CHAPTER 1INDIAN FINANCIAL SYSTEM

MEANING OF FINANCIAL SYSTEM Financial system is a combination of financial markets and financial

institutions.

In other words the financial system provides the intermediation between investors and institutions and helps the process of leading to greater financial development for faster economic situation.

DEFNITION OF FINANCIAL SYSTEM

According to Prof. S.B. Gupta Financial System “a set of institutional arrangements through which financial surpluses available in the economy are mobilized”

Features of Financial System:

It plays a vital role in economic development of a country. It encourages both savings and investment. It links savers and investors. It helps in capital formation. It is applicable at global, regional and firm level It helps in allocation of risk. It facilitates expansion of financial market. It aids in financial deepening and broadening. Financial deepening

means increasing financial assets as a percentage of GDP and financial broadening means building an increasing number and variety of participants and instruments.

Its main objective is to formulate capital, investment and profit generation.

Functions of financial system The main functions of financial system are as follows;

Provision of liquidity

The term liquidity refers to conversion of stock and other assets into cash. It is the major functions of financial system for procuring cash and cash related activity and converting it into profitable one.

Size transformation function or small savings to big investment.

By collecting deposits from small customers and giving them as loan for different customers. Adopting these strategy the marketer perform as well as increasing their branches in different region is also analysed

Maturity transformation function

Are the one in which marketer may accept deposit from public in different maturities and they were taking initiatives to role the functions according to their liquidity preference and lend them to the borrowers in different maturities according to their needs and economic activities of a country.

Mobilisation of savings

The financial system facilitates the transformation of savings into investment and consumption [Rolling of profit]. It is one of the main important functions we may be analysed in our financial system.

Risk transformation function

Risk transformation function is the one in which the financial intermediaries collects the saving from individual investors, sometime in particular financial flow there may be a possibility of risk and uncertain happenings may expect for the financial marketer, in that stage he must be in a capacity to lead risk as well as uncertainty issues.

Other functions

It promotes self-employment opportunities It improves economic development of our country It provides and ensures effective allocation of the investor

investment in a accurate manner.

Role and Importance of Financial System:

It links the savers and investors. It helps in mobilizing and allocating the savings efficiently and effectively.

It plays a crucial role in economic development through saving investment process. This savings investment process is called capital formation.

It helps to monitor corporate performance It provides a mechanism for managing uncertainty and controlling

risk. It provides a mechanism for the transfer of resources across

geographical boundaries. It offers portfolio adjustment facilities( monetary policy that allows

the banks to borrow money through repurchase agreements).(provided by financial markets and financial intermediaries).

It helps in lowering the transaction costs and increase returns. This will motivate people to save more.

It promotes the process of capital formation.Objectives of financial system:

o To mobilize the savings: It begins its operation by the mobilizing of savings from the small saving community.

o To distribute the savings for the industrial investment: The purpose of mobilizing the fund from the saving community is to invest them in different industries,(growth in industrial sector).

o To stimulate capital formation: It helps them to make the industries to form a capital out of their earnings for the further capital requirement and industrial investment.

o To accelerate the process of economic growth: The ultimate aim of the financial institutions is to support the process of economic growth of a nation.

i) Financial Institutions is “an establishment that focuses on dealing with financial transactions, such as investment, loans and deposits”.

Its features:

1. It is an Institution as well as Intermediary.

2. It channelizes savings fund into investment fund.

3. It creates financial assets such as deposits, loans, securities etc.

4. It includes banking and non banking institutions.

5. And also includes both organized and unorganized institutions.

6. Established with a clear operating function.

7. Regulated by the government and regulating authority.

Classification of financial institutions:

1. Banking Institutions: These are the type of financial institutions which involve in accepting public deposits and lending the same to the needy customers.

These are fundamentally established to earn profit, secondarily to safe guard the interest of the members.

Its types are:

1. Commercial Banks: also called as Business banksPublic sector

Private sector

Regional Rural Banks (RRBs)

Foreign banks

2. Cooperative banks: These are established to safeguard the interest of its members. These are organized on a cooperative basis, accept deposit and lend money to the required money to the required members.

2. Non Banking Institutions: The non banking institutions that provide banking services without

meeting the legal definition of a bank.The non banking institutions are classified into organized and

unorganized financial institutions. Provident and Pension Fund Small Saving Organization Life Insurance Corporation(LIC) General Insurance Corporation(GIC) Unit Trust of India(UTI) Mutual Funds Investment Trust etc.

ii) Financial Markets: is defined as a market for the exchange of capital and credit, including the money markets and capital markets.

Classification of Financial markets

(i) Unorganized Financial markets: These are comprised with private money lenders , pawn brokers, indigenous bankers, traders etc.

they lend money to the public from their own fund.(Operations and activities are not regulated by RBI).

(ii) Organized Financial markets: They follow high degree of institution and instrumentalisation. (Operations and activities are regulated by RBI).

Further divided into 2 types capital market and money market.

Capital Market: Is a market for financial assets which have a long or indefinite maturity. The capital market instruments become mature for the period above one year. It is also called as long term securities market.

Features

1. Link between Savers and Investment Opportunities:Capital market is a crucial link between saving and investment

process. The capital market transfers money from savers to entrepreneurial borrowers.

2. Deals in Long Term Investment:Capital market provides funds for long and medium term. It

does not deal with channelising saving for less than one year.

3. Utilises Intermediaries:Capital market makes use of different intermediaries such as

brokers, underwriters, depositories etc. These intermediaries act as working organs of capital market and are very important elements of capital market.

4. Determinant of Capital Formation:The activities of capital market determine the rate of capital

formation in an economy. Capital market offers attractive opportunities to those who have surplus funds so that they invest more and more in capital market and are encouraged to save more for profitable opportunities.

5. Government Rules and Regulations:The capital market operates freely but under the guidance of

government policies. These markets function within the framework of government rules and regulations, e.g., stock exchange works under the regulations of SEBI which is a government body.

An ideal capital market is one:

1. Where finance is available at reasonable cost.2. Which facilitates economic growth.

Indian Capital market is classified into Government Security market

Industrial Security market

Development financial institutional markets

Financial intermediaries

Government Security market: A government security is a bond issued by a government authority with a promise of repayment upon maturity. Government securities such as savings bonds, treasury bills and notes also promise periodic coupon or interest payments. These securities are considered low-risk, since they are backed by the taxing power of the government.

Types of Government securities in India:

(i) Treasury Bills: These are money market and short term instruments issued by government of India and are presently issued in three tenors, namely, 91days, 182 days, 364 days.

(ii) Cash management Bills(CMBs): These are the new short term instruments issued by government of India, in consultation with the RBI, to meet the temporary mismatches in the cash flow of the government.

(iii) Dated government securities: These are te long term securities and carry a fixed or floating rate of interest paid on the face value, payable at fixed time period(usually half-yearly). The tenor of dated securities can be up to 30 years.

(iv) State development loans: These are dated securities issued through an auction similar to the auctions conducted for dated securities issued by the central government.

Industrial Securities Market: It is an ideal market for corporate securities such as bonds (i.e., debt) and equities. Business corporations raise capital through three major types of securities. They are:

Ordinary or Equity shares

Preference shares

Debentures or Bond

Further divided into Primary market and Secondary market

Primary Market: It is called as new issue market. In this market the securities are purchased directly from the issuer.

It is that market in which shares, debentures and other securities are sold for the first time for collecting long-term capital.

This market is concerned with new issues. Therefore, the primary market is also called NEW ISSUE MARKET.

The company may raise capital in primary market out of any

Public issue: Raising the fund by issuing the securities to the general public.

Rights issue: These are the securities issued to the existing shareholders as statutory right to meet working capital requirement.

Private placement: These are the securities offered to the private individuals or groups and not for general public.

Features of Primary Market

It Is Related With New Issues It Has No Particular Place It Has Various Methods Of Float Capital: Following are the methods

of raising capital in the primary market: i) Public Issue ii) Offer For Sale iii) Private Placement iv) Right Issue v) Electronic-Initial Public Offer

It comes before Secondary Market

IMPORTANT NOTES: Initial public offering (IPO) The first sale of a company’s stock to the

general public.

Investment bankers Financial specialists who handle the sales of most corporate and municipal securities.

Underwriting Process of purchasing an issue from a firm or government and then reselling the issue to investors.

Marketable securities are securities or debts that are to be sold or redeemed within a year. These are financial instruments that can be easily converted to cash such as government bonds, common stock or certificates of deposit.

Secondary Market

The secondary market is that market in which the buying and selling of the previously issued securities is done.

The transactions of the secondary market are generally done through the medium of stock exchange.

The chief purpose of the secondary market is to create liquidity in securities.

If an individual has bought some security and he now wants to sell it, he can do so through the medium of stock exchange to sell or purchase through the medium of stock exchange requires the services of the broker presently, their are 24 stock exchange in India.

FEATURES OF SECONDARY MARKET

It Creates Liquidity: Provides easy marketability and liquidity for investors

It Comes After Primary Market It Has A Particular Place It Encourage New Investments Aids in financing the industry Ensures safe & fair Dealing( MEDIA BROADCASTING) The intending buyer and seller can buy and sell securities through

brokers It deals in previously issued securities It does not directly contribute to capital formation(acts). Accurate information: Help in determining fair prices based on

demand and supply forces and all available information

Functions of secondary market

Provides regular information about the value of security. Helps to observe prices of bonds and their interest rates. Offers to investors liquidity for their assets. Secondary markets bring together many interested parties. It keeps the cost of transactions low.

Provides safety and securities in dealings are conducted according to rules and fraudulent are checked efficiently.

Continuous and ready market for securities (buying and selling of securities). Acts as outlet or counter for sale.

Provides clearing house facility were it settles the transactions among the members quickly and ease.

Serves as economic barometer, indicates the health of the companies and national economy.

Facilitates public borrowings, enables government to raise public debt easily and quickly.

MONEY MARKET Money market instruments are those instruments, which have a

maturity period of less than one year.

Geoffrey Crowther in his book” An outline of Money” has stated “Money market is a collective name given to the various firms and institutions that deal with various grades of near money”.

FEATURES OF MONEY MARKET

It is a market purely for short-terms funds or financial assets called near money.

It deals with financial assets having a maturity period less than one year only.

In Money Market transaction can not take place formal like stock exchange, only through oral communication, relevant document and written communication transaction can be done.

Transaction have to be conducted without the help of brokers. It is not a single homogeneous market, it comprises of several

submarket like call money market, acceptance & bill market. The component of Money Market are the commercial banks,

acceptance houses & NBFC (Non-banking financial companies). Characteristics of A Developed Money Market

Existence of Central Bank: The role of central bank is notable, it control the entire money market operations by making the availability of funds depending upon the economic cycles.

 Highly organized commercial Banking System: As the money market are the main dealers in short term funds, the commercial banks are considered as nervous system of the money market.

Existence of sub-markets: The money market various sub-market exists and functions smoothly such as bill market, call money market, acceptance market, discount market etc.

Integration of sub-markets: There is a proper flow of funds from one sub market to another.

Availability of proper credit instruments: Freely available of treasury bills, promissory notes, bills of exchange ,etc.

Adequacy and Elasticity of funds: The flow of funds into the money market should also be flexible, the flow of funds can be increased or decreased depending upon the demand for funds.

International attraction: Attract funds from foreign countries also (dealers, borrowers and lenders).

Uniformity of interest rates: Prevalence of uniformity in interest rates in different parts of the country.

Stability of prices: stability of price all over the country will be an outcome of the effective functioning of a developed money market.

Highly developed Industrial system: Money market will function smoothly and can achieve the basic purposes of Industrial system.

IMPORATNCE OF MONEY MARKET Financing Industry: It helps the industries to secure short term loans

for meeting their working capital requirements, thus number of industrial units from becoming sick.

Financing trade: It plays a role in financing the domestic and international trade. The traders can get short term finance from banks by discounting the bills of exchange.

Self sufficiency of banks: If commercial banks are in need of funds, they can meet their requirements by recalling their old short term loans from the money market.

Effective implementation of monetary policy: The central bank mops up excess short term liquidity through the sale of treasury bills and injects liquidity by purchase of treasury bills.

Encourages economic growth: If money market is well organized, it safe guards the liquidity and safety of financial asset this encourages the twin functions of economic growth, savings and investments.

Help to government: To borrow funds through the sale of treasury bills at low rate of interest.

Proper allocation of resources: the demand for and supply of loanable funds are brought at equilibrium.

Functions of money market Economic development – Money market assures supply of funds;

financing is done through discounting of the trade bills, commercial banks, acceptance houses and brokers.

Profitable Investment – the excess reserves of commercial banks invested in near money assets.

Borrowings by the Government – short term funds at very low interest.

Importance For Central Bank – If the money market is well developed, the central bank implements the monetary policy successfully.

Mobilization of Funds – helps in transferring funds from one sector to another.

Savings And Investment – encouraging savings and investment by promoting liquidity and safety of financial assets.

Self-sufficiency Of Commercial Banks – commercial banks can meet their financial requirements by recalling some of their loans.

MONEY MARKET INSTRUMENTS

1. GOVERNMENT SECURITIES(G- Secs) Issued by the Government for raising a public loan or as

notified in the official Gazette. Maturity ranges from of 2-30 years. G-secs consist of Government Promissory Notes, Bearer

Bonds, Stocks or Bonds, Treasury Bills or Dated Government Securities.

No default risk as the securities carry sovereign guarantee. Ample liquidity as the investor can sell the security in the

secondary market

2. MONEY MARKET AT CALL AND SHORT NOTICE

o Money at call is a loan that is repayable on demand, and money at short notice is repayable within 14 days of serving a notice.

o Participants are banks & all other Indian Financial Institutions as permitted by RBI.

o Banks borrow call funds for a variety of reasons to maintain their CRR, to meet their heavy payments, to adjust their maturity mismatch etc.

3. TREASURY BILLSa. Short term (up to one year) borrowing instruments of the

Government of India.b. Enable investors to park their short term surplus funds while

reducing their market risk.c. Issued at a discount to face value. The return to the investor is

the difference between the maturity value and issue price.d. RBI issues T-Bills for three different maturities: 91 days, 182

days and 364 days

4. COMMERCIAL BILLSa. Commercial bill is a short term, negotiable, and self-

liquidating instrument with low risk.b. Written instrument containing an unconditional order.c. Once the buyer signifies his acceptance on the bill itself it

becomes a legal document.

5. CERTIFICATES OF DEPOSITSa. A CD is a time deposit, financial product commonly offered to

consumers by banks.b. CDs are negotiable instrument.c. Financial Institutions are allowed to issue CDs for a period

between 1 year and up to 3 years.d. Normally give a higher return than Bank term deposit, and are

rated by approved rating agencies.

6. COMMERCIAL PAPERa. Commercial Paper is a money-market security issued (sold) by

large banks and corporations to get money to meet short term debt obligations .

b. Commercial paper is usually sold at a discount from face value.

c. Interest rates fluctuate with market conditions, but are typically lower than banks‘ rates.

7. Repurchase Agreementsa. Repo or Reverse Repo are transactions or short term loans in

which two parties agree to sell and repurchase the same security.

b. They are usually used for overnight borrowingc. Repo/Reverse Repo transactions can be done only between

the parties approved by RBI and in RBI approved securities

DEFECTS OF INDIAN MONEY MARKET Existence of unorganised sector Lack of coordination Lack of developed bill market Shortage of funds Lack of uniformity in interest rates Lack of well organised banking system Underdeveloped banking habits

SUGGESTIONS: The activities of money lender and chit funds should be controlled. Banking facilities should be provided of unbanked and neglected

area. The number of clearing house should be increased. Adequate and easy remittance facilities should be provided for

businessman. Co-ordination between sub-markets should be achieved.

FINANCIAL ASSETSFinancial assets are also called as Financial Instruments/securities.

Financial assets are the intangible assets which receive value due to contractual transactions.Features:

1. Liquidity, for the quick conversion into cash.2. Collateral value for pledging of instruments for obtaining loan.3. Price fluctuations of security.4. Tax status5. Transferability, allows easy transfer of instruments.

CLASSIFICATION OF FINANCIAL INSTRUMENTS1. Term Financial Instruments: These are the tradable financial assets

and exchanged on term basis, were these are classified into short term, medium term, long term securities.

Short term securities: This sub category comprises securities with maturity of one year or less.

Medium term securities: This sub category comprises securities with maturity from 1 to 5 years.

Long term securities: This sub category comprises securities with maturity longer than those of short and medium term securities.

Type based securities: Financial securities are classified into primary, secondary and innovative instruments.

Primary Instruments/securities: (Equity, Preference and debentures). “A financial instrument whose value is not derived from that of another instrument, but instead is determined directly by the market”.

Secondary Instruments/securities: (Mutual Funds, Commercial Paper, Certificate of deposits).“A financial instrument issued directly by the financial institutions to an investor”.

Innovative instruments: (Derivates, Securitized assets, Foreign currency mortgages etc).“These are the financial innovative instruments to suit the need of cooperates and investors group”.

FINANCIAL SERVICESFinancial services are the products or services offered by financial

institutions like banks, credit card companies, insurance companies, stock brokerage companies etc.

Classification of Financial Services

1. Fund Based Services: Fund based or asset based financial services are those services which are rendered for commission basis or for a certain amount of interest.

Leasing: A lease transaction is a commercial arrangement whereby an equipment owner or Manufacturer conveys to the equipment user the right to use the equipment in return for a rental.

In other words, lease is a contract between the owner of an asset (the lessor) and its user (the lessee) for the right to use the asset during a specified period in return for a mutually agreed periodic payment (the lease rentals).

Factoring: Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount.

Bills discounting: Trading or selling bills to financial institution prior to its maturity period for discount rate is called discounting bill of exchange. The rate of discount depends on the time left before the bill mature and risk attached to it.

Venture capital: Venture capital is a way of financing by investor to companies for its start up and to promote project. Investor joins entrepreneurs as co-promoter and share risk and returns.

Loan: Loan is a oral or written agreement between lender and borrower for temporary transfer of property(cash) from lender to borrower where borrower promises to return the same property or cash along with predetermined interest as per the agreement.

Housing finance: Housing finance is a finance facility provided by financial institutions company on acquisition or construction of houses, which includes acquisition or development of land in connection there with.

Hire purchase: hire purchase system is a method of selling goods on credit where purchaser is allowed to purchase goods and allowed him to pay the amount in installment basis and the title of the goods transferred from seller to buyer at the end of final installment.

2. Fee Based Services: Portfolio management: it is a method of managing and allocating

funds on various best alternatives to reduce the uncertainty. Loan syndication: is the process where large number of lender

contributes amount and grant loans to company or any project and share risk and returns of the same.

Corporate counseling: refers to a set of activities performed to ensure the efficient running of a corporate enterprise and to improve the performance.

Foreign collaboration: is an alliance in corporate to carry on agreed task collectively with the participation of resident and non resident entities.