Indian Financial System

Introduction
A Financial System plays a vital role in
the economic growth of a country
It intermediates between those who
have surplus funds and those who need
them
It 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

Indian Financial System Introduction

Formal and informal Financial Sectors
Formal Organized, institutional and regulated
system
Informal Unorganized, flexible, low transaction
cost, minimal default risk, higher rate of
interest
Interpenetration exists between formal and
informal systems in terms of operation,
participation and nature of activities which in
turn have led to their coexistence. Priority
should be accorded to development of efficient
formal financial system

Indian Financial System Introduction

Control Formal financial system is
controlled by Ministry of Finance, RBI,
SEBI,IRDA and other regulatory bodies
Informal financial system
Consists of moneylenders, group of
persons such as partnership firms,
funds or associations, pawn brokers etc
function under a system of their own
rules

Indian Financial System Introduction

Formal Financial System
Institutions, Markets, Instruments and Services
Financial Institutions Banking and NonBanking. Banks can accept deposits and give
loans whereas Non-Banking Companies can
give only loans unless specifically permitted
by RBI to accept deposits. Development FIs,
NBFCs, HFCs are major institutional purveyors
of credit. Other specialized finance institutions
are EXIM Bank, TFCI, IFDC, NABARD, NHB etc
State Level FIs are SFCs, SIDC. Post reform
there has been tremendous change in role and
activity

Indian Financial System Introduction

Financial Markets
Mechanism enabling participants to deal in
financial claims. Markets provide a facility
in which demand and supply interact to set
a price for such claims
Organized markets in India are Money
market and Capital Market. Money Market
is for short term securities and Capital
Market is for long term securities which are
those having maturity period of one or
more years

Indian Financial System Introduction

Financial Markets are classified as Primary
and Secondary markets
Primary markets deal with new issues
Secondary markets deal with outstanding or
existing
securities.
There
are
two
components OTC market and Exchange
traded market. Govt. securities market is
OTC market where it is spot trade. In
Exchange traded market, trading takes place
over a trading cycle in stock exchanges.

Indian Financial System Introduction

Financial Instruments
Different Financial Instruments can be
designed to suit the risk and return
preferences of different classes of investors
Savings and Investments are linked
through a wide variety of complex financial
instruments
known
as
securities.
Securities are defined in the Securities
Contracts Regulation Act (SCRA), as
including shares, scripts, stocks, bonds,
debentures or other marketable securities
of a similar nature

Indian Financial System Introduction

Financial
Securities
are
Financial
Instruments that are negotiable and
tradeable. They may be primary or
secondary securities. Primary/Direct are
directly issued by ultimate borrowers to
ultimate
savers
such
as
shares,
debentures. Secondary/Indirect are those
that are issued by financial intermediaries
to ultimate borrowers like Bank deposits,
Mutual fund units, insurance policies etc

Indian Financial System Introduction

Financial Instruments differ in terms
of
marketability,
liquidity,
reversibility, type of options, return,
risk and transaction costs. Financial
instruments help financial markets
and
financial
intermediaries
to
perform the important role of
channelizing funds from lenders to
borrowers.

Indian Financial System Introduction

Financial Instruments
It 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.
FIs represent paper wealth shares, de mat
shares, debentures, bonds and notes.
FIs are marketable

Indian Financial System Introduction

Financial Services are those that help in:

Borrowing
Funding
Lending
Investing
Buying
Selling
Enabling payments and settlements
Managing Risk exposures in financial
markets

Indian Financial System Introduction

Intermediating services link the saver and
borrower which in turn leads to capital
formation
Liquidity is essential for smooth functioning
of a financial system. It is enhanced
through trading in securities
Liquidity is provided by brokers who act as
dealers by assisting sellers and buyers and
also market makers who provide buy and
sell quotes

Indian Financial System Introduction

The producers of financial services are
financial intermediaries such as banks,
insurance companies, mutual funds and
stock exchanges. They provide key
financial services such as merchant
banking, leasing, hire purchase and
credit rating. These services bridge the
gap between lack of knowledge on the
part of investors and the increasing
sophistication of financial instruments &
markets

Indian Financial System Introduction

Financial Services are vital for creating of firms,
industrial expansion and economic growth
Before investors lend money, they need to be
reassured that it is safe to exchange securities
for funds.
The
financial
regulators
provide
this
reassurance. The regulator regulates the
conduct of issuers of securities and the
intermediaries to protect the interests of
investors in securities and increases their
confidence in markets.

Indian Financial System Introduction

RBI regulates the Money market
SEBI regulates the Capital market
Securities Market is regulated by DEA, DCA, RBI
and SEBI
A high-level committee on capital and financial
markets coordinates the activities of these
agencies
Intermediation among the above components
Interdependent All four coordinate continuously
Interactive leads to development of a smoothly
functional system

Indian Financial System Introduction

Close Links with the financial markets in
economy
Competing with each other Financial
Intermediaries rely on financial markets to
raise funds whenever the need arises. This
increases
the
competition
between
financial
markets
and
financial
intermediaries for attracting investors and
borrowers

Indian Financial System Introduction

Functions of a Financial System
Link Savers and Investors
Help in mobilizing and allocating the savings
efficiently and effectively
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
broadening

Indian Financial System Introduction

Key element of a Financial System

Strong legal and regulatory environment
Stable money
Sound public finances and public debt
management
A Central Bank
Sound banking system
Information system
Well functioning securities market

Indian Financial System Introduction

Financial System Designs
Bank based bank dominated system
where
few large banks play a
dominant role and stock market is not
important (Germany)
Market based Financial markets play
an important role while the banking
industry is much less concentrated
(US)

Indian Financial System Introduction

Nature
and
Role
of
Financial
Institutions
(Intermediaries)
and
Financial Markets
Liability,
Asset
and
size
transformation
Maturity transformation
Risk transformation

Indian Financial System

Introduction
Financial Intermediaries
Liability, asset and size transformation consisting of
mobilization 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

Indian Financial System Introduction

Financial Markets
These are a mechanism for the
exchange
trading
of
financial
products under a policy framework.
Money market a market for short
term debt instruments
Capital market a market for long
term equity and debt instruments

Indian Financial System Introduction

Segments
Primary a market for new issues
Secondary a market for trading
outstanding or existing securities

Indian Financial System Introduction

Functions of Money Markets
To serve as an equilibrating force that
redistributes cash balances in accordance with
liquidity needs of the participants
To form a basis for the management of liquidity
and money in the economy by monetary
authorities and
To provide reasonable access to the users of
short-term
money
for
meeting
their
requirements at realistic prices
As it facilitates conduct of monetary policy, it is
a very important segment of financial system

Indian Financial System Introduction

Functions of Capital Markets
Mobilize long-term savings to finance long-term
investments
Provide risk capital in the form of equity or quasiequity entrepreneurs
Encourage broader ownership of productive assets
Provide liquidity with a mechanism enabling the
investor to sell financial assets
Lower the costs of transactions and information and
Improve the efficiency of capital allocation through
a competitive pricing mechanism

Indian Financial System Introduction

Money market and capital market
There is strong link between money market
and capital market
Financial institutions involved in capital
market are also involved in the money
market
Funds raised in money market are used to
provide liquidity for long-term investment
and redemption of funds in capital market
Development of money market precedes the
development of capital market

Indian Financial System Introduction

Link between Primary Capital Market and
Secondary Capital Market
Primary market is for new issues but
volume, pricing and timing of new issues
are influenced by returns in the stock
market. Secondary market is for existing
securities. A buoyant secondary market in
turn induces investors to buy new issues if
they think that is a good decision.

Indian Financial System Introduction

A
buoyant
secondary
market
is
indispensable for the presence of a
vibrant primary capital market
The secondary market provides a basis
for the determination of prices of new
issues
Depth of the secondary market depends
on the primary market
Bunching of new issues affects prices in
secondary market

Indian Financial System Introduction

Characteristics of Financial Markets
Large volume of transactions and the
speed with which financial resources move
from one market to another
Various segments stock markets, bond
marketsprimary
and
secondary
segments, where savers themselves
decide when and where they should invest
Scope for instant arbitrage among various
markets and types of instruments

Indian Financial System Introduction

Highly volatile and susceptible to panic and distress
selling as the behaviour of a limited group of operators
can get generalized
Dominated by financial intermediaries who take
investment decisions as well as risks on behalf of their
depositors
Negative externalities are associated with financial
markets. A failure in any one segment of these markets
may affect other segments, including non-financial
markets
Domestic financial markets are getting integrated with
worldwide
financial
markets.
The
failure
and
vulnerability in a particular domestic market can have
international
ramifications. Problems in external
markets can effect the functioning of domestic markets.

Indian Financial System Introduction

Functions of Financial Markets
Enabling economic units to exercise their
time preference
Separation, distribution, diversification and
reduction of risk
Efficient payment mechanism
Providing information about companies. This
spurs investors to make inquiries themselves
and keep track of the companies activities
with a view to trading in their stock efficiently
Transformation of financial claims to suit the
preferences of both savers and borrowers