Introduction To Financial System:

Savers

Borrowers

Financial
System

• Financial System is the Biggest Cog in the Wheel of Finance. It drives Savers
and borrowers by bringing them together and moving scarce resources from
savers to borrowers, thus making efficient utilization of resources possible.

• A financial System consists of various sub-systems like Financial Institutions,

Markets, instruments, services etc. We will be reading about these sub-
systems below.
 Capital Economic
Financial
Formation Development
System

• The above chart shows how an efficient financial system results in capital
formation and economic development of the country.
• By bringing together Savers and borrowers, it helps in capital formation for
the country.

What is Capital Formation?

• The process of capital formation involves 3 distinct and inter-related activities:

o Savings- The ability of financial system by which claims to resources
are set aside and become available for other purposes (saving of
money by people)
o Finance- The activity by which savings are driven towards investors/
borrowers through banking or market based financial system
o Investments- the activity by which resources are committed to
production by institutions which borrow from the market/ bank
 Transfer Process (if capital formation is to take
place):

Saving Surplus Units

Units

• Financial system is the institutional arrangement, which enables coming

together of saving surplus and saving deficit units and transfer of idle
resources from saving surplus units to saving deficit units.
 Basic Structure of a Financial System:

The Organization of Financial System consists of:

• Financial Institutions or Intermediaries

• Financial markets
• Financial instruments
• Financial Regulators and
• Financial Services

Financial Institutions-
• FIs are intermediaries that mobilize savings and facilitate allocation of funds
in an efficient manner.
• FIs can be classified as Banking and Non-Banking FIs.
 • Banking institutions create credit and also distribute/ sell credit. But Non-
banking institutions are mere distributors/ sellers of credit
• FIs have an important function called as “transmutation effect”. TE means
ability of financial institutions to convert contracts with a given set of
characteristics into contracts with very different features. This means that FIs
make one type of contract with lenders and another type of contract with
borrowers.

Economies Provided by Financial Institutions-

i. Convenience
ii. Lower Risk
iii. Expert Management
iv. Economies of Scale

Types of Financial Institutions-

i. Commercial Banks
ii. NBFCs
iii. Mutual Funds
iv. Insurance organizations

1. Financial Markets- Financial Markets perform a crucial function in the

savings-investment process as facilitating organizations. They are not source
of finance but a link between savers and investors. Financial Markets can be
classified into Money Market and Capital/ Securities Market.
o Money Market- Money market deals with monetary assets of short-
term nature, generally less than 1 year.
o Money market is that segment of financial market which enables
 “raising of short-term funds for meeting temporary shortages of cash
and obligations and temporary deployment of excess funds for earning
returns”.

o Major participants in money market are RBI and commercial banks

o Capital Market- It is a market for long-term funds. Its focus is on

financing of fixed investment in contrast to money market which is the
institutional source of working capital finance. Capital Market has two
segments- Primary or New Issue Market and Secondary Market.

Financial Assets/ Instruments-

o Financial Instruments represent claims on a stream of income and assets of
another economic unit and are held as a store of value and for expected
return.
o Financial instruments are of 3 major types- Direct/ Primary, Indirect/
Secondary and Derivatives
o Primary Assets- A security issued by Non-Financial Economic Unit is called
as a primary asset. Examples- Bonds, debentures, equity, preference shares.
In a Primary Asset, there is direct relation between borrower and investor.
o Secondary Assets- Securities issues by Financial intermediaries such as
mutual funds, insurance companies, Banks, ARCs etc. In secondary assets,
there is a financial intermediary involved between borrower and investor.
o Derivatives- An instrument whose value is derived from the value of an
underlying asset is called a derivative. The underlying asset can be a financial
asset or a real asset. Derivatives are instruments of risk management.
 Financial Services-
o Various financial functions like depositing, borrowing, credit rating,
Underwriting are termed as financial services, without which the financial
markets cannot perform. Financial Services help in functioning of financial
functions.

Some Financial Services are:

o Depositories
o Credit rating
o Merchant Banking
o Underwriting
o Portfolio Management

Financial Regulators-
o Financial Regulators are organizations that regulate and look after fair and
efficient functioning of financial system as a whole. They keep an eye on
financial functions and ensure fair and honest play for benefit of all. Various
financial regulators are- SEBI, RBI, IRDA, NABARD etc.

Functions of a financial system:

• To link savers and borrowers- one of the major functions of a financial
system is to create a link between people who wish to save and people who
need funds. By carrying out this function, the financial system helps in
mobilizing and allocating savings efficiently and effectively.
 • A well functioning financial system inspires operators to monitor corporate
performance and exert corporate control by regular oversight on performance
of firms.
• Components of a financial system ensure movement of funds quickly, safely
and in a timely manner, thereby increasing trust over the financial system. In
banks, movement of funds is ensured through cheques, credit and debit
cards and wallets. In stock markets, movement of funds is done through
depositories and clearing corporation.
• Risk reduction is provided in a financial system by providing a diversified set
of portfolios to investors.
• A Financial system provides mechanism of “price discovery” to its
participants. By disseminating price related information, the problem of
asymmetric information is resolved, which ensures wider participation and
correct/ accurate pricing of instruments dealt on the market.
• A well functioning financial system provides depth as well as breadth to
financial markets. Depth refers to increase of financial assets as a
percentage of GDP. Breadth refers to an increase in number of participants
and variety of instruments dealt on the market.

What is Financial Dualism?

The coexistence of formal and informal financial sectors in the financial system of a
country is referred to as financial dualism. In every country, both formal and informal
sectors work in varying proportions. Regular interaction and cooperation among these
sectors define the strength of financial system.
 Informal financial system consists of:
• Moneylenders
• Chit funds/ Nidhi companies (collective investment schemes)
• Saving clubs in rural areas