Overview of Financial System

CA. Sonali Jagath Prasad

Financial System
The financial system is possibly the most important institutional and
functional vehicle for economic transformation.
Finance is a bridge between the present and the future and
mobilization of savings or their efficient, effective and equitable
allocation for investment
Its the access with which the financial system performs its functions
that sets the pace for the achievement of broader national
objectives.
According to Robinson, the primary function of the system is to
provide a link between savings and investment for the creation of
new wealth and to permit portfolio adjustment in the composition of
the existing wealth.

Features of Financial System

The features of a financial system are as follows
1. Financial system provides an ideal linkage between depositors and
investors, thus encouraging both savings and investments.
2. Financial system facilitates expansion of financial markets over
space and time.
3. Financial system promotes efficient allocation of financial resources
for socially desirable and economically productive purposes.
4. Financial system influences both the quality and the pace of
economic development.

Financial System
A financial system or financial sector functions as an intermediary
and facilitates the flow of funds from the areas of surplus to the
deficit.
It is a composition of various institutions, markets, regulations and
laws, practices, money manager analyst, transactions and claims
and liabilities.
Functions of financial system:

1. Promotion of liquidity
2. Link between savers and investors
3. Information available
4. Helps in projects selection
5. Allocation of risk
6. Minimizes situations of Asymmetric information - It provides financial services such as
insurance and pension and offers portfolio adjustments facilities.
7. Reduce cost of transaction and borrowing
8. Financial deepening and broadening
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Functions
Facilitates capital formation by providing a link between savers &
Investors
a market for creation and exchange of financial assets

Performs the following Functions essential for the modern economy:

Payment
System

Pooling Of
Funds

Transfer Of
Resources

Risk
Manageme
nt

Price
Information

Indian Financial System An Overview

FUNCTIONS

Collection of SAVINGS & Distribution for INDUSTRIAL INVESTMENT.

Stimulating CAPITAL FORMATION & ACCELERATING THE ECONNOMIC
GROWTH

STRUCTURES
1. Regulatory Bodies (RBI/SEBI/IRDA/PFRDA)
2. Financial Intermediataries
3. Financial Markets
4. Financial Assets / Instruments
5. Financial services

PHASES
* Upto 1951
Pvt. Sector
* 1951 to 1990 Public Sector
* Early Ninties Privatisation
* Present Status Globalisation
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Indian Financial System An Overview

Process of Capital Formation
Involves three distinct, although inter-related activities.
(i) Savings: The ability by which resources are set aside and become
available for other purpose.
(ii) Finance: The activity by which claims to resources are either assembled
from those released by domestic savings, obtained from abroad,
or specially
created usually as bank deposits or notes and then
placed in the hands of
the investor.
(iii) Investments: The activity by which resources are actually committed to
production.
The financial system is a link between the savers (savings surplus economic
units) and the investors (savings deficit economic units). It is made up of all those
channels through which savings become available for investment.

Financial System An Overview

Orderly mechanism & structure in economy.
Mobilises the monetary resources/capital from
surplus sectors.

Distributes resources to needy sectors.

Transformation of savings into investment &
consumption.
Financial Markets Places where the
above activities take place.
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Indian
Financial
System

Regulators;
MoF, SEBI,
RBI, IRDA

Financial
Institutions
(Intermediaries)

Formal
(organized
Financial
system)

Informal
(Unorganized
financial
system)

Financial
Markets

Money lenders,
Local bankers,
Traders
Landlor

Financial
Instrument

Financial
Services

Formal and Informal Financial

System
The financial systems of most developing
countries are characterized by co-existence and
co-operation between the formal and informal
financial sectors.
The formal financial sector is characterized by
the presence of an organized, institutional and
regulated system which caters to the financial
needs of the modern spheres of economy.
The informal financial sector is an
unorganized, non-institutional and non-regulated
system dealing with traditional and rural spheres
of the economy.
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Component of Formal Financial

System
Regulators
Financial Intermediaries / Institutions
Financial Markets
Financial Instruments
Financial Services

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Regulators
The formal financial system comes under
the regulations of the Ministry of finance
(MOF), Reserve Bank of India (RBI),
Securities and Exchange board of India
(SEBI) and other regulatory bodies.

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Constituents of a Financial System

Indian Financial System An Overview

ORGANISATION Financial System consists of
What they do
Financial Intermediaries/ Institutions (a) Collect Savings
(b) Issue claim against themselves
(c) Use Funds, thus raised, to purchase
ownership or debt-claims
Notes: Characteristics of claims issued against
self & debt-claims are absolutely different.

Who They Are

Banks, NBFC,
M.F, insurance
organisations etc.

(ii) Financial Markets

(a) Not a Source of funds

(b) Act as a facilitating organisation and link
saver & investor
(c) Based on nature of work they are classified
as (1) Money Market (2) Capital/Security
Markets.

Call Market
T-Bill Market
CP-Market
Repo Market
Stock Exchange

(iii) Financial Asset/Instrument/

Security

(a) Financial Product innovation

(b) Three broad categories
(1) Direct/Primary e.g. Share, Debt.,
Pref. Share etc.
(2) Indirect - MF, Security Receipts,
Securitized Debt Investment.
(3) Derivatives- Forward, Future, Options.

Shares, Debt
Instruments,
Debentures etc.

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Components of Financial System

Financial
Intermediaries
Banks
NBFCs,
Includes
Development
financial
institutions &
State level
financial
institutions
Mutual
Funds
Insurance
Organizations

Financial
Markets
Money
markets (Short
term)
Capital
Markets (long
term)
Main
Participants
FIIs
Mutual
Funds
Individuals
Corporates
Insurance
Cos

Financial
Instruments
Primary
securities
(Direct)
Eg.
Debentures,
equity
shares,etc
Secondary
Securities
(Indirect)
Eg. Bank
deposits,
Insurance
policies,etc

Financial
Services
Merchant
Banking, Credit
rating, etc.
Bridges the
gap between
the knowledge
on the part of
investors &
increasing
sophistication
of financial
instruments &
Markets

Financial Institutions
Financial
Institutions
(Intermediaries)

Banking
Institutions

Non-Banking
Institutions

Mutual Funds

Public sector

Insurance
and
Housing
Finance companies

Private Sector

http://www.authorstream.com/Presentation/nehasinghal-721270-financial-institutions-of-india/

16

Financial Institution
Financial institutions are intermediaries that mobilize savings & facilitate the
allocation of funds in an efficient manner.
Financial institutions can be classified as banking & non-banking financial
institutions.
Banking institutions are creators of credit while non-banking financial
institutions are vendors of credit.
While the liabilities of banks are part of the money supply, this may not be
true of non-banking financial institutions.
In India, non-banking financial institutions, namely, the developmental
financial institutions (DFIs) & non-banking financial companies (NBFCs) as
well as housing finance companies (HFCs) are the major institutional
purveyors of credit.
Financial institutions can also be classified as term-finance institutions such
as the industrial development bank of India (IDBI), industrial credit &
Investment Corporation of India (ICICI), industrial financial corporation of
India (IFCI), small industries development bank of India (SIDBI) & industrial
investment bank of India (IIBI).
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Financial Markets
Financial markets are a mechanism enabling participants to deal in financial
claims.
The markets also provide a facility in which their demands & requirements
interact to set a price for such claims.
The main organized financial markets in India are the money market &
capital market.
The first is a market for short-term securities. Money market is a market for
dealing with financial assets & securities which have a maturity period of
upto one year.
While the second is a market for long term securities, that is, securities
having a maturity period of one year or more. The capital market is a market
for financial assets which have a long or indefinite maturity. They are also
divided into 2 primary market and secondary market

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STRUCTURE OF FINANCIAL MARKETS IN INDIA

Financial Markets in India

Debt Market
Primary /
Secondary

RBI

Forex
Market

RBI

Capital Market
Primary /
Secondary &
Depository

SEBI

Insurance
Life/General

IRDA

Banks (including
RRBs, co-op etc)

RBI

Mutual Funds,
Venture Funds,
Investment
Bonds

RBI/SEBI

REGULATORY AUTHORITY

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Financial Instruments/ assets

Financial
Instruments

Primary
Securities

Secondary
Securities

Equity,
Preference
shares, Debt

Time deposits,
MF units
Insurance policies
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Features of Financial Instruments

i. Most of the instruments can be easily transferred from one hand to another without many
cumbersome formalities.
ii. They have a ready market, i.e., they can be bought and sold frequently and thus, trading in
these securities is made possible.
iii. They possess liquidity, i.e., some instruments can be converted into cash readily. For instance,
a bill of exchange can be converted into cash readily by means of discounting and rediscounting.
iv. Most of the securities posses security value, i.e., they can be given as security for the purpose
of raising loans.
v. Some securities enjoy tax status, i.e., investment in these securities are exempted from income
tax, wealth tax, etc., subject to certain limits. E.g. public sector tax free bonds, magnum tax saving
certificates.
vi. They carry risk in the sense that there is uncertainty with regard to the payment of principle or
interest or dividend as the case may be.
vii. These instruments facilitates future trading so as to cover risks due to price fluctuations,
interest rates, etc.
viii. These instruments involve less handling costs since expenses involved in buying and selling
these securities are generally much less.
ix. The return on these instruments is directly in proportion to the risk undertaken.
x. These instruments may be short-term or medium term or long term depending upon the
maturity period of these instruments.

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Financial Instruments
Financial instruments refers to those document which represents financial claims on
assets.
As discussed earlier, financial assets refers to a claim to the repayment of certain
sum of money at the end of specified period together with interest or dividend.
Examples : bills of exchange, promissory notes, treasury bills, government bonds,
deposit receipts, shares debentures etc.
Financial instruments can also be called financial securities. Financial securities can
be classified into:
i. Primary or direct securities
ii. Secondary or indirect securities.

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Financial Instruments
Primary securities
These are securities directly issued by the ultimate investors to the ultimate savers.
Examples, shares and debentures issued directly to the public.
Secondary securities
These are securities issued by some intermediaries called financial intermediaries to
the ultimate savers. E.g. unit trust of India and Mutual funds issue securities in the
form of units to the public and money pooled is invested in companies.
Again these securities may be classified on the basis of duration as follows:
i. Short-term securities
ii. Medium-term securities
iii. Long-term securities.
Short-term securities are those which mature within a period of one year. E.g. Bills of
exchange, treasury bills, etc. medium term securities are those which have a maturity
period ranging between one and five years.
e.g. Debentures maturing within a period of 5 years. Long-term securities are those
which have a maturity period of more than five years. E.g. government Bonds
maturing after 10 years.

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Capital market Instruments

Equity Shares.
Preference shares.
Debentures.
Forward Contract.
Futures.
Options.

Money Market Instruments

Commercial Paper.
Call Money market.
Inter-bank term money.
Money market mutual
funds.
Repo.
Treasury Bills.
Commercial Bills.
Inter-corporate
Deposits.
Certificate of Deposit.

MEANING OF FINANCIAL
SERVICES
Typically, it means mobilizing and allocating
SAVINGS.
It includes all activities involved in the
transformation of SAVINGS into
INVESTMENTS.
Financial Services can also be called
Financial Intermediation.

Financial services
Financial intermediaries provide key financial services such as merchant
banking, leasing hire purchases, credit-rating, and so on.
Financial services rendered by the financial intermediaries bridge the gap
between lack of knowledge on the part of investors and increasing
sophistication of financial instruments and markets.
These financial services are vital for creation of firms, industrial expansion,
and economic growth.
Before investors lend money, they need to be reassured that it is safe to
exchange securities for funds. This reassurance is provided by the financial
regulator, who regulates the conduct of the market, and intermediaries to
protect the investors interests. The Reserve Bank of India regulates the
money market and Securities Exchange Board of India (SEBI) regulates
capital market.

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FEATURES OF FINANCIAL
SERVICES
Customer Oriented
Intangibility
Simultaneous Performance
Dominance Of Human Elements
Perishability

IMPORTANCE OF FINANCIAL
SERVICES
Economic Growth
Promotion of Savings
Capital Formation
Provision of Liquidity
Financial Intermediation
Contribution to GNP
Creation of Employment Opportunities

CLASSIFICATION of providers of
financial services
1. CAPITAL MARKET:
Term Lending Institutions
Investing Institutions
Long Term Funds
2. MONEY MARKET:
Consists of Commercial banks, Co-operative
banks and other agencies.
Short term funds.

SCOPE OF FINANCIAL SERVICES

A. TRADITIONAL ACTIVITIES
1. FUND BASED ACTIVITIES: includes
Underwriting
Dealing in secondary market activities
Participating in money market instruments
Leasing, hire-purchase, venture capital, etc.

2. FEE BASED ACTIVITIES: includes

Managing the capital issues
Arrangements for placement of capital and
debt instruments
Arrangement of funds from financial
institutions
Assisting in Government and other clearance

B. MORDERN ACTIVITIES
Few of them are:
1. Rendering project advisory services
2. Planning for Mergers and Acquisitions
3. Acting as trustees to the Debenture-holders
4. Hedging of risks
5. Managing the portfolio of large public sector
companies.
6. Undertaking risk management services.

FINANCIAL SERVICES AND PROMOTION OF

INDUSTRIES

Industrial promotion through Merchant

Banking Services
Working Capital Finance Through Factoring
Services
Equipment Finance through Leasing
Financial resources through Mutual Funds
Long-term Risk Capital through Venture
Capital

Risk Management through Derivatives

Debenture issue through Credit rating
Development Finance through Development
Banking Sector
Industrial Development through Specialized
Services

NEW FINANCIAL PRODUCTS AND SERIVES

Merchant Banking
Loan Syndication
Leasing
Mutual Funds
Factoring
Venture Capital
Custodial Services

Corporate Advisory Services

Securitization
Reverse Mortgage
Derivatives:
- Forward Contract
- Options
- Futures
- Swaps

Financial System
An institutional framework existing in a country to
enable financial transactions.
Three main parts
Financial assets (loans, deposits, bonds, equities, etc.)
Financial institutions (banks, mutual funds, insurance
companies, etc.)
Financial markets (money market, capital market, forex
market, etc.)

Regulation is another aspect of the financial system

(RBI, SEBI, IRDA, FMC)

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, KVP, 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
Mobilization of savings
Effective distribution of savings

Institutions are banks, insurance

companies, mutual funds- promote/
mobilize savings
Individual investors, industrial and trading
companies- borrowers

Financial Markets
Money Market- for short-term funds (less
than a year)
Organised (Banks)
Unorganised (money lenders, chit funds, etc.)

Capital Market- for long-term funds

Primary Issues Market
Stock Market
Bond Market

Function of the Financial System

Prevision of liquidity
liquidity refers to cash or money and other
assets which can be converted into cash readily
without loss of value and time.
Mobilization of savings

Weaknesses of India financial

system

Lack of co-ordination between different

financial institutions.
Monopolistic market structures
-LIC in life insurance
-UTI in mutual fund
Dominance of development banks in
industrial financing
Inactive and erratic capital market
Imprudent financial practice