FIN SYS-UNIT-1

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“ Financial System ”



The word “system” means an orderedorganization & assemblage of facts ,

principles or components relating to

particular field or for specified purpose.The word "system", in the term "financial

system", implies a set of complex and

closely connected or interlined institutions,agents, practices, markets, transactions,

claims, and liabilities in the economy.



• “Finance" in our simple understanding it isperceived as equivalent to 'Money'.

• But Finance exactly is not money.

• It is the source of providing funds for aparticular activity.



Finance is the art and science of managingmoney.

Virtually all individuals and organisations earnor rise money and spend or invest money.

Finance is concerned with the process,institutions, markets and instruments involvedin the transfer of money among and betweenindividuals, business and governments.



The word system in “Financial System” refers to set of closely held financial

institution, services, instruments &

markets.A Financial System of country can be

defined as set of organizations & methods

of operational procedures that areinterrelated with each-other.



Every modern economy is based on a sound financial system. The

principal aim of financial system is to transform surplus income &savings into investments.

SEEKERS OF

FUNDS,

MAINLY

BUSINESS

FIRM

& GOVT.

SUPPLIERS

OF FUNDS,

MAINLY

HOUSEHOLD

FLOW OF FUNDS

FLOW OF FINANCIAL

SERVICES



Mobilization Of Savings.Provision Of Liquidity

Providing Information

Credit Function and payment functionReduce cost of transaction and borrowing

Risk function

Proper allocation of the fund for the development of theeconomy

Projects selection



Financial Component:

Financial Assets.Financial Intermediaries.

Financial Markets.

Financial Instruments.

Financial Services



A Financial Asset is the one which isused for production or consumption or for

future creation of assets.

Types Of Financial Assets:

Marketable Non-marketable



Marketable

Assets

Debentures

Shares &Bonds

Govt.Securuties

Mutual fundunits

Financial Assets



Non-Marketable

Assets

PO

certificates

Bankdeposits

PF

LICschemes

Financial Assets



FINANCIAL MARKET

Financial markets provide channels for allocation of savings to

investment. It is a market where financial assets are created ortransferred through buying & selling of financial assets.

FINANCIAL MARKET

MONEYMARKET

CAPITALMARKET

PRIMARYMARKET

SECONDARYMARKET

FOREXMARKET

CREDITMARKET



• A Financial Market can be defined as themarket in which financial assets are createdor transferred.

• As against a real transaction that involves

exchange of money for real goods orservices, a financial transaction involvescreation or transfer of a financial asset.

• Financial Assets or Financial Instruments

represents a claim to the payment of a sumof money sometime in the future and /orperiodic payment in the form of interest ordividend.





Function of Financial Markets

1. Allowstransfers offunds fromperson orbusiness

withoutinvestmentopportunities to one whohas them

2. Improveseconomicefficiency

Source: Mishkin, Frederic S. and Apostolos Serletis, The Economics of Money, Banking and Financial Markets , 2nd Canadian Edition,

Pearson Addison Wesley, 2004



An Overview of the Financial System



Regulation of Financial Markets

Two Main Reasons for Regulation

1. Increase information to investorsA. Decreases adverse selection and moral hazard

problems

B. Securities commissions force corporations todisclose information

2. Ensuring the soundness of financialintermediaries

A. Prevents financial panicsB. Chartering, reporting requirements, restrictions

on assets and activities, deposit insurance, andanti-competitive measures



CapitalMarket

IndustrialSectorMarket

Govt.Securities

Market

Long Term

Market

MoneyMarket

Call moneyMarket

Commercialbill Market

Treasury billMarket

Short term

loan Market

Financial Market

ORGANIZED

MARKETUNORGANIZED

MARKET

LENDER



• Money Market- The money market ifs a wholesale debtmarket for low-risk, highly-liquid, short-terminstrument. Funds are available in this market for periodsranging from a single day up to a year. This market isdominated mostly by government, banks and financialinstitutions.

it refers to the market, where borrowers & lenders exchangeshort term funds to solve their liquidity needs. funds are

available in this market for periods ranging from a single dayupto a year. the financial claims here have low risk, highliquidity & maturities under one year





• A capital market is a market for securities (debt orequity), where business enterprises (companies)

and governments can raise long-term funds. It isdefined as a market in which money is provided forperiods longer than a year

• PRIMARY MARKET

• SECONDARY MARKET



• PRIMARY MARKET : First Time Salesof Equity Also Called the new issuemarket, is the market for issuing new

securities. Many companies, especiallysmall and medium scale, enter theprimary market to raise money from thepublic to expand their businesses. They

sell their securities to the public throughan initial public offering.



• it is the market which provides the

channel for sale of new issues.resources are required for both new as

well as existing projects with a view to

expansion, modernisation,diversification & upgradation. it is the

market where resources are mobilised

by companies through issue of newsecurities.



• A market where investors tradeoutstanding securities/ issues are called

secondary market. secondary market

comprises of stock exchanges, which

provide platform for purchase & sale of

securities by investors, where the

trading is accessible only through

brokers & trading is confined only to

stock exchanges.





Intermediary Market Role



Intermediary Market Role

Stock Exchange Capital Market Secondary Market to

securities

Investment Bankers Capital Market, Credit Market Corporate advisory services,

Issue of securities

Underwriters Capital Market, Money Market Subscribe to unsubscribed

portion of securities

Registrars, Depositories,

Custodians

Capital Market Issue securities to the

investors on behalf of the

company and handle share

transfer activity

Primary Dealers Satellite

Dealers

Money Market Market making in

government securities

Forex Dealers Forex Market Ensure exchange ink

currencies





• Money Market Instruments

• THE MONEY MARKET IS A MARKET FOR SHORT TERMMONEY & FINANCIAL ASSETS THAT ARE CLOSERSUBSTITUTES OF MONEY. HERE THE TERM SHORT TERMMEANS GENERALLY A PERIOD UPTO ONE YEAR &

CLOSER SUBSTITUTES OF MONEY MEANS ANY ASSETWHICH CAN BE QUICKLY CONVERTED INTO MONEYWITH MINIMUM TRANSACTION COST.

• Money market instruments are briefly discussed below;

1. Call/Notice Money 2. Treasury Bills 3. Term Money 4. Certificate of Deposit 5. Commercial Papers

• 1 Call /Notice-Money Market

http://www.stcionline.com/working-of-money-market.html

http://www.stcionline.com/call-notice-money-inter-bank-term-money.html


http://www.stcionline.com/deposit-market-inter-corporate-market.html


http://www.stcionline.com/commercial-papers-market.html





http://www.stcionline.com/call-notice-money-inter-bank-term-money.html





• 1. Call /Notice-Money Market • Call/Notice money is the money borrowed or lent on

demand for a very short period. When money isborrowed or lent for a day, it is known as Call

(Overnight) Money. Intervening holidays and/orSunday are excluded for this purpose. Thus money,borrowed on a day and repaid on the next workingday, (irrespective of the number of interveningholidays) is "Call Money". When money is borrowedor lent for more than a day and up to 14 days, it is"Notice Money". No collateral security is required tocover these transactions.

• 2. Inter-Bank Term Money • Inter-bank market for deposits of maturity beyond 14

days is referred to as the term money market. Theentry restrictions are the same as those forCall/Notice Money except that, as per existingregulations, the specified entities are not allowed tolend beyond 14 days.



• 3. Treasury Bills.

• Treasury Bills are short term (up to one year)borrowing instruments of the union government. It

is an IOU of the Government. It is a promise by theGovernment to pay a stated sum after expiry of thestated period from the date of issue(14/91/182/364 days i.e. less than one year). They

are issued at a discount to the face value, and onmaturity the face value is paid to the holder. Therate of discount and the corresponding issue priceare determined at each auction.





• 5. Commercial Paper

• CP is a note in evidence of the debt obligation of the issuer. Onissuing commercial paper the debt obligation is transformed intoan instrument. CP is thus an unsecured promissory noteprivately placed with investors at a discount rate to face valuedetermined by market forces. CP is freely negotiable byendorsement and delivery. A company shall be eligible to issueCP provided - (a) the tangible net worth of the company, as perthe latest audited balance sheet, is not less than Rs. 4 crore; (b)the working capital (fund-based) limit of the company from thebanking system is not less than Rs.4 crore and (c) the borrowalaccount of the company is classified as a Standard Asset by thefinancing bank/s. The minimum maturity period of CP is 7 days.





CALL/NOTICE MONEY:

IT IS THE MONEY BORROWED OR LENT ON DEMAND FOR A VERY SHORT PERIOD.

WHEN MONEY IS BORROWED OR LENT FOR A DAY, IT IS KNOWN AS CALL/ OVERNIGHT

MONEY. HOLIDAYS & SUNDAYS ARE EXCLUDED HERE. THUS MONEY BORROWED ON A

DAY & REPAID ON THE NEXT WORKING DAY IS “CALL MONEY”. BUT WHEN MONEY LENTOR BORROWED FOR MORE THAN A DAY & UPTO 14 DAYS, IT IS NOTICE MONEY.

TERM MONEY :

INTER BANK MARKET FOR DEPOSITS OF MATURITY BEYOND 14 DAYS IS REFERRED TO

AS THE TERM MONEY MARKET.

TREASURY BILL :

IT IS A SHORT TERM BORROWING INSTRUMENT OF THE UNION GOVT. IT IS AN IOU I.e.

ACKNOWLEDGEMENT OF DEBT OF THE GOVT. TO PAY A STATED SUM OF AFTER EXPIRY OF

STATED PERIOD FROM THE DATE OF ISSUE.(LESS THAN 1 YEAR).

COMMERCIAL PAPERS : IT REPRESENTS SHORT TERM UNSECURED PROMISORY NOTES ISSUED BY FIRMS THAT ARE

GENERALLY CONSIDERED TO BE FINANCIALLY STRONG. COMMERCIAL PAPERS USUALLY

HAS A MATURITY PERIOD OF 90 - 180 DAYS. IT IS GENERALLY SOLD AT DISCOUNT &

REDEEMED AT PAR.

IT IS EITHER DIRECTLY PLACED WITH THE INVESTORS OR SOLD THROUGH DEALERS. BUT IT

DOES NOT PRESENTLY HAVE A WELL DEVELOPED SECONDARY MARKET IN INDIA.



EQUITY SEGMENTS : DEBT SEGMENTS :

EQUITY SHARES . DEBENTURES .

PREFERENCE SHARES . ZERO-COUPON BOND

CONVERTIBLE PREFERENCE SHARES . DEEP DISCOUNT BOND

NON-CONVERTIBLE PREFERENCE SHARES .

CAPITAL MARKET INSTRUMENTS :

THE CAPITAL MARKET GENERALLY CONSISTS OF THE FOLLOWING LONG TERM

PERIOD i.e. MORE THAN 1 YEAR PERIOD. THE MAJOR FINANCIAL INSTRUMENTS

USED FOR A CAPITAL MARKET ARE :

HYBRID INSTRUMENTS :

HYBRID INSTRUMENTS HAVE BOTH THE FEATURES OF EQUITY & DEBENTURE. THIS KIND OF

INSTRUMENT IS CALLED AS HYBRID INSTRUMENTS. EXAMPLES ARE: CONVERTIBLE

DEBENTURES.

WARRANTS, ETC.







Financial Intermediaries

• Specialized financial firms that facilitate the

indirect transfer of funds from savers to

borrowers by offering savings instruments and

borrowing instruments



Financial Intermediation

• The process by which financial intermediaries

transform funds

provided by savers into funds

used by borrowers











• Having designed the instrument, the issuer shouldthen ensure that these financial assets reach theultimate investor in order to garner the requisite

amount. When the borrower of funds approachesthe financial market to raise funds, mere issue ofsecurities will not suffice. Adequate information ofthe issue, issuer and the security should be passed

on to take place. There should be a proper channelwithin the financial system to ensure such transfer.To serve this purpose, Financial intermediariescame into existence.



• This service was offered by banks, FIs, brokers, anddealers. However, as the financial system widenedalong with the developments taking place in the

financial markets, the scope of its operations alsowidened. Some of the important intermediariesoperating ink the financial markets include;investment bankers, underwriters, stock

exchanges, registrars, depositories, custodians,portfolio managers, mutual funds, financialadvertisers financial consultants, primary dealers,satellite dealers, self regulatory organizations, etc.



Financial intermediaries includes all types of

organisation which intermediate & facilitatefinancial transactions of both individuals &corporate customers.

It refers to all financial institutions & investinginstitutions which facilitate financial transactions infinancial markets.

Financial intermediaries in India consisits ofOrganised & Unorganised Sector.





The Function of Financial Institutions

Financial intermediaries channel funds betweenborrowers and lenders.

Intermediation transforming

assets the function of transforming assets or

liabilities into other assets or liabilities Liabilities – deposits

Assets – loans

this is the principal activity of most financial

institutions.

intermediation improves social welfare by







Function of Financial Intermediaries(Cont’d)

Transactions Costs

1. Financial intermediaries make profits by reducing

transactions costs.

2. They reduce transactions costs by developingexpertise and taking advantage of economies of

scale.



Function of Financial Intermediaries(Cont’d)

Risk Sharing

• Create and sell assets with low risk characteristics

and then use the funds to buy assets with more risk

(also called asset transformation)• Lower risk by helping people to diversify portfolios



Asymmetric Information

Adverse Selection

• Before transaction occurs

• Potential borrowers most likely to produce adverse

outcomes are ones most likely to seek loans and beselected



Asymmetric Information (Cont’d)

Moral Hazard

• After transaction occurs

• Hazard that borrower has incentives to engage in

undesirable activities making it more likely thatloan won’t be paid back



• Ease liquidity constraints

– Reallocate consumption/savings patterns

• Often the liquidity required to make certain purchases is not inline with the immediate flow of income available to

individuals.

– The ability to influence the allocation of consumption

and investment is probably the most important function

of intermediation.

• Provide security

– Intermediation provides a host of services that reduce or

shift risk.

– Financial institutions can also influence the riskiness of

financial transactions [contracts and insurance].



• Reduce asymmetric information problem

– Moral hazard• the chance that an individual may have an incentive to

act in a way such as to put that individual at greater risk;the individual perceives as beneficial actions that aredeemed undesirable by another.

– Adverse selection• decision making that results from the incentive for some

people to engage in a transaction that is undesirable toeveryone else

– Banks have a comparative advantage inoffering specialized services that help to

reduce this problem. – Banks can also take advantage of this

asymmetric information problem, with direconsequences.





The Function of Financial Institutions

Brokerage an “agency”

function

Brokers are agents who bring would-bebuyers and sellers together sotransactions can be made.

Intermediation provides value-

added but there are potential“externalities”. One intermediary’s

actions can have consequences for

the entire system.



• Banks are particularly adept atintermediation because they can

perform the necessary functions more

cheaply than most institutions.

• Technological change and deregulation

have narrowed the comparative

advantage of banks.



Types of Financial Institutions

Deposit-taking (a.k.a. depository institutions)

accept and manage deposits and make loans.

These institutions are divided into banks and

other deposit-taking institutions (near-banks).

Other deposit-taking institutions:

Trust companies – also provide administrative servicesfor estates and trusts (fiduciaries).

Credit unions or caisses populaires – these aremember owned so that depositors are alsoshareholders.

Mortgage loan companies – also permit investors to

invest in a portfolio of assets primarily real estate.



• Insurance Companies and Pension Funds – Insurance companies provide the means of channeling

savings to provide for unforeseen expenses by poolingthe risks of their clientele.

– There are also institutions that specialize in themanagement of pension plans and funds.Government legislation plays are large role in dictatinghow these pensions are administered.

• Registered Retirement Savings Plans (RRSPs) are individuals’ tax-sheltered funds administered by the individuals themselves or by adeposit-taking institution or investment dealer on their behalf.

• Registered Retirement Plans (RRPs) are the pooled retirementsavings of a group of employees administered by their employer orlabour union.



• Investment Dealers and Investment Funds – The plethora of investment funds (a.k.a. mutual funds) pool funds

for investment in a wide range of activities and instruments

without providing the other functions of a typical bank

– Investment dealers primarily underwrite corporate andgovernment securities.

• Government financial institutions

– Deposit-taking role

– Channeling funds from the public to private sector

– Protecting private funds by providing deposit insurance (CDIC).

• Other Intermediaries

– Sales, finance, and consumer loan companies.



Financial services refer to the servicesprovided by the finance industry.

Finance industry encompasses a broadrange of organisations that deal withmanagement of money.

Organisations are Banks , Credit card co.s,Insurance co.s , Consumer Finance co.s , Stockbrokerage , Investment Funds etc.







• The economic development of a nation is reflected by theprogress of the various economic units, broadly classifiedinto corporate sector, government and householdsector. While performing their activities these units will beplaced in a surplus/deficit/balanced budgetary situations.

• There are areas or people with surplus funds and there arethose with a deficit. A financial system or financial sectorfunctions as an intermediary and facilitates the flow of

funds from the areas of surplus to the areas of deficit. AFinancial System is a composition of various institutions,markets, regulations and laws, practices, money manager,analysts, transactions and claims and liabilities.















•Most banks were state-owned

• Banks, pension funds andinsurance companies wereforced to buy State Issuedbonds - primary investment.

• Bombay Stock Exchange was

closed market. Run by Brokersfor the benefit of its members.There was no rightgovernance and regulation.

• There was no single derivativemarket.

• All financial transactions werecontrolled by the RBI andMinistry of Finance



Socialistic Model Weapons

• Strict entry barriers in every sub-industry.

• Difficult to start a bank, a mutualfund, a brokerage firm, aninsurance company, a pensionfund, a securities exchange or

sub-broking firm.• Foreign firms were restricted to

touch any one of these parts

• Comprehensive capital controland restrictive legislations

• Look at a typical bureaucrats ofyester years as perceived

Big Villains were• MRTP act, 1969• The Capital Issues

(control) act, 1947

• Indian Companies Act,1956

• Industries Act, 1956• Foreign Exchange

Regulation Act, 1973

• Male , Balding head , Ugly stained metal rimmedl



glasses .

• Thick bushy eyebrows[Usually as a mono-brow],Mustache[See pictures], No beard., Paan Chewing [The teeth and tongue are often discolored].

• “I-don't-care-what-you-say, I'll-do-it-only-my-way”

attitude.• Drinking coffee 10 times a day.

• Looking for a slightest opportunity to take bribe.

• Take home salary is Rs. 5000[Official] + Rs.25000[Bribes and Misc. tips].

• Taking the rules and law by word and notunderstanding the true essence of it. Even though thelaws usually date back to the 1850 British Colonial

period .• No respect for anyone's privacy.

• Not taking anyone's ideas on improving productivityeven though they are right.

• Piles and piles of paper with folders and gem-clipsstrewn about.

• A rotary dial telephone on the desk..

• No air-conditioning and a ceiling fan that rotates 6times in an hour.

• Runs errands for his bosses or chats with familyduring work. Also misuses official equipment.

• Is usually in a vital position of authority/ In a positionthat requires interaction with people everyday.

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• Individuals,Firms, State

Surplus Units •Money Market

•Debt Market

•Equity Market

•Derivative Market

•Forex Market

Free FinancialSystem

•Equity

•Bonds

•Hybrid•Money Market Instruments

•All are customized

Vehicles

• Individuals,Firms,State

Deficit Units



• Market driven

• All players with integrity and accountability

• Innovators and Creators flourish• Contributes favorably to the Economy

• No greedy

• Global but not taking external shocks

• State facilitates rather than suppresses





Liberalization Facilitators

• Eighteen to Three – Scheduled Industries

• Eight Hundred to Fifty – SSI• MRTP not active• Capital Issues Act repealed• Foreign Exchange

Regulation Act repealed• Insurance, Banking

Industries open its gates forPrivate Players

• MNC allowed

• Banking Regulation Actsimplified

• Security Exchange Boardconstituted

• Foreign ExchangeManagement Act – passed

• Company’s Act – subject to

scrutiny• Private players allowed to

do insurance and bankingbusiness

• SEZs opened• FDI encouraged



• Lender's risk has dwindled

substantially• Liquidity position is improved• Return is certain on his

savings (either fixed or

variable)• Lender gets impetus to save• He will get accurate

information from specializedfinancial institutions.

• Lenders botheration withrespect to selecting a promptborrower is reduced



• Their need make lesseffort and minimumtime in questing for anultimate lender.

• In whatsoever fashionthey needs funds theycan procure

• They can seekprofessionals and

specialized assistancefrom specialist in thefield.



• 1. Banking financial institutes (RBI, Commercial banks

and co-operative banks)• 2. Development banks (all India financial institutes

like IDBI, IFCI)• 3. Investment financial institutes (LIC,GIC,UTI, since

2000 Private insurance companies like SunLife, AllianzBajaj, ICICI Prudential etc. )

• 4. Non-Banking financial institutes (SBI capitalservices, Merchant banking companies Hire-purchasecompanies, etc.,)

• 5. Postal department Financial services (Recurringdeposits, NSC, KVP, Postal Life-Insurance etc.).




Surplus Units

• Market

• State

Financial System

• MoneyMarket

• Equity Market

• Debt Market

Financial Market

• CustomizedInstruments

Vehicles


Deficit Units



1. Under developed saving Vehicles or

Negative Returns on Saving or both

2. Inefficient allocation of saving byFinanacain intermediaries

3. Poor financial policies Discourage firms

from investing



Indian financial system was characterized by :

•Absence of organized capital market

•Dependence of industries & other users on

internal sources.

•Rare cases of public issues of capital for expansion& modernization.

•Few financial institutions & players in the market.

•Awkward & very strict conditions for loanassistance to companies .







INDIAN

FINANCIAL

STSTEM

IN



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