EBS FMS Lecture I

BASICS

Meaning of Financial System

A set of sub systems of financial institutions, markets, instruments and services. Intermediates with the flow of funds between savers and borrowers. Facilitates transfer and allocation of scarce resources efficiently and effectively.

"y#es of Financial System

Formal financial system Informal financial system
Organized, institutional and regulated Advantages: Lo transaction costs Minimum default ris! "rans#arency of #rocedures $isadvantages: %ide range of interest rates &ig'er rates of interest (nregulated

Com#onents of t'e Financial System

Financial Financial Financial Financial Institutions Mar!ets Instruments Services

Types of Financial Institutions

Banking and Non Banking Banking: creators and purveyors of credit.
Types: Commercial Banks
Cooperative Banks

Non-Banking :purveyors of credit

Types: Developmental financial
institutions !utual Funds Insurance companies NBFCs

Functions of Financial Institutions

"rovide t#ree transformation services:
$ia%ility& asset and si'e transformation !aturity transformation (isk transformation

Financial Mar!ets
Types:
Money Market A market for short term debt instruments Capital Market - A market for long -term equity and debt instruments

Segments:
Primary Market A market for new issues Se ondary Market A market for trading outstanding issues

$ink Bet)een "rimary and *econdary Capital market:

+ %uoyant secondary market indispensa%le for t#e presence of a vi%rant primary market *econdary market provides a %asis for t#e determination of prices of ne) issues Dept# of t#e secondary market depends on t#e primary market Bunc#ing of ne) issues affects prices in t#e secondary market

Financial Instruments
Types : Primary

Se ondary

!istin t "eatures : Marketable

Tradeable Tailor-made

Financial Services Ma#or ategories : "unds $ntermediation

Payments Me hanism Pro%ision of liquidity &isk Management "inan ial 'ngineering

Functions of Financial system

!o%ilise and allocate savings !onitor corporate performance "rovide payment and settlement systems ,ptimum allocation of risk %earing and reduction Disseminate price related information ,ffer portfolio ad-ustment facility $o)er t#e cost of transactions "romote t#e process of financial deepening and %roadening

Key elements of a well -functioning financial system

+ strong legal and regulatory environment *ta%le money *ound pu%lic finances and pu%lic de%t management + central %ank *ound %anking system Information system .ell -functioning securities market

Financial system designs

Types : Bank %ased !arket %ased

!arket -%ased Financial *ystem

+dvantages:
"rovide attractive terms to %ot# investors and %orro)ers Facilitate diversification +llo) risk s#aring +llo) financing of ne) tec#nologies

Dra)%acks:
"rone to insta%ility /0posure to market risk Free rider pro%lem

Bank %ased Financial *ystem

+dvantages:
Close relations#ips )it# parties "rovide tailor made contracts /fficient inter-temporal risk s#aring No free rider pro%lem

Dra)%acks:
(etards innovation and gro)t# Impedes competition

Functions of Financial !arkets

/na%ling economic units to e0ercise t#eir time preference *eparation& distri%ution& diversification and reduction of risk /fficient payment mec#anism "roviding information /n#ancing li1uidity "roviding portfolio management services.