evaluate the taxation involved in the transaction, before actually
completing the transaction.