A financial System is a complex set of sub structures

It include financial institutions, markets, instruments & services

It facilitates the transfer, allocation of funds efficiently with in the economy

It helps in the growth of the economy

Most of the countries have financial dualism

Formal System(Organized) : It characterized by the presence of an organized, institutional & regulated system , which caters to the financial needs of the modern spheres of economy.

Un-Organized system (unorganized) : It is unorganized, non-institutional & non-regulated system dealing with traditional & rural spheres of the economy. For example, individual money lenders, savings funds, etc

Financial Institutions : These act as intermediaries that mobiles savings & help in proper allocation of funds

These can be classified into:

Financial Markets : Financial markets can be categorized into:

Financial Instruments: It is a claim against a person or an institution for payment , at future date, of a sum of money or periodic payment in the form of interest or dividend.

Financial instruments represents shares, debentures/ bonds, etc

These negotiable and tradable

They can be classified into primary and secondary securities.

Financial Services: These are those that help with borrowing, lending /investing , buying & selling securities, making and enabling payments & settlements & managing risk exposure in financial markets.

Following are the functions of the financial system:

Mobilizes & allocate savings Monitor corporate performance Provide payment & settlement systems Optimum allocation of risk bearing & reduction Disseminate price related information Lower the cost of transactions Promote the process of financial deepening &

broadening

The RBI was established by legislation in 1934 through the RBI Act,1934

It started functioning from 1st April, 1935

Its office is at Mumbai

It was nationalized in 1949 i.e. owned by government of India

It is the central bank of our country

Following are the roles performed by RBI:

Note issuing authoroty Government Banker Bankers Bank Controller of Credit Supervisory functions Exchange Control Authority Promoter of financial system

Following are the functions performed by RBI:

To maintain financial stability & ensure sound financial institutions so that monetary stability can be safely pursued & economic units can conduct their business with confidence

To maintain stable payments system so that financial transactions can be safely & efficiently executed

To maintain monetary stability so that the business & economic life can deliver welfare gains

To promote the development of financial infrastructure of markets & systems

To regulate the overall volume of money & credit in the economy to ensure price stability

Monetary policy: It is the process a government, central bank, or monetary authority of a country uses to control (i) the supply or availability of money, and (ii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.

Monetary policy is referred to as either being an expansionary policy, or a contractionary policy:

An expansionary policy increases the total supply of money in the economy. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates

A contractionary policy decreases the total money supply. contractionary policy involves raising interest rates to combat inflation.

Techniques of monetary policy:

Open Market Operations: In this measure the RBI purchase & sell the government securities to banks, NBFCIs like NABARD, EXIM bank, etc. Securities in which RBI deals are T-Bills, state & central go9vernment securities. Through OMO RBI can affect the reserves position of banks, yields on government securities, volume & cost of bank credit. There is no restriction on the quantity or maturity of government securities which can be bought or sold.

Bank rate: Bank rate, also referred to as the discount rate, is the rate of interest which a central bank charges on the loans and advances that it extends to commercial banks and other financial intermediaries. Changes in the bank rate are often used by central banks to control the money supply.

Cash reserve ratio: The reserve requirement (or required reserve ratio or cash reserve ratio) is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. It would normally be stored in a bank vault (vault cash), or with a central bank. The reserve ratio is sometimes used as a tool in the monetary policy, influencing the country's economy, borrowing, and interest rates.

Statutory Liquidity ratio: Statutory Liquidity Ratio (SLR) is a term used in the regulation of banking in India. It is the amount which a bank has to maintain in the form:1. Cash2. Gold valued at a price not exceeding the current market price,3. Approved securities (Government securities or Gilts come under this)

valued at a price as specified by the RBI from time to time.

The objectives of SLR are:1. To restrict the expansion of bank credit.2. To expand the investment of the banks in Government securities.3. To ensure solvency of banks. A reduction of SLR rates leads to the credit

growth in India.

Most G-Sec held by banks are long-term fixed-rate bonds, which are sensitive to changes in interest rate

Liquidity Adjustment Facility (LAF): It is a tool used in monetary policy that allows banks to borrow money through repurchase agreements. This arrangement allows banks to respond to liquidity pressures and is used by governments to assure basic stability in the financial markets. Liquidity adjustment facilities are used to aid banks in resolving any short-term cash shortages during periods of economic instability or from any other form of stress caused by forces beyond their control. Various banks will use eligible securities as collateral through a agreement and will use the funds to lighten their short-term requirements, thus remaining stable.

Repo Rate: Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive.

Reverse repo rate: Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are always happy to give away money to RBI since their money are in safe hands with interest payment. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to this attractive interest rates. It can cause the money to be drawn out of the banking system.

Fiscal policy uses government spending and revenue collection as a tool to influence the economy.

Two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:

Aggregate demand and the level of economic activity

The pattern of resource allocation (industry)

The distribution of income /9household)

Three possible standpoint of fiscal policy are:

A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through rises in government spending or through a fall in taxation revenue, or a combination of the two. This will lead to a budget deficit if the government previously had a balanced budget or a smaller budget surplus than the government previously had. Expansionary fiscal policy is usually associated with a budget deficit.

A contractionary fiscal policy (G < T) occurs when net government spending is reduced either through higher taxation revenue, or due to reduced government spending, or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus.

Methods of expenditure funding fiscal deficit : Taxation Printing money Borrowing money from the population, due to fiscal deficit Consumption of fiscal reserves Sale of assets (e.g., land)

Funding the deficit: A fiscal deficit is often funded by issuing bonds, like treasury bills. These pay interest, either for a fixed period or indefinitely.

Consuming the surplus: A fiscal surplus is often saved for future use, and may be invested in local (same currency) financial instruments, until needed. When income from taxation or other sources falls, as during an economic slump, reserves allow spending to continue at the same rate, without incurring additional debt.

The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another.

It is by far the largest market in the world, in terms of cash value traded, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The trade happening in the forex markets across the globe exceeds $3.2 trillion/day (on an average) presently.

However, There is no single unified foreign exchange market. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currency instruments are traded. This implies that there is no such thing as a single dollar rate - but rather a number of different rates (prices), depending on what bank or market maker is trading. In practice the rates are often very close.

The main trading centers are in London, New York, and Tokyo. As the Asian trading session ends, the European session begins, then the US session, and then the Asian begin in their turns. Traders can react to news when it breaks, rather than waiting for the market to open.

Exchange rate fluctuations are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in GDP growth, inflation, interest rates, budget and trade deficits or surpluses, and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. Thus, forex trading may be perceived as a competition of minds.

The following are the instruments through which investors can deal in FX:

1. Spot : This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract. Spot transaction is a two-day delivery transaction.

2. Forward: In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a one day, a few days, months or years. Usually the date is decided by both parties.

3. Future: Foreign currency futures are exchange traded forward transactions with standard contract sizes and maturity dates — for example, $1000 for next November at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months.

Swap :The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange.

For example, in an interest rate swap, each counterparty agrees to pay either a fixed or floating rate denominated in a particular currency to the other counterparty. The fixed or floating rate is multiplied by a notional principal amount (say, USD 1 million). This notional amount is generally not exchanged between counterparties, but is used only for calculating the size of cash flows to be exchanged.

The most common interest rate swap is one where one counterparty A pays a fixed rate to counterparty B, while receiving a floating rate (usually pegged to a reference rate such as LIBOR).

A pays fixed rate to B (A receives variable rate) B pays variable rate to A (B receives fixed rate).

4. Option: A foreign exchange is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.

Foreign Exchange market is important in the following ways:

1. Liquidity :In terms of international trade, liquidity is the ease in which foreign currency is converted into domestic currency. FX markets provide liquidity to buyers and sellers to bring about speedy, orderly transactions for convertibility of currencies as per their needs.

2. Hedging: Traders use foreign exchange derivatives, which "derive" their valuations and costs from the spot market. Options and futures contracts effectively lock in exchange rates for a set period, to hedge against the risks of exchange rate fluctuations.

3. Reserves: International governments enter the FX market to build and manage foreign exchange reserves. They build the reserves to make official payments and influence domestic currency flow.

4. International Trade: Businesses rely on FX markets to buy currency that is spent to obtain overseas goods. Corporations will also look to FX markets to convert international earnings back into the domestic currency.

5. Rates :Buyers and sellers set prices using the auction method in the FX market. Sellers try to earn the highest "ask" price possible, and buyers try to purchase currency at the lowest "bid.”. However, large presence of buyers & sellers in this market help in determination of the fair exchange rate.

Financial services refer to services provided by the finance industry. The finance industry include a broad range of organizations that deal with the management of money.

These services are provided by commercial banks, insurance companies, stock brokers, investment funds, asset management companies , financial planners, etc

Functions of financial services: Following are the functions of the financial services

1. Facilitating ease of doing business with sufficient availability of funds by collecting funds from the retail investors (merchant bankers, brokers, etc)

2. Enabling the investors to benefit from the investment opportunities by facilitating appropriate advisory services ( Financial planners/ investment advisors, insurance agents)

3. Helps the enterprises & individual investors to hedge themselves from the risk ( insurance companies)

4. Facilitating the upcoming businesses to grow or to get started (venture capital firms, private equity firms)

The new economic policy of structural adjustment & stabilization programme was given a big push in India in June 1991.

Objectives Of financial sector reforms:

To develop competitive , world integrated, transparent financial system

To increase the allocative efficiency of available savings, & to accelerate growth of the economy through introduction of modern financial instruments

To promote effectiveness, accountability, profitability, growth, professionalism , flexibility & operational economy in the financial sector by building financial infrastructure relating to supervision, audit , technology & legal matters

To make the market competitive by facilitating entry & exit for institutions & market players under supervision

To modernize the instruments of monetary control, to make them suitable for conduct of monetary policy

The financial sector reforms were focusing upon the following sections of the economy:

1. Financial markets 2. Regulators 3. The banking system 4. The capital market 5. Mutual funds 6. Deregulation of banking system 7. Capital market developments

Following were the two main reasons behind the introduction of reforms:

1. The financial deficit crisis that threatened the international credibility of the country and pushed it to the verge of default

2. The serious threat of insolvency confronting the Indian banking system as banks were facing minimal use of technology, low quality of services, no proper use of risk management system, no competitive spirit, high CRR & SLR ratios, etc

1. Banking Reforms: Following were the major reforms for this sector:

i. SBI of India & other nationalized banks were allowed to access the capital market for debt & equity i.e. Capital base of the banks were strengthened through public equity issues and subordinated debt

ii. Norms for income recognition , classification of assets & provisioning for bad debts for commercial banks were introduced

iii. It was made compulsory for banks to obtain the Performance obligations & Commitment (PO & C) from RBI. PO& C are meant to ensure a high level of portfolio quality so that losses does not occur. Non fulfillment of PO& C entail penalty in the form of higher CRR/SLR, stoppage of RBI refinance facility, etc

iv. Interest rates on deposits & advances on commercial banks loans & domestic deposits were decontrolled.

v. Banks were required to make their balance sheet as per international accounting standards

vi. New private sector banks were licensed and branch licensing restrictions were relaxed

4. Government Security market Reforms: Following were the major reforms for this sector:

i. 364 T-bills were replaced by 182 days bills & were sold fortnightly since 1992ii. Auction of 91 day T-Bill was started , January 1993iii. Maturity period of central government securities was shortened from 20 years to 10

years & that for state government securities from 15 to 10 tearsiv. New instruments like zero coupon bond, floating rate bond, etc were introduced v. RBI was allowed to auction government securities as a part of OMO

3. Systemic & Policy Reforms: Following were the major reforms for this sector:

i. SLR was reduced from 38.5 % to 25 % (applicable now also) & CRR was also reduced from 1 5% to 10 %

ii. Capital adequacy norms were introduced (Basle Accord)iii. Board of Financial Supervision was created to focus upon the fulfillment of capital

adequacy norms, asset quality management, liquidity position , etc iv. SEBI was made statutory body in February 1992

2. Capital Market Reforms: Following were the major reforms for this sector:

i. Entry norms for capital issues were tightened through improved disclosure requirements

ii. Mutual funds were permitted to underwrite public issues iii. Capital adequacy and regulations were introduced for brokers, sub-

brokersiv. Dematerialization of scrip's was initiated with the creation of a legislative

framework and the setting up of the first depository (NSDL)v. Introduction of On-line trading was planned for all stock exchanges with

establishment of NSEvi. Settlement period was reduced and tentative moves were made towards

a rolling settlement systemvii. Regulations were framed for insider trading

5. External Financial Market Reforms: Following were the major reforms for this sector:

i. FII’S were allowed to access Indian capital marketii. Indian companies were allowed to access international capital markets through various instrumentsiii. Rupee made convertible on current account & a considerable progress was made in introducing capital

account convertibilityiv. NRI’s & FII’s were allowed to invest up to 24 % in equities of Indian companies (accept agriculture &

plantation companies)v. FIPB was set to encourage FDI investment in Indiavi. ECB’s :

a. Cooperates : Rise up to US $ 3million ( for rupee expenditure with in minimum 3 years )b. Telecommunication companies & oil exploration companies: minimum US $ 15 million ( 7 years maturity)c. Exporters : equaling to US $ 15 million or average exports of previous three years whichever is lowerd. Infrastructure &green field projects: to the extent of 35 % of project cost

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