Understanding the Financial System

• The financial system is a system of borrowing and lending funds.
• It addresses the supply and demand for funds from individuals, institutions, companies, and the government.

Financial System

• It provides an institutional framework to enable financial transactions in a country.
• It has three main components: financial assets, financial institutions, and financial markets.
• Financial assets include loans, deposits, bonds, and equities.
• Financial institutions consist of banks, mutual funds, and insurance companies.
• Financial markets encompass the money market, capital market, and forex market.
• Regulation by bodies like the RBI is another key aspect of a financial system.

Functions of the Financial System

• Transfers resources across time, sectors, and regions, allocating capital to its most productive uses.
• Manages risks, such as through fire insurance, protecting individuals and businesses from financial losses.
• Pools and subdivides funds, matching funds with savers or investors based on their needs.
• Facilitates transactions between payers and payees through clearinghouse functions, improving efficiency.

Role of Financial System

• Serves as a link between savers and investors, efficiently connecting those with surplus funds to those who need them.
• Facilitates the exchange of goods and services by providing payment systems and credit.
• Enables the transfer of resources from one party to another, allowing for investments and spending.
• Promotes capital formation, essential for economic growth and development.

Primary Securities

• Issued directly by ultimate borrowers to ultimate savers or investors
• Examples include Equity shares, preference shares and debentures.

Secondary Securities

• Not issued directly by ultimate borrowers.
• Issued by financial intermediaries to ultimate savers.
• Examples include insurance policies and mutual funds.

Indian Financial System

• Regulated by:
  • Reserve Bank of India (RBI)
  • Securities and Exchange Board of India (SEBI)

Financial Institutions

• Includes institutions and mechanisms which affect generation of savings by the community and effective distribution of savings
• Promote and mobilize savings, like banks, insurance companies, and mutual funds.
• Individual investors, industrial firms, and trading companies are borrowers within the system.

Classification of Institutions

• Regulatory and financial institutions include the RBI and SEBI.
• Both the RBI and SEBI administer, legislate, supervise, monitor, control, and discipline the entire financial system.
• The RBI is the apex institution for all financial institutions in India.
• Financial markets are under the control of SEBI.

Banking Institutions

• Mobilize the savings of the people.
• Provide a mechanism for the smooth exchange of goods and services.
• Categories include commercial banks, cooperative banks, and development banks.

Non-Banking Financial Institutions

• Mobilize financial resources directly or indirectly from the public.
• Lend funds but do not create credit
• Include companies like LIC, GIC, UTI, and other development financial institutions or funds.
• Can be categorized as investment companies, housing companies, leasing companies, hire purchase companies, and specialized financial institutions like EXIM Bank.

Financial Assets/Instruments

• Enable channelising funds from surplus units to deficit units.
• There are instruments for both savers and borrowers.
• Instruments for savers include deposits, equities, and mutual fund units.
• Instruments for borrowers include loans and overdrafts
• Businesses and governments raise funds through bonds and Treasury bills.
• Instruments like PPF and KVP let savers lend money to the government.

Major Financial Instruments

• Money and savings accounts
• Credit market instruments such as bonds and mortgages
• Common stocks
• Money market funds and mutual funds
• Pension funds
• Financial derivatives

Financial Intermediaries

• Mutual Funds can promote savings and mobilize funds for investment in stock and bond markets.
• Mutual Funds serve as an indirect source of finance for companies.
• Mutual Funds pool funds from savers for investment in the stock market and bond market
• Instruments on the saver's end of a Mutual Fund are termed units
• Mutual Funds offer schemes such as growth funds, income funds, and balanced funds.
• Mutual Funds are regulated by SEBI.

Merchant Banking

• Involves managing new issues and underwriting, undertaking credit syndication, and advising corporate clients on raising funds.

• Subject to regulation by SEBI and RBI.

• SEBI regulates issue activity and portfolio management.

• RBI supervises merchant banks that are subsidiaries or affiliates of commercial banks.

• These banks must adopt capital adequacy norms and adhere to a code of conduct.

• There are other financial intermediaries like NBFCs, Venture Capital Funds, Hire and Leasing Companies.

• The financial system in India is very large

• Provides several kinds of demands for funds

Financial Markets

• Deal in financial securities, financial instruments, and services.
• Function as centers for buying and selling any financial stake.
• Deals in money and monetary claims.
• Operates wherever there are financial transactions.
• Transactions include equity stock issues, bond purchases, bank deposits, and fund transfers between accounts.

Financial Markets Defintion

• Usually a group of traders carrying out business in a specific place.
• Market for the creation and exchange of financial assets
• Buying and selling financial stake.
• Provides institutional arrangements for handling various financial assets

Functions of Financial Market

• To assist in the creation and allocation of credit.
• To serve as an intermediary to mobilize savings.
• To assist the process of balanced economic growth.
• To provide financial convenience
• To cater to various credit needs of the business houses.

Types of Financial Markets

• Money Market
  • short term funds are borrowed and lent.
  • deals in short term monetary assets
  • maturity period of one year or less.
  • Treasury bill market, call money market, and commercial bill market.
• Capital Market:
  • market for long term funds.
  • deals in long term claims, securities, and stocks
  • a maturity period of more than one year
  • Examples include the stock market, government bond market, and derivatives market.

Money Market

• A centre for dealing, mainly for short term character, in monetary assets.
• Meets the short term requirements of the borrowers and provide liquidity or cash to the borrowers.

Money Market characteristics

• All transactions are in near money
• Deals with short term funds
• Institutional arrangements to facilitate borrowing and lending.
• Funds borrowed for a short period (less than a year)
• Main sub markets are
  • Call money market
  • Treasury bill market
  • Commercial paper market

Capital Market

• Deals with facilitating long term borrowing and lending.
• Investors hand over money today in exchange for money far in the future

Primary Market

• Deals in new securities.
• Also know as new issue markets
• Securities are issued for the first time.
• Securities issued directly by the companies.

Secondary Market

• Deals with existing securities that have already been issued and are outstanding.
• Consists of stock exchanges.

Financial Intermediaries

• Facilitate the smooth functioning of the financial system
• Meeting point between investors and borrowers
• Savings are mobilized and allocated in productive activities to ensure better return
• Acts as a middlemen between savers and borrower

Types of financial intermediaries

• Banking Institutions
  • Organized sector
    • Commercial banks
    • Cooperative banks
    • Foreign banks
  • Unorganized sector
    • Indigenous bankers
    • Money lenders
• Non banking financial institutions
  • Organized financial institutions
    • Development finance institutions (IDBI, ICICI, IFCINABARD, SFC)
    • Investment institutions (LIC,GICM,UTUAL FUND,UTI)
  • Unorganized financial institutions
    • NBFCS(hire purchase company, lease company,factory company)

Regulatory Framework

• Plays a critical role in ensuring the health, soundness, reliability and stability of the financial system
• Lays down the specific rules for behavior of participants in the financial system
• Necessary to generate and maintain the trust of the participants.
• Main regulatory bodies
  • RBI
  • SEBI
  • NABARD
  • IDBI

RBI

• RBI seeks to regulate the volume and direction of the flow of bank credit
• Apex institution as the monetary authority of the country
• Acts as a guide, regulator, controller and promoter of the financial system

RBI Functions

• Formulates and implements monetary and credit policies
• Acts as a banker's bank
• Supervises the operations of credit institutions
• Control the money supply and credit
• Considered as a lender of last resort
• Also performs function aimed at developing Indian financial system
  • Integrate the unorganized financial sector with organized financial sector
  • Encourages extension of commercial banking system in the rural areas
  • Influences credit allocation
  • Promotes development of new institutions

SEBI

• An important part of the system that actively regulates and monitors the Indian Financial System.
• Entrusts every aspect of securities market regulation to a single visible and independent organization that is backed by statute
• Is accountable to the Parliament and ensures investors retain their trust and confidence.

SEBI Functions

• To regulate business in stock exchanges
• To register and regulate working of mutual funds
• To Prohibit insider trading in securities
• To register and regulate capital market intermediaries

IDBI

• Set up to accelerate the growth of the country.
• Was a wholly owned subsidiary of RBI
• Was expected to help institutions during financing and developing

IDBI Functions

• As a apex institution
• Provide refinance for term loans granted by banks and financial institutions
• Coordinate the activities of institutions providing term finance to industry
• Provide technical and administrative assistance for promotion, management and growth of industry
• Grant direct loans and advances industry's concern

NABARD

• Apex institution for funding agricultural and rural sectors

NABARD Objectives

• To provide credit for development of agriculture, small scale industries and rural
• To provide short term refinance assistance
• To Sanction refinance assistance for government sponsored programs such as rozgar yojna.

Financial market can be classified in 2 basis of timing of delivery:

• Cash / Spot market

  • Buying and selling or commodities
  • Stocks are sold for cash and delivered immediately after the purchase or sale of commodities or securities.

• Forward/Future market

  • participants buy and sell stocks/commodities, contracts and the delivery of commodities or securities occurs at a pre-determined time in future.

• Financial Market is further classified into 2.

  • Foreign exchange market:
    • Foreign exchange market is simply defined as a market in which one country's currency is traded for another country's currency
  • Derivatives market
    • individuals and firms who wish to avoid or reduce risk can deal with the others who are willing to accept the risk for a price.

Financial Instruments

• Financial instruments are the financial assets, securities and claims
• Can define as financial assets and financial liabilities
  • Financial assets:
    • Represent a claim for some form of money in the future, such as interest or dividends
  • Financial liabilities
    • Represent promise to pau someone portion income or prospective

Types of Financial instruments

• The financial instruments may be capital market instrumentsor money market instruments or hybridinstruments.
  • Capital Market Instruments:.
    • Used to raise capital through the capital market and include equity shares, preference shares, warrants, debentures and bonds.
  • Money Market Instruments
    • Used to raise and supplying money in a short period not exceeding one year through money market
    • Includes treasury bills, commercial paper, call money, short notice money, certificates of deposits, commercial bills, money market mutual funds.

Money Market Instruments

• Call and Short NoticeMoney
  • These are short term loans with a maturity varies between one day to fourteen days
  • If money is borrowed or lent for aday, it is called call money or overnight money.
• Commercial Bills
• A bill of exchange contains a written order from the creditor (seller) to the debtor (buyer) to pay a certain sum, to a certain person after a certain period.
• Treasury Bills
  • Credit instruments used by the Treasury to raise short term funds to meet the monetary deficit.
  • These are negotiable instruments
• Certificate Of Deposit
  • Form of promissory note issuedby banks against the short term deposits of companies.
  • Often payable on a fixed date and a 3 to 12 month maturity period.
• Commercial Paper
  • IT is a finance paper like Treasury Bill, an unsecured promissory note.
  • Has a fixed maturity between 3 to 6 months.
  • Often known as corporations