Financial System - Introduction

Prof Ravichandran
 Financial system
• A financial system (within the scope
of finance) is a system that allows the
exchange of funds between lenders, investors,
and borrowers.
• Financial systems operate at national, global,
and firm-specific levels. ...
• Financial systems allow funds to be allocated,
invested, or moved between economic
sectors.
 Financial System
• Financial system is a mechanism that works for
investors and people who want finance.
• It is an interaction of various intermediaries,
market instruments, policy makers, and various
regulations to aid the flow of savings from savers
to investors and managing the proper functioning
of the system.
• Financial System of any country consists of
– financial markets,
– financial intermediation
– financial instruments or financial products.
 Financial Market
• A Financial Market can be defined as the market
in which financial assets are created or
transferred.
• As against a real transaction that involves
exchange of money for real goods or services, a
financial transaction involves creation or transfer
of a financial asset.
• Financial Assets or Financial Instruments
represents a claim to the payment of a sum of
money sometime in the future and /or periodic
payment in the form of interest or dividend
 Financial Market

1. Money Market
2. Capital Market
3. Forex Market
4. Credit Market
 Financial Market
• Money Market- The money market ifs a
wholesale debt market for low-risk, highly-liquid,
short-term instrument. Funds are available in
this market for periods ranging from a single day
up to a year. This market is dominated mostly by
government, banks and financial institutions.
• Capital Market - The capital market is designed
to finance the long-term investments. The
transactions taking place in this market will be for
periods over a year.
 Financial Market
• Forex Market - The Forex market deals with the
multicurrency requirements, which are met by
the exchange of currencies. Depending on the
exchange rate that is applicable, the transfer of
funds takes place in this market. This is one of
the most developed and integrated market across
the globe.
• Credit Market- Credit market is a place where
banks, FIs and NBFCs purvey short, medium and
long-term loans to corporate and individuals.
 Indian Financial System
Pre-planned period
• Close character of entrepreneurship
• Absence of financial intermediaries
• Low industrial growth rate.
Mixed economy based planned period
• Public/Govt. ownership of financial institutions -
RBI, Nationalized banks, Special purpose financial
institutions
• Investors' protection - Companies act, Securities
contract act
 Money Market
• Money market is that area of market that
deals in short term capital.
• Ma rk e t for funds and assets that are close
substitutes for money
• Focuses on providing means by which
government and institutions are able to
rapidly adjust their actual liquidity position
 Money Market Instruments
• Call money instruments- one day loan
• Treasury bills- meeting short term deficits of Govt
• Commercial papers- short term instruments
issued by corporate- introduced in Jan 1990
• Certificate of deposits- issues by banks to the
depositor, introduced in June 989- lowest period
15 days for 5 lakhs
• Repo transactions- maturity of 1 day to six
months
• Money market mutual funds-introduced by RBI
in April 1992 and regulated by SEBI
 Purpose of the money market
• Banks borrow in the money market to:
– Fill the gaps or temporary mismatch of funds
– To meet the CRR and SLR mandatory requirements
as stipulated by the central bank.
– To meet sudden demand for funds arising out of
large outflows (like advance tax payments)
• Call money market serves the role of
equilibrating the short-term liquidity position
of the banks
 Capital Market
• M a r k e t where long term and medium term
financial instruments are traded.
• T h i s market consists of two parts:
• Primary market
• By prospectus
• Offer for sale
• Private placement
• Right issue
• Right issue
• Employees stock option
• Sweat equity
 Capital Market
• Secondary Market
 Located at a fixed place
 Securities of listed companies are traded
 Purpose is to transfer ownership
 Instruments of CapitalMarket
Equity shares
• Preference shares
• Debentures/ bonds
• Innovative debt instruments
– Convertible debentures/bonds
– Wa r ra nt s
– Z e r o interest bond
– S e c ure d premium notes
– Floating rate bond
 Instruments of CapitalMarket
Derivative Instruments:
• Forward Contracts:
– N o n - S t a n d a r d i s e d & O T C i n n a t u r e , involves
counter party risk
• Futures& Options
• Standardized , traded at exchange,
regulated by SEBI, Counterparty risk is
reduced through exchange margin account
mechanism.
 Instruments of CapitalMarket
Hybrid Instruments:
Hybrid instruments have both the
features of equity and debenture.
This kind of instruments is called as
hybrid instruments. Examples are
convertible debentures, warrants
etc.
 Financial Instruments / Assets
• Financial assets / Instruments (loans, deposits,
bonds, equities, etc.)
• What are they are characteristics ?
• How are they traded ?
• How are they priced ?
• How are they used?
• How is the valuation done?
 Financial assets/instruments
• Enable channelizing funds from surplus units to
deficit units
• There are instruments for savers such as deposits,
equities, mutual fund units, etc.
• There are instruments for borrowers such as
loans, overdrafts, etc.
• Like businesses, governments too raise funds
through issuing of bonds, Treasury bills, etc.
• Instruments like PPF, etc. are available to savers
who wish to lend money to the government
 Financial Institutions
• Includes institutions and mechanisms which
– Affect generation of savings by the community
– Mobilisation of savings
– Effective distribution of savings
• Institutions are banks, insurance companies,
mutual funds- promote/mobilise savings
• Individual investors, industrial and trading
companies-borrowers
 Financial Intermediaries
Banking Non-banking Developmental Regulatory
Institutions

•RBI •LIC •ICICI, IDBI,IFCI •SEBI

•Commercial •GIC •NABARD •RBI
banks •UTI SIDBI •IRDA- insurance
•Co-operative •Housing •Tourism finance regulatory and
banks development finance corporation development
•Post office companies-HDFC, •SFCs authority
savings banks HUDCO •Board of regulatory
and development
authority-BIFR
 Equilibrium in FinancialMarkets
Interest rate
Lending Price
Supply

Borrowings
Demand

Amount of loan funds Amount of securities

If the interest rate rises lenders Investors are willing to buy more
are ready to provide more funds securities as price falls, and sell
Borrowers are ready to borrow more when price rises.
when interest rate falls.
 Financial intermediaries
• Financial intermediaries came into existence.
Financial intermediation in the organized sector is
conducted by a wide range of institutions
functioning under the overall surveillance of the
Reserve Bank of India.
• In the initial stages, the role of the intermediary
was mostly related to ensure transfer of funds
from the lender to the borrower.
• This service was offered by banks, FIs, brokers,
and dealers
• However, as the financial system widened along with
the developments taking place in the financial markets,
the scope of its operations also widened.
• Some of the important intermediaries operating ink
the financial markets include; investment bankers,
underwriters, stock exchanges, registrars, depositories,
custodians, portfolio managers, mutual funds, financial
advertisers financial consultants, primary dealers,
satellite dealers, self regulatory organizations, etc.
Though the markets are different, there may be a few
intermediaries offering their services in move than one
market e.g. underwriter. However, the services offered
by them vary from one market to another.
 Financial Intermediaries
• Some of the important intermediaries operating ink
the financial markets include;
– investment bankers,
– underwriters,
– stock exchanges,
– registrars, depositories,
– custodians,
– portfolio managers,
– mutual funds,
– financial advertisers financial consultants,
– primary dealers, satellite dealers,
– self regulatory organizations, etc.
 Financial Intermediaries
• Though the markets are different, there may
be a few intermediaries offering their services
in move than one market e.g. underwriter.
• However, the services offered by them vary
from one market to another.
 Financial Intermediaries
Intermediary Market Role

Stock Exchange Capital Market Secondary Market to securities

Corporate advisory services,

Investment Bankers Capital Market, Credit Market
Issue of securities

Subscribe to unsubscribed
Underwriters Capital Market, Money Market
portion of securities

Issue securities to the investors

Registrars, Depositories,
Capital Market on behalf of the company and
Custodians
handle share transfer activity

Market making in government

Primary Dealers Satellite Dealers Money Market
securities

Forex Dealers Forex Market Ensure exchange ink currencies

 Financial Intermediaries
• Mutual Funds- Promote savings and mobilise
funds which are invested in the stock market
and bond market
– Indirect source of finance to companies Pool
funds of savers and invest in the stock
market/bond market.
– Their instruments at saver’s end are called units.
– Offer many types of schemes: growth fund,
income fund, balanced fund.
– Regulated by SEBI
 Financial Intermediaries
• Merchant banking- manage and underwrite
new issues, undertake syndication of credit,
advise corporate clients on fund raising
– Subject to regulation by SEBI and RBI
– SEBI regulates them on issue activity and portfolio
management of their business.
– RBI supervises those merchant banks which are
subsidiaries or affiliates of commercial banks
– Have to adopt stipulated capital adequacy norms
and abide by a code of conduct
 Financial Intermediaries
There are other financial intermediaries such
as NBFCs, Venture Capital Funds, Hire and
Leasing Companies, etc.
– India’s financial system is quite huge and caters to
every kind of demand for funds
– Banks are at the core of our financial system and
therefore, there is greater expectation from them
in terms of reaching out to the vast populace as
well as being competitive