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FINANCIAL SYSTEM

The term financial system includes a complex of institutions and mechanisms which affect the generation of savings and their transfer to those who will invest.

FEATURES OF THE FINANCIAL SYSTEM

Ideal linkage between depositors and investors Facilitates expansion of financial markets Promotes efficient allocation of financial resources for socially desirable and economically productive purposes Influences both the quality and the pace of economic development

Financial Institutions Funds Deposits/ shares Commercial banks Insurance Cos Mutual Funds Provident Funds Non Banking Financial Cos Funds Loans

Suppliers of Funds Individuals Businesses Governments

Demanders of funds Individuals Businesses Governments Financial Markets Money Market Capital Market

Funds

Funds Securities

Securities

The institutions include


1.

Financial institutions / intermediaries like banks, insurance org., mutual funds and so on which collect capital from savers and distribute them to entrepreneurs/ productive enterprises.

2. Financial markets comprising of capital /securities market , the money market and the foreign exchange market

3. Financial assets/instruments like shares, debentures, units etc

The main function of financial systems is the collection of savings and their distribution for industrial investment, thereby stimulating capital formation and to that extent accelerating the process of economic growth

ORGANISATION OF THE FINANCIAL SYSTEM

FINANCIAL INTERMEDIARIES

FINANCIAL MARKETS

FINANCIAL ASSETS/ INSTRUMENTS

FINANCIAL INTERMEDIARIES

BANKS

NBFCs

MUTUAL FUNDS

INSURANCE COS

1. 2. 3. 4. 5. 6. 7. 8. 9.

Leasing Companies Hire purchase/Consumer Finance Cos Housing Finance Cos Venture Capital Funds Merchant Banking Organisations Credit Rating Agencies Factoring and Forfeiting organisations Stock Broking Firms Depositories

FINANCIAL INTERMEDIARIES
Their relevance to the flow of savings is derived from what is called the TRANSMUTATION EFFECT. Transmutation refers to the ability of the financial intermediaries to convert contracts with a given set of characteristics into contracts with different features.

FINANCIAL INTERMEDIARIES
The services that tailor financial assets to the desires of savers- investors are: 1. Convenience

Divisibility Maturity Diversification eg. Mutual Funds

2. 3.

Lower Risk

Expert management

Benefits of trained, experienced and specialised mgt along with continuous supervision Lower cost

4.

Economies of scale

Main financial intermediaries

Commercial Banks NBFC Mutual Funds Insurance Organisations

Commercial Banks
Traditional practice Short term funds for working capital needs Emerging needs of economic and financial system Term lending particularly in infrastructure sector Capital market Retail finance such as housing finance, consumer finance etc Enlarged their geographical and functional coverage in terms of rural/ agriculture and other priority sector financing like exports, small enterprises etc.

NBFC
Provide a variety of fund/asset based and non fund based /advisory services Types of services Leasing Companies Hire purchase/Consumer Finance Cos Housing Finance Cos Venture Capital Funds Merchant Banking Organisations Credit Rating Agencies Factoring and Forfeiting organisations Stock Broking Firms Depositories

Mutual Funds

Pools the savings of relatively small investors and invest in a well diversified portfolio of sound invt. A mutual fund is set up in the form of a trust which has
1. 2. 3. 4.

A Sponsor Trustees Asset Management Company (AMC) Custodian

Insurance Organisations

Protection against risk Contractual Nature contributes to mobilisation of funds as it tends to commit the policyholder Desire to save due to
1. 2. 3.

Emergency fund to guard his family Build a potential family estate Accumulation of fund for retirement

Peculiar combination of savings and family protection

FINANCIAL MARKETS

Money Market

Capital/ Securities Market

Primary /New Issue Market

Secondary /Stock Market/Exchange

FINANCIAL MARKETS
A link between the savers and investors both individual as well as institutions

FINANCIAL MARKETS
Based on the nature of the funds which are stock in trade, the financial markets are classified into

Money Market Capital Market

Money Market

Dealing in monetary assets of short term nature ie namely working capital finance Major participants are
1. 2.

RBI Commercial Banks

Money Market
The broad objectives are 1. Equilibrium for balancing out short term surpluses and deficiencies 2. Focal point for intervention by RBI for influencing liquidity 3. A reasonable access to the users of short term funds at reasonable cost Egs- Commercial paper market, Treasury bills market, Certificate of deposit market etc Negotiated dealing system (NDS) is an electronic platform for facilitating dealing in Govt. Securities and Money Market Instruments

Capital Market

Primary Market/ New Issue Market

Secondary Stock Market /Exchange

Capital Market

1.

Primary market / New Issue Market (NIM)


Capital formation takes place Triple function


1. 2. 3.

Origination Underwriting Distribution

2. Secondary Stock Market /Exchange (SE) Market for old/existing securities Three Vital functions
1. 2. 3.

Nexus between savings and investments Liquidity to investors Continuous price formation

FINANCIAL ASSETS/ INSTRUMENTS

Primary /Direct

Indirect

Derivatives

Equity/Ordinary Preference Shares Shares

Debentures

Innovative Debt instruments

Forward Futures

Options

1. Mutual Fund Units 1. Convertible debenture 2. Security Receipts 2. Non convertible deb 3. Pass Through 3. Secured Premium Notes Certificates 4. Warrants

FINANCIAL ASSETS/ INSTRUMENTS

Direct / Primary Indirect Derivatives

Direct / Primary
1.

2.
3.

Ordinary / equity shares Preference Shares Debentures/ bonds including innovative debt instruments

Innovative debt instruments

Participating Debentures Convertible Debentures with options Third party convertible debentures Convertible debentures redeemable at premium Debt Equity swaps Zero coupon convertible notes Zero interest fully convertible debentures Warrants either with equity or debentures Fully convertible debentures with interest (Optional)

Indirect Securities

Financial assets issued by financial intermediaries


1. 2. 3.

Units of Mutual Funds Policies of insurance cos Deposits of banks etc

Better suited to small investors

Derivatives/Derivative instrument

Used to partially/ fully transfer price risks by locking in asset prices. Derivative is a product whose value is derived from the value of one/more basic variables called base( underlying asset/index/reference rate) in a contractual manner

The most commonly used derivative contracts are: Forward Contract

Derivatives/Derivative instrument
An agreement to exchange an asset, for cash, at a predetermined future date specified today Not typically tradeable and has to be settled by delivery of asset They are transferable specific delivery forward contracts. They are agreement between two counterparties to fix the terms of an exchange/lock in price today of an exchange that will take place between them at some fixed future date.

Futures/ Future contract


Options Options are contracts that give the holder the right (but not the obligation) to buy (call option) or sell (put option) securities at a pre determined price (strike /exercise price) within /at the end of a specified period (expiration period)

INDIAN FINANCIAL SYSTEM

INDIAN FINANCIAL SYSTEM


The evolution of the Indian Financial system falls into three distinct phases 1. Up to 1951,corresponding to the post independence scenario, on the eve of the initiation of planned economic development. 2. Between 1951 and the mid eighties reflecting the imperatives of planned economic growth 3. After the early nineties responding to the requirements of liberalised/deregulated/globalised economic environment.

Features Closed circle character of industrial entrepreneurship A semi organised and narrow industrial securities market Devoid of issuing institutions Virtual absence of participation of intermediary financial institutions in the long term financing of the industry

PHASE I PRE -1951 ORGANISATION

PHASE II 1951 TO MID-EIGHTIES


Features 1. Public/ Government ownership of financial institutions 2. Fortification of the institutional structure 3. Protection to investors 4. Participation of financial institutions in corporate management

Public/ Government ownership of financial institutions

Nationalisation of the RBI in 1948 Setting up of SBI in 1956 by taking over Imperial Bank of India 245 Life insurance cos were nationalised and merged with LIC 14 Major Banks were nationalised in 1969 GIC in 1972 6 more banks were nationalised in 1980 DFIs / term lending institutions were set up UTI was created The entire instutional structure was owned and controlled by Government.

Fortification of the institutional structure


Establishment of DFIs and financial lending institutions Industrial Finance Corporation of India (IFCI) in 1948 State Financial Corporation Industrial Credit and Investment Corporation of India (ICICI) in 1955

Pioneer in many aspects like underwriting of shares, channelisation of foreign currency loans from World Bank to private industry etc

Industrial Development Bank of India (IDBI) in 1964 as a subsidiary of RBI and was delinked in 1976 Small Industrial Development Bank of India as a subsidiary of IDBI LIC in 1956 UTI in 1964

Diversification in forms of financing of commercial banks such as Term Lending, underwriting of new issues. Enlargement of functional coverage

Protection to investors
Enactment of 1. Companies Act of 1956 2. Capital Issues (control) Act, 1947 3. Securities Contracts (Regulation) Act, 1956 4. Monopolies and Restrictive Trade Practices Act, 1970 5. Foreign Exchange Regulation Act (FERA), 1973

Phase II- Organisation of Indian Financial System


Public/Govt. Ownership of Financial Institutions Nationalisation of: RBI SBI LIC Banks GIC DFIs: IFCI SFCs ICICI IDBI SIDCs SIICs IIBI Fortification of Institutional Structure Investor Protection Companies Act Capital Issues (Control) Act Securities Contracts (Regulations) Act Monopolies And Restrictive Trade Practices Act UTI

New Institutions DFIs UTI


Banks: 1.Diversification Of forms of Financing 2. Enlargement LIC of functional Coverage 3. Innovative

Foreign Exchange Reglulation Act

Participation by Financial Institutions In Corporate Management

NOTABLE DEVELOPMENTS POST 1991

Privatisation of financial institutions Reorganisation of institutional structure Investor protection

Post 1991 Phase Organisation of the Indian Financial System

Privatisation of Financial Institutions 1. Banks 2. Mutual Funds 3. Insurance companies

Re organisation of Structure

DFIs PFIs

Banks

NBFCs

Mutual funds

Capital Money Market market Stock Exchange

Investor Protection SEBI

Primary

Privatisation of financial institutions


Conversion of Industrial Finance Corporation of India in to a public company. (IFCI Ltd.) IDBI and IFCI offered equity to public investors Pvt. mutual funds set up Pvt. Banks have come up With the enactment of IRDA, 1999 pvt. Insurance Cos set up by both domestic and foreign promoters Establishment of Pension Fund Regulation and Development Authority, pvt. Entities are posed to enter this field.

Reorganisation of institutional structure

Development/Public Financial Institutions 1. Greater reliance of industry on capital market. 2. Giving core working capital to industry in addition to traditional loan 3.Growing focus on non fund based financial activities like merchant banking etc 4. Pattern of financing changed 5. Change in the nature of institutions sponsored from TCO, MDI to CRISIL, CARE,ICRA 6. Extension of internationally accepted accounting std has improved the bottomline 7. With conversion of ICICI Ltd and IDBI into banks, DFIs and PFIs have disappeared.

Commercial Banks

Geographically wide and functionally diverse banking system But gross profits progressively declined

Factors affecting Profitability

Macro aspects of Envt.

Internal Factors Couldnt cope with Interest on SLR load of servicing more very low branches Credit to priority sector Diluted the quality of resulted in deterioration in manpower quality and growth of over dues Accounting practices not Political and adm. in conformity with interference international stds. Escalation in interest cost Lack of autonomy

NBFCs

Fund based activities


Hire purchase Bills discounting Venture capita Stock broking Loans/investments Equipment leasing

Fee based/advisory services


Issue management Portfolio management Loan /lease syndication Merging and acquisition

Main elements of regulation


1.

2.
3.

4.

5.

Chapter III B of the RBI Act amended in 1998 RBI Acceptance of Deposits Regulations, 1998 NBFCs Prudential Norms (RBI) Directions, 1998 NBFCs Auditor Reports (RBI) Directions , 1998 RBI has set up Department of Non Banking Supervision which undertakes both on site and off site surveillance over the institutions

A remarkable development post 1991 Vehicle for institutionalisation of security invts for the relatively small investors Domestic mutual funds sponsored by UTI, bank subsidiaries, insurance organisations, private sector with foreign collaboration and foreign institutional investors/ merchant banks Several off shore/overseas/country funds sponsored by Indian Financial institutions as well as Foreign institutional investors A variety of schemes focusing on income

Mutual Funds

Capital/Securities Market

Dormant till mid 1980s After that it has emerged as the most important mechanism for allocating resources
Shown by rapid expansion in quantum of funds raised the number of investors in primary market Increase in number of stock exchanges and listed securities Speedy rise in market capitalisation and volume of trade Entry of FIIs and mutual funds

Capital Market

Primary Market

Secondary Market

Primary Market

New Issue Market One component of the organisation, namely, the market intermediaries comprise of
Specialist merchant banks/ lead manager Underwriters Bankers to an issue Registrars to an issue Share transfer agents Porfolio managers Brokers, FIIs etc

Rigorous compliance to SEBI

Secondary Market

A few stock exchanges , dominated by Bombay Stock Exchange provided the trading platforms for secondary market transactions NSE introduced Screen based trading in 1992 The Depositories Act, 1996- Central Depository services Ltd(CDSL) and National Securities Depository Ltd.(NSDL) were set up Successful dematerialisation of shares upto 99 percent of total market capitalisation

Shortening of settlement cycle from 14 days to T+2 Introduction of securities related derivatives FIIs have been allowed to invest in India

Money Market

Sophisticated and articulate money market has emerged Emergence of specialised institutions Primary Dealers and money market mutual funds Consists of inter related sub markets

Call/notice mkt, Commercial bills mkt, T-bills mkt, Commercial paper mkt, Certificates of deposits market and Repo market

Protection of investors: Securities and Exchange Board of India


The Capital Issues (Control) Act was repealed in 1992 The office of the Controller of Capital Issues was abolished SEBI was set up in 1988

Mandate of SEBI
1.

2.

3.

Protect the interest of the investors in securities Promote the development of the securities market Regulate the securities market

SEBI exercises power under

The SEBI Act Securities Contract s(Regulation) Act Depositories Act The delegated powers under the Companies Act

The SEBI regulates and supervises the securities markets through 1. regulation 2. guidelines and schemes

OBJECTIVES

To protect the interest of investors so that there is a steady flow of savings into the capital market To regulate the securities market and ensure fair practices by the issue of securities so that they can raise resources at minimum cost

FINANCIAL MARKET

FINANCIAL MARKET

Capital Market

Money Market

Capital Market

Primary Market/ New Issue Market

Secondary Market/ Stock Exchange

Two stages are involved in purchase and sale of securities


First stage- Securities are acquired from the issuing companies Second stage- Purchased and sold continuously among investors without involvement of the companies except for registering ownership The section of the market dealing with first stage is referred to as the NIM, while the secondary market covers the second stage of the dealings in securities

Difference between Stock Exchange and Primary Market

1 2 3 4

New Issue Market Types of security New Nature of Financing Organisation Functions Direct No geographical existence Specialist institutional triple services Origination Underwriting Distribution

Stock Exchange Existing/ old Indirect Physical existence Nexus between savings and investments Market place Continuous price formation

Similarities between NIM and the stock exchanges

Stock exchange Listing Stock Exchange exercise considerable control over new issues Economic Interdependence Has two dimensions
Behaviour of Stock Exchange has significant bearing on the level of activity in the NIM Prices of new issues are influenced by the price movements on the stock market

Functions of Stock/Secondary Markets/ Exchanges


1.

2.
3.

Nexus between Savings and Investments Market Place Continuous price formation

Nexus between Savings and Investments

Savings of the community are mobilised and channelled by stock exchanges for investment into those sectors and units which are favoured by the community Stock Exchanges render this service thru new issues and sale of existing securities Ensures that the various listing rules are complied with Members of stock exchange help by acting as

As brokers try to procure invts from all over the country As underwriters

Market Place

Provide market place for purchase and sale of shares thereby ensuring transferability

Continuous price formation

Large number of buyers and sellers has the effect of bringing about changes in the levels of security prices in small graduations Ever changing demand and supply conditions result in continuous revision of assets Stock exchanges act as a barometer of the state of health of the nations economy , by constantly measuring its progress or otherwise

Functions of New Issues/ Primary Market

Transfer of resources from sav ers to entrepreneurs Is a complex set of institutions thru which funds can be obtained directly or indirectly by those who require the, from investors have savings The Securities issued by the company for the first time either after the incorporation or conversion from Private to Public companies are designated as initial issues, while those issued by cos which already have stock exchange quotation either public issue or by rights to existing shareholders, are referred to as old

Two types of issues are excluded from the category of new issues

Bonus issues Exchange issues by which shares are exchanged for securities in another co.

General function of NIM can be split into three services

Origination Underwroters Distribution

Origination

Refers to the work of investigation as analysis and processing of new proposals Are performed by specialist agencies which act as the sponsors of issues A careful study of technical, economic , financial and legal aspects of the issuing companies In this process, the sponsoring institutions render some services of an advisory nature which go to improve quality of capital issues

Services include

Determination of the class of security to be issued and prices of the issues in the light of market conditions The timing and magnitude of issue Methods of floatation Technique of selling etc

Underwriting

A form of guarantee that issues would be sold by eliminating the risk arising from uncertainty of public response

Distribution

The sale of securities to the ultimate investors is known as distribution

Issue Mechanism

Public issue through prospectus Tender / Book building Offer for sale Placement Rights issue

Public issue through prospectus

Issuing companies offer directly to the public Issues are underwritten Minimum contents of a issue are prescribed by the Companies Act, 1956.