UNDERSTANDING THE FINANCIAL SYSTEM

- Prof. Bhattacharyya

Questions

1. What does a Financial System facilitate? 2. What are different components/ segments of

financial system?3. What is the difference between secured and

unsecured bond? 4. What is a ‘put bond’ and ‘callable bond’?5. What is Convertible Bond? 6. What is Floating Rate Bond?

Questions

7. What is the function of Primary Dealer?8. What are the requirements of a good Financial

System ?9. Name different regulators of Financial Markets. 10. What is LBO ?11. Mr. Watson a British National wants to Invest in

Indian Market without getting into regulatory hassle. What is the easiest way out ?

12.Who regulates G-Sec Market in India ?

Financial System

• Transfer of Resources1. Financial Intermediaries2. Financial Instruments3. Financial Assets

Intermediaries Market Responsibilities

Stock Exchange Capital Secondary market

Inv. Bankers Capital, Credit Issue of Securities, Advisory

Underwriters Capital, Money Subscribe

Registrars, Depositories, Custodians

Capital Issue securities,handle share transfer

P Ds Money G-Secs

Forex Dealers Forex Ensure exchange

CURRENT REGULATORS OF THE INDIAN FINANCIAL SYSTEM

The regulation and supervision of the financial system in India is carried out by different regulatory authorities.

• Reserve Bank of India (RBI) regulates commercial banks, urban cooperative banks (UCBs), some financial institutions and non-banking finance companies (NBFCs).

• Securities Exchange Board of India (SEBI) regulates the capital market, mutual funds, and other capital market intermediaries.

• Insurance Regulatory and Development Authority (IRDA) regulates the insurance sector.

• The Pension Funds Regulatory and Development Authority (PFRDA) regulates the pension funds.

• Forward Markets Commission (FMC) is a regulatory authority for commodity futures market in India.

CURRENT REGULATORS OF THE INDIAN FINANCIAL SYSTEM

• Some of the financial institutions, in turn, regulate or supervise other institutions in the financial sector, for instance, – Regional Rural Banks and the Co-operative banks

are supervised by National Bank for Agriculture and Rural Development (NABARD); and

– Housing finance companies by National Housing Bank(NHB).

FINANCIAL INSTITUTIONS• Channelise funds from suppliers to users.• E.g. Commercial banks, Finance companies, Insurance

companies, MFs, Pension Funds, etc..• Monitoring costs (use quality and quantity of information.)• Asset transformer.• Diversify risk• Reduced transaction cost• Maturity Intermediation• Denomination Intermediation

Diagram

FINANCIAL INSTITUTIONS

• Economic function of FIs.• Transmission of Monetary Policy• Credit allocation• Time Intermediation• Payment services

FINANCIAL MARKETS

• Primary and Secondary• Money and Capital

FINANCIAL MARKETS

• Facilitate sale & resale of transferable securities.

• Securities arising out of direct lending.• Principal Financial Markets:

a) Market for G-Secb) Mortgage Marketc) Debt Marketd) Equity Markete) Derivative Market

FINANCIAL MARKETS

• Bond issues vs Stock issues• Debt vs Equity• Safe Debt – Minimum maintenance• Risky Debt – High Maintenance• Benchmark Rate• Preferred Equity• Secured Bonds• Mortgage Bonds

FINANCIAL MARKETS

• Unsecured Bonds• Put Bonds• Callable Bonds• Floaters / Variable rate bonds• Convertible bonds• Market for New Issues – Underwriters• Secondary Market – Price discovery

Monetary Aggregates in India

• M1 = Currency with the public + demand deposits of the Public

• M2 = M1 + Term deposits with maturity upto one year + CDs

• M3 = M2 + Time deposits of the Public with banks for more than 1 year

Financial Markets• Definition

An institution or arrangement that facilitates the exchange of financial instruments, including deposits and loans, corporate stocks and bonds, government bonds, and more exotic instruments such as options and futures contracts.

The place where people and organizations wanting to borrow money are brought together with those having surplus funds is called a “financial market.”

Functions

• Intermediary Functions

• Financial Functions

Intermediary Functions

• Transfer of resources • Enhancing income • Productive usage • Capital formation • Price determination • Sale mechanism • Information

Financial Functions

•Providing the borrowers with funds so as to enable them to carry out their investment plans

•Providing the lenders with earning assets so as to enable them to earn wealth by deploying it in productive ventures

•Providing liquidity in the market so as to facilitate trading of funds

Requirements of a Good Financial System

• Legal and Regulatory environment• Stable Money• Sound Public Debt Management• Central Bank• Banking System• Information System• Security Market

NBFCs• A Non-Banking Financial Company (NBFC) is a company

registered under the Companies Act, 1956

• It is engaged in the business of loans and advances, acquisition of shares/stock/bonds/debentures/securities issued by Government or local authority or other securities of like marketable nature, leasing, hire-purchase, insurance business, chit business but does not include any institution whose principal business is that of agriculture activity, industrial activity, sale/purchase/construction of immovable property.

• A non-banking institution which is a company and which has its principal business of receiving deposits under any scheme or arrangement or any other manner, or lending in any manner is also a non-banking financial company (Residuary non-banking company).

N B F C

• They provide various types of fund and non-fund based services. Depending on the type of services provided they could be : Leasing / hire-purchase/Housing finance companies/ Venture capital funds/Stock-broking firms etc.

MUTUAL FUNDS• A Mutual Fund is a trust that pools the savings of a number of investors

who share a common financial goal.• The money thus collected is then invested in capital market instruments

such as shares, debentures and other securities.• The income earned through these investments and the capital

appreciation realised are shared by its unit holders in proportion to the number of units owned by them.

• Mutual Fund Operation Flow Chart

Mutual Funds

• Mutual funds are set up in the form of trust comprising of a) sponsor b) trustees c) AMC and d) custodian. Sponsor is the promoter. Trustees hold the assets for the benefit of the unit holders. The AMC manages the funds by investing in various types of securities. The custodian holds the securities of the various schemes in its safe custody.

Mutual Funds

• They offer convenience because of lower denomination of investment and liquidity, lower risk through diversification, expertise in management and low transaction costs due to economies of scale. Biggest advantage is diversification

• NAV – Market price of the securities + other assets – total liabilities outstanding on the date.

HEDGE FUNDS• A hedge fund is an investment fund charging a

performance fee and typically open to only a limited range of investors.

• Like MFs. • Unlike MFs. • Incentives compensate risk. • Poor liquidity.• In the United States, hedge funds are open to

accredited investors only. Because of this restriction they are usually exempt from any direct regulation by the SEC, NASD and other regulatory bodies.

• Sketchy data. .• Leveraged.

Hedge Fund

• Three important players :• 1. The Fund Manager• 2. Prime Broker• 3 Administrator

Private Equity

• Market for relationship equity financing. • Private equity returns derive from an

appreciation in value of the acquired asset or company. Such investments are often followed by efforts at restructuring to resuscitate loss making companies or substantially improving performance of profit making companies.

• Providers of private equity do their own monitoring and control.

Private Equity • Investment in equity linked to an asset which is not

listed and therefore not publicly traded in stock markets. In short private equity is acquired either through the private placement of new shares or the sale of pre-existing shares by the controlling interest or minority interest

• Organized private equity management – intermediated.

• Angel Investing• Organized P E Market – V.C., Expansions, Buyouts,

Vulture Capital • Exit mechanism.

Participatory Notes • PNs are instruments used by foreign funds /

investors who are not registered with SEBI but are interested in taking exposure in Indian securities.FIIs that do not wish to register with the SEBI but would like to have exposure in Indian securities also use the participatory notes.

• Instruments that derive their value from an underlying financial instrument e.g. equity share.

• Offshore derivative instruments.

INSURANCE BASICS• "Insurance is a contract between two parties whereby one

party called insurer undertakes in exchange for a fixed sum called premiums, to pay the other party called insured a fixed amount of money on the happening of a certain event.“

• Insurance is a protection against financial loss arising on the happening of an unexpected event. Insurance companies collect premiums to provide for this protection. A loss is paid out of the premiums collected from the insuring public and the Insurance Companies act as trustees to the amount collected.

• Insurance Companies are quite dominant intermediaries in the financial systems

PENSION PLAN

• Defined Benefit

• Defined Contribution

DEFINED BENEFIT PLAN• Participants promised a level of benefits upon

retirement. No. of years an employee has worked in the organization, persons’ pay in the final years of employment are some of the factors taken into account.

DEFINED CONTRIBUTION PLAN

• Each participant has an account where sponsor contributes certain amount every year. Sometimes participants also contribute. Contribution is proportional to earnings.

• Upon retirement, the amount at the credit of the account is paid out to the participant. - Investment risk- Inflation risk

Pension Fund Assets to GDP for India

• PFRDA – NPS – defined contribution largest pension markets – U.S.A., U.K., Japan.

Financial System Designs• Bank-dominated system

In Germany, where a few large banks play a dominant role and the stock market is not important.

• Market-dominated systemIn US, where financial markets play an important role while the banking industry is much less concentrated.

• In India, banks have traditionally been the dominant entities of financial intermediation.

Nature & Role of Financial Institutions• Liability, asset and size transformation consisting

of mobilization of funds, and their allocation by providing large loans on the basis of numerous small deposits.

• Maturity transformation by offering the savers tailor-made short term claims or liquid deposits.

• Risk transformation by transforming and reducing the risk involved in direct lending by acquiring diversified portfolios.

Financial Markets

• Financial markets are an important component of the financial system. They are a mechanism for the exchange trading of financial products under a policy framework. Financial markets comprise two types of markets : 1) Money Market2) Capital Market

Money Market

• It is a short-term debt instruments.

• It is a highly liquid market wherein securities are bought and sold in large denominations to reduce transaction costs.

Functions Of Money Market• To serve as an equilibrating force that

redistributes cash balances in accordance with the liquidity needs of the participants.

• To form a basis for the management of liquidity and money in the economy by monetary authorities.

• To provide reasonable access to the users of short-term money for meeting their requirements at realistic prices.

Capital Market • A capital market is a market for long-term

securities. The purpose of capital market is –– to mobilize long-term savings to finance long-term

investments. – to provide risk capital in the form of equity or quasi-

equity to entrepreneurs. – to encourage broader ownership of productive assets. – to provide liquidity with a mechanism enabling the

investor to sell financial assets. – to lower the costs of transactions and information– to improve the efficiency of capital allocation through

a competitive pricing mechanism.

Characteristics Of Financial Markets

• Large volume of transactions and the speed with which financial resources move from one market to another.

• There are various segments like stock markets, bond markets, primary and secondary segments where savers decide when and where they should invest money.

• Instant arbitrage among various markets and types of instruments.

• Highly volatile and susceptible to panic and distress selling as the behaviour of a limited group of operators can gen generalized.

• Markets are dominated by financial intermediaries who take investment decisions as well as risks on behalf of their depositors.

• Negative externalities are associated with financial markets.

• Domestic financial markets are getting integrated with world wide financial markets.

THANK YOU