An Introduction on · An Introduction on. Meaning and Definition ... SIDBI,IIBI. Components of Formal Financial System-Institutions

INDIAN FINANCIAL SYSTEM

An Introduction on

Meaning and Definition

Financial System is a complex, well-integrated setof sub-systems of

Financial institution,

Markets,

Instruments, and

Services

which facilitates the transfer and allocation of funds,efficiently and effectively.

Formal and Informal Financial system

Formal Financial Sector is characterized bypresence of an organized, institutional and regulatedsystem which caters the financial needs of themodern spheres of the economy.

Informal Financial Sector is an unorganized,non-institutional and non-regularized systemdealing with the traditional and rural spheres of theeconomy.

Financial Dualism

Financial Dualism: It is the combination offormal and informal financial system.

Informal financial system

Informal Financial Sector is an unorganized, non-institutional and non-regularized system dealing with the traditional and rural spheres of the economy.

Advantages: 1). Low Transaction, 2). Minimum default risk, 3). Less of formalities, 4). Less time consuming, 5). Fulfillment of urgent requirements.

Disadvantages: 1). Unregulated 2). High rates of interest 3). Less transparency of procedures, 4). Rise to black money, 5). Exploitation of victims.

Components of Formal Financial System

1. Financial institutions;

2. Financial markets;

3. Financial instruments;

4. Financial services.

Components of Formal Financial System

Term finance institutions: IFCI, IDBI, ICICI,SIDBI,IIBI.

Components of Formal Financial System-Institutions

Term finance institutions: IFCI (1948), IDBI(1964), ICICI (1955), SIDBI (1989), IIBI (1997).

Specialized services institutions: EXIM(1982), TFCI(1994), ICICI VENTURE;

Sectoral financial institutions:NABARD(1982), NHB(1988).

Investment institutions: UTI(1964),LIC(1955), GIC(1972) and its subsidiaries;

state-level financial institutions:SIDC(1955), SFC(1951).

Financial Markets

Financial markets are the mechanism enablingparticipants to deal in financial claims.

Literally, financial markets also provide a facility inwhich their demands and requirements interact toset a price for such claims. (D=S)

Types of Financial Markets

1. Money Market: a market for short-termsecurities or securities with a maturity of less thanone year;

2. Capital market: A market for long-termsecurities or securities with a maturity period ofone or more year.

Primary market;

Secondary market.

Types of the Capital Market

1. Primary market: it refers to the market:

Where securities are created/issued;

where the securities are traded for very first time;

2. Secondary market: it refers to the market wherethose securities traded which have already beenissued in the primary market:

Over the counter;

Trade through stock exchanges;





2. Secondary market: it refers to the market where those securities traded which have already beenissued in the primary market:

Over the counter: trade thorough the directcounters of the company or on the immediatebasis;

Trade through stock exchanges: approach toBSE, NSE or any other stock exchange throughstock brokers or agents of registered brokingcompanies.


1. Primary market:

2. Secondary market:

Over the counter: trade thorough the direct counters of the company or on theimmediate basis;

Trade through stock exchanges: approach to BSE, NSE or any other stockexchange through stock brokers or agents of registered broking companies.

Stock brokers or agents of registered brokingcompanies: these are the individuals, companiesor the institutions registered with SEBI (1992)and are authorised to sale and purchase ofsecurities or the financial assets.

Share khan, Religare and Unicorn etc.

3. Financial Instruments

Financial asset or the financial instrument is the claim of money, against a particular person or institution, at a future date, for a specific amount;

A financial asset may also include the claim of periodic payment in form of interest or dividend,

Implies Debentures, shares, bonds and notes;

1. Primary securities: Equity, Debentures;

2. Secondary securities: Bank deposits, Insurance policies and Mutual funds.

Features of a Security

Marketable;

Traceable;

Tailor-made.

Financial Services

Financial facilitate theease of:

1. Borrowing and funding;

2. Lending and investing;

3. Buying and selling;

4. Making and enablingpayments and settlements;

5. Managing risk andexposures;

Need for Financial Services

Categories of Financial Services

1. Fund intermediation:

2. Liquidity facility:

3. Payment mechanism:

4. Risk management:

5. Financial engineering is the application ofmathematical methods to the solution of problemsin finance. It is also knownas financial mathematics, mathematical finance,and computational finance.

Functions of a Financial System

Mobilize and allocate savings;

Monitor corporate performance;

Provide payment and settlement system;

Optimum allocation of risk bearing and reduction;

Disseminate price related information;

Offer portfolio adjustment facility;

Lower the cost of transactions;

Promote the process of financial deepening ofbroadening. Financial Deepening: It refers to the increased

provision of financial services with a wider choice ofservices geared to all levels of society.

Financial System and Economic

Increase in rate of saving and investments;

Increase in the productivity and production;

Growth in GDP and GNP of India;

Helps in capital formation;

Utilization of idle funds;

Maintains circular flows in economy;

Increase transparency and reduce risk of several defaults.

Improvement in living standard;

Keys elements of well functioning financial system

A strong legal and regulatory environment;

Stable money;

Sound public;

Sound finances and public debt management;

A central bank;

Sound banking system;

Information system;

Well functioning securities market;

Mobilization of Funds

Financial Markets

Financial markets are the mechanism enablingparticipants to deal in financial claims.

Literally, financial markets also provide a facility inwhich their demands and requirements interact toset a price for such claims. (D=S)

Types of Financial Markets

1. Money Market: a market for short-termsecurities or securities with a maturity of less thanone year;

2. Capital market: A market for long-termsecurities or securities with a maturity period ofone or more year.

Primary market;

Secondary market.

THE MONEY MARKET

An Introduction to


Money market refers to the market for financial assets that are close substitutes for money;

It is the market for overnight to short-term funds and instruments;

Instrument having maturity period of one or less than one year.

Features and characteristics of money market

1. Money market refers to the market for financial assetsthat are close substitutes for money;

2. It is the market for overnight to short-term funds andinstruments;

3. Instrument having maturity period of one or less than oneyear.

4. It is not a physical location (like stock exchanges),hence activities are conducted over telephones;

5. Collection of several instruments and their markets;6. Whole sale market of short term debt instruments;7. Creditworthiness of the participants is important;8. Main players are: DHFI, RBI, Banking institutions,

NBFCs, STCI, PSUs and non-residents Indians.9. Need based market;10. Price determination through free play of demand and

supply forces;

Functions of money market

• Money market is generally expected to perform three broad functions:

1. Provide balancing mechanism to even out the demand for and supply of short term funds;

2. Provide a focal point for central bank intervention for influencing liquidity and general level of interest rates in the economy;

3. Provide reasonable access t suppliers and users of short term funds to fulfill their borrowings and investment requirements at an efficient and market clearing price.

Benefits of The Efficient Money Market

1. Provides a stable source of funds to banks;

2. Encourage development of non bank entities;

3. Facilitates government, market borrowing;

4. Makes effective monetary policy actions;

5. Helps in pricing different floating interestproducts.

The Indian Money Market

Role of Reserve Bank of India in The Money Market

Money market comes under the direct purview ofReserve Bank of India;

The aims of RBI’s operations in the money marketare:

1. To ensure that liquidity and short term interestrates are maintained at levels consistent with themonetary

2. objectives of maintaining price stability;

3. To bring about order in foreign exchange market;

Tools of RBI: CRR, SLR and open market operations etc.

Organization of money market in India

Formal/organized money market;

Informal/unorganized money market.

Historical Background of Money Market in IndiaDevelopments in Money Market in India

In the 1980s:

1. Sukhamoy chakravorty committee on recommended need for development of money market instruments: 1985;

2. N. Vagul’s working group on money market:1987;

3. Introduction of money market instruments: 182-days treasury bills, certificate of deposit and inter-bank participation certificate(1988-89) and commercial papers(1990);

4. Abolition of interest rate ceiling on call money and market based determination of interest rates (1988);


In the 1990s:1. M. Narsimham committee (1991): a high level committee set by

government of India for financial sector reforms;

2. Recommendations of Narsimham committee:

Set up Security Trading Corporation of India(1994);

Primary dealer system(1995), satellite dealer system (1997) [In orderto increase the liquidity in the money market];

Focuses on financial deepening and financial liberalization;

Introduction of treasury bills with several maturity periods;

Auctioned treasury bills introduced (market determinedinterest rates)


In the 1990s:1. M. Narsimham committee (1991): a high level committee set by

government of India for financial sector reforms;

2. Recommendations of Narsimham committee:

Introduction of repo rates by RBI;

Reactivation of Bank rate(1997), introduction of LAF(2000), openmarket operations (1998);

Introduction to the Money Market derivatives-FWD rate agreementand interest rates swaps (1999);

Payment system infrastructure: negotiated dealing system(2002),Clearing corporation of India(2002), RTGS(2004);

Operationalised Collateral Borrowing and Lending Obligation(CBLO) under CCIL (2003);

Money Marker Centers In India

There are three money market centers in India,which are located at:

1. Mumbai

2. Delhi

3. Kolkata.

Note: Mumbai is the only money market center inIndia with money flowing in from all parts of thecountry getting transacted there.

Money Market Instruments

1. Treasury bills;

2. Call money;

3. Notice money;

4. Term money;

5. Commercial papers (CP);

6. Certificates of deposits(CD);

7. Commercial bills (CB);

8. Collateralized borrowing and lending obligations (CBLO).


1. Treasury bills are short-term instruments used bythe government to raise short-term funds;

• Negotiable securities;

• Highly liquid;

• No default risk;

• Assured yield, low transaction cost, inclusion in SLRlimit;

• Transacted through SGL account and not issued as ascrip;

• Maturity periods are: 91-days, 181-days and 364-days;

• Min. amount of 25,000Rs. And multiples of the same.

• Categorized as: On-tap, auctioned and Adhoc T-bills.


2. Call money: commercial banks borrow money from other banks to maintain minimum cash balance known as cash reserve ratio (CRR);

Maturity: over the night;

Rating:

Denomination: not specified or equal to NDTL;

Raised by: commercial banks;

Related term: notice money and term money.


3. Notice Money: commercial banks borrow moneyfrom other banks to maintain minimum cashbalance known as cash reserve ratio (CRR);

Maturity: 1 day to 14 days;

Rating:

Denomination: not specified;


Related term: call money and term money.


4. Term money: commercial banks borrow money from other banks to maintain minimum cash balance known as cash reserve ratio (CRR);

Maturity: 15-364 days;

Rating:

Denomination: not specified;


Related term: notice money and call money.

Link between the call money market and other financial markets

Call rate interest rate paid on the call loans;

MIBOR (1998): developed by National stock exchange of India along with MIBID-Mumbai inter-bank bid rate for overnight money markets; provides quotations from overnight to 24 months;

LIBOR- London inter-bank offer rate;

Call rate volatility: call rates are subject to change;

Measures for curbing high rate of volatility in the call money market

Money market intermediaries in India

DHFI(1988)- discount and finance house of India;

Money market mutual funds of India;

Link between the money market and monetary policy of India

Direct instruments :

Reserve requirements;

Limits on refinance;

Administered interest rates;

Qualitative and quantitative restrictions on thecredit;

Indirect instruments:

Open market operations

Repos.

Money market derivatives-Interest rates swaps

Money market derivatives-Plain vanilla interest rate swaps


5. Commercial papers (CP-1990) is an unsecuredshort-term promissory note issued at a discount bycreditworthy corporate, primary dealers and all-Indian financial institution.

maturity: 7 days – 364 days;

Rating: P series of CRISIL;

Denomination: 5 lac and multiples;

Investment through: demat account.


6. Certificates of deposits(CD-1989) are short-term tradable time deposits issued by commercialbanks and financial institutions;

Maturity:7 days to 1 year for banks but 1-3 years forFIs ;

Rating:

Denomination: 1 lakh and multiples;

Issued by: financial institutions.

Related term: it is same as FD but freelytransferable and tradable unlike the FD.


7. Commercial bills (CB) are negotiable instruments drawn on the seller by the buyer, in turn, accepted and discounted by commercial banks;

1. Types of commercial bills: Demand bill Usance bill: Clean bill: Documentary bill: Inland bill: Foreign bill: Hundi: Derivative usance promissory notes: Inchoate:


7. Commercial bills (CB) are negotiable instruments drawn on the seller by the buyer, in turn, accepted and discounted by commercial banks;

1. Features of commercial bills:

Maturity: 30, 60,90 days usually;

Rating:

Denomination: not specified-can be any amount;

Discounted through: Commercial banks;

some time also known as trade bills; but known as thecommercial bill when discount by the bank.


9. Collateralized borrowing and lendingobligations (CBLO): same as the call moneyfacility availed by the non-bank financialinstitutions and entities;

Because non-bank financial institutions are noteligible for availing the facility of the call money.

THE CAPITAL MARKET

An Introduction to


Capital market is a market where securities with the long tenure are bought and sold such as equity and debt, funds are raised for long period;





2. Secondary market: it refers to the market wherethose securities traded which have already beenissued in the primary market:

Over the counter;

Trade through stock exchanges;

Role of capital markets in the growth of economy

It helps in economic growth of a country bymobilizing the savings and direct is to the right wayfor more productive uses:

Directs cash from deficit sector to the surplus sector:issue of securities in the primary; domestic,government, corporate sector.

direct cash from the surplus sector to the financialintermediaries: issue of the secondary in the primarymarket;

Facilitation of the liquidity: resale and repurchase ofthe financial assets through the secondary market.

Functions of The Capital Market

1. Mobilization of savings;2. Provides risk capital to entrepreneurs such as equity and quasi

equity;3. Encourage broader ownership of productive assets through

equity participation;4. Lower cost of transaction and information;5. Improve efficiency of capital allocation through competitive

pricing methods;6. Enable quick valuation of the financial assets i.e. share and

debentures;7. Provides insurance against market risk;8. Increases the width of market by enabling wider participation;9. Provide operational efficiency;10. Develop integration among different sectors and participants.

Components of Capital Market

1. Primary market: it refers to the market wherefinancial securities are created/issued and sold forvery first time; it serves the mobilization functionand capital creation/formation function;

2. Secondary market: it refers to the market wherethose financial securities are re-bought and re-soldwhich have already been issued and sold in primarymarket; it facilitates the liquidity function.

Hence, primary market is for the new issues andsecondary market is for the outstanding or theexisting issues;

Primary Market

1. Primary market: it refers to the market wherefinancial securities are created/issued and sold forvery first time; it serves the mobilization functionand capital creation/formation function;

Issue of The Securities in Primary Market

Name of the Security Domestic issue External issue

1. Equity Corporate (primary issues)Financial intermediaries (secondary issues)

Through issue of:Global Depository Receipts (GDR);American Depository Receipt (ADR)

2. Debt Corporate (primary issues)Government (primary issues)

External commercial borrowing (ECB)

3. Other external borrowings:i. Foreign Direct Investment (FDI)

See next slide

Issue of The Securities in Primary Market

Other external borrowings Method of investment

1. Foreign Direct Investment (FDI) Equity form;Debt form;

2. Foreign Institutional Investments (FII)

In the form of portfolio investment;

3. Non-resident Indian Deposits (NRI) short- term and medium term borrowings;

Methods of Issuing Equity in Primary Market

1. Public issues through prospectus: IPOs, FPOs;

2. Private placement;

3. Right issues;

4. Preferential issues;

Secondary Market

Secondary market: it refers to the market where those financial securities are re-bought and re-sold which have already been issued and sold in primary market; it facilitates the liquidity function.

Functions of The Secondary Market

1. Facilitates liquidity and marketability of securities;

2. Provides valuation of securities;

3. Reduces cost of capital;

4. Enable price discovery;

5. Creates a wealth effect;

History of Indian Capital Market

To be updated soon…

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An Introduction on · An Introduction on. Meaning and Definition ... SIDBI,IIBI. Components of Formal Financial System-Institutions