Let’s talk about Financial System.

Financial system implies a set of complex and closely connected or interlinked institutions, agents,
practices, markets, transactions, claims, and liabilities in the economy.

It is the system that allows the transfer of money from savers and investors to borrowers. A Financial
System is made up of Financial Intermediaries, Financial Markets and Financial Assets.

It helps in the formation of capital and meets the short term and long term capital needs of households,
corporate houses, Govt. and foreigners.

The primary responsibility of a Financial System is to mobilize the savings in the form of money and invest
them in the productive manner.

Now let’s have a look at how funds flow in the Financial System. There are two kinds of flows. Direct and
Indirect.

We will talk about Indirect Flows first. As the name implies, in an Indirect Flow, the borrower accesses
funds of the saver or investor indirectly, through a financial intermediary operating in the financial market.
Banks, nonbanking financial institutions, mutual funds and insurance companies are examples of such
intermediaries.

In case of direct flows, funds are transferred from savers to borrowers and back directly without the aid
of any financial intermediary. The examples of direct flows are issuance of shares, bonds and debentures
by a company.

Financial system performs many critical functions in an economy, such as connecting savers with
borrowers and investors, monitoring the performance of investment, allocation and diversification of risk,
providing information on features, risks and pricing, and broadening and deepening the market through
financial inclusion.

The structure of a Financial System is made up of three integral components. Financial intermediaries,
Financial Markets, and Financial Assets. Let’s discuss financial intermediaries first.

Financial intermediaries operate between ultimate borrowers and ultimate lenders. They provide key
financial services such as commercial and retail banking, merchant banking, leasing, credit rating,
brokering & factoring etc. The main benefits of financial intermediaries are Convenience, maturity
matching, divisibility of investments, diversification of risk, expertise in investment management and
economies of scale.

There are several types of financial intermediaries but these are most prevalent. Banks, non-banking
financial institutions, mutual funds, and insurance companies.

Commercial banks are arguably the biggest of all the components of financial system. Their main function
is to collect savings primarily in the form of deposits and finance short term working capital requirement
of individuals and businesses. However, with the emerging needs of economic and financial systems,
commercial banks have started providing term loans to businesses, particularly for funding their long term
Capex requirements. Commercial banks of today, also provide retail and consumer finance such as
housing loans, auto finance, personal loans and credit card loans. Commercial Banks also invest in
securities traded in capital markets, both directly and indirectly.
The second type of financial intermediaries are Non-banking financial institutions or NBFIs. NBFIs are
companies registered under the Companies Act and engaged in the business of loans and advances,
acquisition of shares, stocks, bonds or other marketable securities, leasing, hire-purchase, brokerage etc.
NBFIs Provide variety of fund-based and non-fund based and advisory services. Their funds are raised
mainly through equity investment by sponsors, borrowing and term deposits or certificates of
investments. NBFIs are of various types but most common types include Asset finance companies, Housing
finance companies, venture capital funds, Merchant and investment banks, leasing companies, credit
rating agencies, Factoring and forfaiting organizations, Stock brokering firms, and Depositories.

The third type of financial intermediary is mutual funds. A mutual fund is a company that pools money
from individuals and businesses and invests in a diversified portfolio of financial and non-financial assets
and securities. Mutual fund issues securities, also called units, to its investors who are also called unit
holders, in accordance with the quantum of money invested by them. Profits generated from investments
are shared by the unit holders in proportion of their investments. Mutual funds are organized as trusts
which has an asset manager or asset management company as trustee and custodian of investors’ funds.
Mutual funds offer several advantages to investors such as investment expertise, convenience, liquidity,
and lower transaction costs.

The fourth significant component of financial system is insurance companies. Insurance companies
provide a combination of risk protection and savings services. Insurance companies issue policies for
various types of risks. Most common types of risks covered are life, health, disability, fire, theft, accidents,
shipment, employee fidelity, crops, weather, disasters, etc. Policy holders pay premiums for their risk
coverage and claim losses under the policies upon happening of risks covered under the policies.
Insurance companies spread the risks undertaken by them through reinsurance contracts with other
insurance companies and invest the pooled premiums in various financial and non-financial investments
and securities offering returns higher than the cost of risks assumed.

In this section, we will discuss Financial Market and its various components.

Financial Market is a place where funds from surplus units are transferred to deficit units. It is a market
for creation and exchange of financial assets. Financial market is not, in itself, a source of finance but a
link between savers and investors. Corporations, financial institutions, individuals and governments trade
in financial products on this market either directly or indirectly.

Financial markets are of two types. Money Market and Capital Market.

Money market is a market for dealing in monetary assets of short term nature, mostly less than one year.
It enables raising short term funds for meeting temporary shortage of fund and obligations and temporary
deployment of excess fund. Major players are Federal and Provincial Governments, Central Bank,
Commercial Banks and Brokerage Houses. The market equilibrium mechanism evens out the short term
demand and supply gaps. Money market has the maximum influence on the liquidity conditions in the
economy. The main instruments traded on Money Market include treasury bills or T Bills, Commercial
Papers, Certificate of Deposits, and Repurchase Agreements commonly known as Repos and reverse
repos.

In contrast with money market, capital market deals in long term funds. The main players include mutual
funds, insurance companies, local and foreign institutional investors, and individuals from general public.
Capital market is divided into two mutually exclusive and distinct segments. Primary market and
secondary market. Primary market is market for raising fresh capital. It provides the channel for sale of
new securities, not previously available. This is in fact a virtual market place and does not have any
physical brick and mortar existence. It performs triple service function which include Origination,
underwriting, and distribution.

Secondary market has solid physical existence. Once securities are issued in primary market, they become
available for trading in the secondary market. The secondary market is a place where buyers and sellers
of securities can enter into transactions to purchase and sell shares, bonds, debentures etc. Existence of
secondary market enables corporates, entrepreneurs to raise resources for their companies and business
ventures through public issues. The main advantages of secondary market include ensuring liquidity by
providing a platform for the buyers and sellers of financial securities, availability of information,
ownership transfers, and transactions settlements and financing.

The last but not the least among components of financial system is the financial instruments. Let’s discuss
it briefly. Simply put, the financial instruments are the stock in trade of financial markets. There are three
types of financial instruments. Primary securities, Indirect securities and Derivatives. We will explore these
three one at a time.

Primary securities are the Securities issued by the non-financial economic units. These include equity
shares, preference shares, debentures, and innovative debt instruments. Very briefly, equity shares are
ownership securities. Equity shareholders bear the risk and enjoy the rewards of ownership. Preference
shares are also called quasi equity as they stand between debt and equity and carry selected features of
both. Preference shareholders may enjoy preferential right as to the payment of dividend at a fixed rate
during the life time of the Company, and the return of capital on winding up of the Company. Debentures
are debt securities and debenture holders are entitled to predetermined interest and claim on the assets
of the company. Besides these three, a variety of debt innovative instruments have emerged with the
growth of financial system with attractive features and options. Examples are participative debentures,
convertible debentures with options, third party convertible debentures, debt equity swap, zero coupon
convertible bonds, deep discount bonds, warrants, options, etc.

Indirect securities are issued by financial intermediaries such as, certificates of deposits or CODs by
commercial banks, units by mutual funds, and policies by insurance companies. Indirect securities are
better suited to small investors. They offer several advantages such as benefits of pooling of savings by
intermediaries, lower risk, expert management, and convenience.

Derivatives are the third type of financial instruments. Derivative is a product whose value is derived from
the value of one or more basic variables, called base, in a contractual manner. The underlying asset can
be equity, forex or any other assets. Formally defined, a derivative security include a security derived from
a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences
or any other form of security. It also includes a contract which derives its value from the prices, or index
of prices, of underlying securities. Most common types of derivative instruments are forward contracts,
futures contracts and options.

A forward contract is a customized contract between two entities, where settlement takes place on a
specific date in the future at today's pre agreed price. At the end offsetting is done by paying the
difference in the price.
Future Contract is an agreement between two parties to buy or sell an asset at a certain time in the future
at a certain price.

Options are contracts that give the investor the right to buy or sell securities at a predetermined price
within or at the end of a specified period. There are two types of options, Call options and Put options.
Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a
given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a
given quantity of the underlying asset at a given price on or before a given date.

Financial system plays an extremely important role in the economic development of a country. Economic
development depends upon financial system for channeling funds to areas where they are needed most.
The financial system performs a number of functions which help facilitate these shifts in money that are
important for sustainable economic growth.