Financial System

Financial System

Financial System

• Topics– Concept of

• Financial Assets • Financial Markets

– Functions of • Financial systems • Financial Intermediation

– Structure of Financial markets – Types of financial markets.

Financial System

Financial System

• Financial System –– Definition – Components

Financial System - Definition

• Financial System –– A Financial System is a complex, well

integrated set of sub-systems of financial institutions, markets, instruments, and services which facilitates the transfer and allocation of funds, efficiently and effectively.

Financial System - Components

• Components of Financial System– Financial Participants– Financial Markets– Financial Assets– Financial Regulatory Environment

Financial Participants

Financial Participants

• Financial Participants– Major participants are the buyers and sellers of

securities.• Investors(primary lenders) are buyers of securities – They

prefer to ‘lend short’• Issuers(ultimate borrowers) are the sellers of securities –

They prefer to ‘borrow long’

– Second major class of participants are the Financial Intermediaries/Institutions. They borrow for short durations from the primary lenders and lend for long durations to the ultimate borrowers.

Financial Institution/Intermediaries

Financial Institutions

• Definition• Functions• Types

Financial Institutions - Definition

• Definition – – These are intermediaries that mobilise savings and

facilitates the allocation of funds in an efficient manner.– These are business organisations serving as a link

between savers and investors and so help in the credit-allocation process.

– Lenders and borrowers differ in regard to terms of risk, return and terms of maturity. Financial institutions assist in resolving this conflict between lenders and borrowers.

Financial Intermediaries - Functions

• Financial Institutions provide three transformation services – – Liability, asset and size transformation consisting of

mobilisation 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 and so offering borrowers long-term loans matching the cash flows generated by their investment.

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

Financial Intermediaries - Functions

– By facilitating the availability of finance, financial institutions enable the consumer to spend in anticipation of income and the entrepreneur to acquire physical capital.

– Besides providing direct loans, many fianancial institutions have diversified themselves into areas of financial services such as merchant banking, underwriting and issuing guarantees..

Financial Intermediaries - Types

• Main Types of Financial Intermediaries are - – Banking Institutions– Non Banking financial institutions– Mutual Funds– Insurance Organisations

Financial Intermediaries – Brief Introduction

• Banking Institutions or Commercial Banks – – The primary focus area of commercial banks are working capital

financing. These collect savings primarily in the form of deposits and traditionally finance the working capital requirements of corporates. The traditional practice of banks supplying mainly short term funds for financing the working capital needs of industry is base on the theory of deposit banking. In tune with the emrging needs of the economic and financial system, banks have also entered into

• Term-lending business particularly in the infrastructure sector• Capital Market • Retail finance such as housing finance, consumer finance and so on.


• Non Banking Financial Companies– – They provide a variety of funds/asset-based and non-fund

based/advisory services. Most of their funds are raised in the form of public deposits. Depending on the nature and type of service provided , they are categorised, inter-alia, into:

• Asset financing companies• Housing finance companies• Venture Capital funds• Merchant banking organisations• Credit Rating agencies• Factoring and forfaiting organisations• Stock broking firms• Depositories.


• Mutual Funds– A MF is a special type of investment institution which pools the

savings of relatively small investors and invests them in a well diversified portfolio of sound investment. MFs issues securities(knows as units) to the investors(known as unit holders) in accordance with the quantum of money invested in them. The profit and losses are shared by the investors in proportion to their investments

– As an investment intermediary, MFs offer a variety of services/advantages to the relatively small investors who, on their own, cannot successfully construct and manage invetment portfolio mainly due to the small size of their funds, lack of expertise/experience and so on.


• Insurance Organisations – – Insurance Organisations/Companies essentially invest the

savings of their policyholders(insurance premium) and in exchange promise them and/or beneficiaries a specified sum at a later stage(on maturity of insurance policy) or upon the happenings of a certain event(i.e. death of the policyholder).

– They differ from the MFs in that while the main business of mutual funds and in fact the only reason for the existence, is investment in securities, such investement are only incidental to the main business of insurance companies to provide protection against risk.

Financial Markets

Financial Markets

• Market – A place for buying and selling goods.

• Features of a Market– Place – Some buyers– Some sellers – Some commodity to be exchanged for money or

some other commodity.

Financial Markets• Financial Markets

– A mechanism enabling participants to deal in financial claims

– Provides a mechanism for those with excess funds (savers) to lend to those who need funds (borrowers)

Money Surplus (Units in the household Sector - Investors)

Money Deficient (Units in industrial, government and Commercial Sectors)

Financial Markets

Financial Market - Segment

• Financial Markets Segmentation– Money Markets and Capital Market (On the

basis of maturity period of the securities traded in the market)

– Primary Market and Secondary Market (On the basis of whether the securities traded are newly issued or already owned by investors)

Financial Market - Segment

• Types of Financial Market

Financial Market

Money Market(Short

Term)

Capital Market(Long

Term)

Primary Market(New

Issues)

Secondary Market(Already

Owned Securities)

Financial Market – Money Market

• Money Market – is the market for short term financial assets with

maturities of one year or less. These are the main source of working capital funds for business and industry

• Short term securities traded in the Money Market– Treasury Bills– Commercial Bills– Commercial paper– Certificate of deposit etc.

Financial Market – Capital Market

• Capital Market– is the market segment where securities with

maturities of more than one year are bought and sold. These are the source for long term funds for business and industry.

CAPITAL MARKET

Debentures

Bonds

Equity Shares

Preference Shares

Financial Assets

Financial Assets/Instruments

• Financial Assets/Instruments

– The transfer of funds between primary lenders and ultimate borrowers takes place through the creation of Financial Assets.

– A Financial Instrument is a claim against a person or an institution for payment, at a future date, of a sum of money and/or a periodic payment in the form of interest or dividend.


– Financial Instruments help financial markets and financial intermediaries to perform the important role of channelizing funds from lenders to borrowers.

– Eg. • If the investor(primary lender) deposits the money in the fixed

deposit of a commercial bank(financial intermediary), the bank issues him a fixed deposit receipt which is a financial asset.

• In a public issue of shares if shares are allotted to the investors, the company which is the borrower of funds will issue a share certificate to the investor. The share certificate is the financial asset in such a case.


– Financial Securities are Financial Instruments that are negotiable and tradeable.

– Types of Financial Securities –• Primary Securities – directly issued by the ultimate

borrowers of funds to the ultimate savers/lenders. Eg. Equity Shares and Debentures

• Secondary Securities – issued by the financial intermediaries to the ultimate savers/lenders. Eg. Bank deposits, mutual fund units, insurance policies.

Financial Regulatories

Financial Regulatory Environment

• Financial System in a country is suject to a set of regulations in the form of various Acts passed by the legislative bodies.

• In each country the regulatory control of the financial system is exercised by designated regulatory authorities.

Financial Regulatory Environment

• In India, the MoF, the RBI, the SEBI, etc. are the major regulatory bodies exercising regulatory control and supervision over the functioning of the financial system in the country.

• The securities thus issued may be traded or exchanged between investors in securities markets with the help of intermediaries, within the regulatory framework approved by the Government and other regulatory bodies.

Financial System Structure and Function

Structure of Indian Financial System

Indian Financial System

Formal (organized Financial system)

Regulators;MoF, SEBI, RBI, IRDA

Financial Institutions

(Intermediaries)

Financial Markets

FinancialInstrument

Financial Services

Informal(Unorganized

financial system)

Money lenders,Local bankers,

Traders

Functions of Financial systems

• Functions of Financial systems-– Mobilise and allocate savings– Monitor Corporate performance– Provide payment and settlement systems– 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 and broading

Key Elements of a Well Functioning Financial Systems

Financial Systems

A strong legal and regulatory

framework

Stable Money

Sound public finances and public debt

management

A Central BankSound Bankin System

Information System

Well functioning Securities

Market

Economy & Finance

Financial System