Financial System

by Tapan Sharma

Economy is classified into:

Household Sectorsfd
Government Sector
Corporate Sector

Concept of Financial System

The financial system is the collection of
markets, institutions, laws, regulations, and
techniques through which bonds, stocks, and
other securities are traded, interest rates are
determined, and financial services are
produced
and
delivered
around
the
worldasddgfasdgqaehg
Provides
for efficient flow of funds from saving
to investment by bringing savers and
borrowers together via financial markets and
financial institutions
3

Financial System- Introduction

Financial System is the group of individuals,
intermediaries
and institutions that can potentially
interact or participate in transactions that involve
real or financial assets.

The financial assets are instasdgvasdgb g

fmr6emqa4jahruments that facilitate transactions in
real assets or constitute the subject of
a
transaction between market participants.

The financial markets facilitate the trading of

financial
assets between market participants and

The financial intermediaries facilitate the

financial
transactions of market participants
4

Financial System
Van Horne defined the financial system as,
the system to allocate savings efficiently in
an economy to ultimate users either for
investment
in
real
assets
or
for
consumption.

Functions of Financial System

The main function of a financial system is the
collection of savings and their distribution for
investment, thereby stimulating capital formation
and, to that extent, accelerating the process of
economic growth.
The financial system is a link between the savers
(savings-surplus economic units) and the investors
(saving-deficit economic units). It is made up of all
those channels
through which savings become
available for investment.

Flow of Funds.

Financial markets are markets for financial

instruments, also called financial claims or
securities. The financial markets channel savings
to those individuals and institutions needing more
funds for spending than are provided by their
current incomes.
Financial institutions (also called financial
intermediaries) facilitate flows of funds from
savers to borrowers

Lending and borrowing relationships in a financial system

ORGANISATION OF THE FINANCIAL

SYSTEM

Financial Intermediaries

Financial

Markets

Financial

Assets/Instruments

Financial

Services
10

Financial Intermediary

Financial intermediaries (FIs) represent a

significant change in the whole process of a
transfer of choice of investment from an
individual saver to an institutional agent.
They convert primary securities with a given set
of characteristics, into indirect securities with
very different features.
A primary security is a security issued by a nonfinancial economic unit. A security issued by a
financial intermediary is an indirect security.
The ability of FIs to transform a primary security
into an indirect security makes it more attractive
to both the borrowers and the lenders.
11

The pooling of funds by an FI leads to a number

of indirect and derived benefits that add greatly
to the effectiveness and efficiency of the savingsinvestment process.
The
benefits/services associated with the
tailoring of financial assets according to the
desires of the savers and investors are:
(i) convenience in terms of denomination and
liquidity,
(ii) lower risk due to diversification of the portfolio,
(iii) expert management of the portfolio and
(iv) lower cost resulting from economies of scale. 12

A diversified structure of FIs in a matured and

sophisticated financial system consists of
banks, NBFCs, mutual funds, insurance
organisations and so on.
With a variegated structure, these are able to
mobilise savings from the widest section of the
investing public and channelise them to a crosssection of economic/industrial enterprises.

13

MINISTRY OF
FINANCE

RBI

Pension,
Financial
Provident
Institutions
Funds

Banks

SEBI

NBFCs

Term
Sectoral
Investment
Lending
EXIM, TFCI,
LIC, UTI,
IDBI, IFCI,
NHB
GIC
ICICI
NABARD

Stock
Exchanges
Underwriters
Stock Brokers
FIIs
Retail Investors

State
Level
SFC,SIDC

IRDA

Mutual
Funds

Insurance
Companies

.
The Ministry
of Finance

The top of the hierarchy of financial institutions in India

Controls various pension funds, provident funds, term

lending

institutions

(IFCI,

ICICI,

IDBI),

investment

institutions (LIC, GIC, UTI), sectoral (NABARD, NHB,

EXIM, TFCI) and state level institutions (SFC, SIDC).
Comprises five departments namely Department of

Economic

Affairs,

Department

of

Expenditure,

Department of Revenue, Department of Disinvestments

and Financial Services.

RBI (Reserve Bank of India)

CENTRAL BANK OF INDIA
Started functioning on

April 1, 1935 during the

British Raj in accordance with the provisions of

the Reserve Bank of India Act, 1934.
Also called the banker of banks or the lender of
last resort.

Commercial Bank
They collect savings primarily in the form of
deposits

and

traditionally

financed

working

capital requirements. However, in tune with the

emerging trends, they have entered into term
lending business.

Co-operative Bank
A financial entity which belongs to its members,
who are at the same time the owners and the
customers of their bank.
Co-operative banks are often created by persons
belonging

to

the

same

local

or

professional

community or sharing a common interest.

NBFCs
NBFCs

(Non

Banking

Financial

Companies)

provide a variety of fund based and non fund

based services.
Most of their funds are raised in the form of public
deposits ranging one year to three years of
maturity.
Depending on the nature and type of services,
they

are

finance

asset

finance

companies,

companies,

venture

capital

housing
funds,

SEBI
(Securities and Exchange Board of India)
The basic functions of Securities and Exchange Board of India
are to protect the interests of investors in securities and to
promote the development of and to regulate the securities
market.

It was established on April 12, 1992 in accordance with the

provisions of the Securities and Exchange Board of India Act,
1992.

It exercises control over the stock exchanges, stock brokers,

various investors in the stock markets, mutual funds, ETFs etc.

IRDA
(Insurance Regulatory and Development Authority)
IRDA was formed by an act of Indian Parliament
known as IRDA Act, 1999.
Mission of IRDA as stated in the act is "to protect
the interests of the policyholders, to regulate,
promote

and

ensure

orderly

growth

of

the

insurance industry and for matters connected

therewith or incidental thereto.

Financial Markets
Financial markets are a significant component of
the financial system. They are not a source of
funds, but they act as a facilitating organisation
and link the savers and investors, both individual
as well as institutional.
As facilitating organisations, financial markets
provide a wide variety of specialist institutional
facilities. Based on the nature of funds which are
their stock-in-trade, they are classified into:
(i)
money markets and
(ii)
capital/securities markets.
(iii) Forex market
22

FINANCIAL
MARKETS

MONEY

Call market
T Bills market
CP market,
CD market

CAPITAL

PRIMARY

FOREX

SECONDARY

Financial Markets
Money

market is a market for dealing in

monetary/financial assets of a short-term
nature, generally less than one year.

Its broad objectives are to provide

an
equilibrating mechanism for evening out
short-term surpluses and deficiencies in the
financial system, a focal point of central bank
(RBI) intervention for influencing liquidity in
the
economy
through
a
variety
of
instruments, and a reasonable access to the
users of short-term funds to meet their
requirements
at
realistic/reasonable
24
price/cost.

Money Market

The money market organization comprises of a

number of interrelated sub-markets such as call
market, T-bills market, commercial bills
market, CP market, CD market, repo market and
so on.

25

Capital Market
Capital/securities market is a market for long-term
funds. It has two segments:
i.
primary/new issue market and
ii.
secondary/stock exchange/market.
The primary market deals in new securities,
offered to the investors for the first time. It
performs a triple-service function, at the different
stages of the issue, namely, origination, that is,
investigation, analysis and processing of new
issue proposals; underwriting; and distribution of
securities to the investors.
26

The stock exchange is a market for existing

securities. It discharges three vital functions: it
acts as a nexus between savings and
investment, it provides liquidity to investors by
offering a place for transaction in securities and
it helps in continuous price formation.

27

Structure of Capital Markets

Primary Markets

Secondary Markets

When companies need financial

The place where such securities are
resources for its expansion, they
traded by these investors is known as
borrow money from investors through the secondary market.
issue of securities.
Securities issued
a) Preference Shares
b) Equity Shares
c) Debentures

Securities like Preference Shares and

Debentures cannot be traded in the
secondary market.

Equity shares is issued by the under

writers and merchant bankers on
behalf of the company.

Equity shares are tradable through a

private broker or a brokerage house.

People who apply for these securities

are:
a) High net worth individual
b) Retail investors
c) Employees
d) Financial Institutions
e) Mutual Fund Houses
f) Banks

Securities that are traded are traded

by the retail investors.

One time activity by the company.

Helps in mobilising the funds for the

Forex Market
The foreign exchange market popularly called
the

forex

market,

deals

in

multicurrency

requirements, which are met by the exchange of

currencies.
Depending

on

the

exchange

rate

that

is

applicable, the transfer of funds takes place in

this market.

Financial Assets/Instruments
A financial asset/instrument/security is a claim on
a stream of income and/or assets of another
economic unit and is held as a store of value and
for the expected return. There are three types of
financial assets: primary/direct, indirect and
derivatives.

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FINANCIAL
INSTRUMENTS

PRIMARY/ DIRECT

INDIRECT

DERIVATIVES

Primary Security
A primary security is a security issued by a nonfinancial economic unit, such as ordinary/
preference
shares,
debentures/bonds
and
innovative
debt
instruments
including
participating, convertibles, warrants and so on.

32

Indirect Security
An indirect security is a security issued by
an FI such as units of mutual funds.
It is based on an underlying primary
security.
The pooling of funds by an FI and
converting a primary security into an
indirect security is associated with a
number of benefits, namely, convenience,
diversification, expert management and
lower cost.
33

Derivative Instrument
A derivative instrument includes:
(i)
a security derived from a debt instrument,
share, secured or unsecured loan, risk
instrument, contract for differences or any
other form of security and
(ii) a contract which derives its value from the
prices/index of prices of the underlying
securities. It is an instrument of risk
management.
(iii) The most commonly used derivative contracts
are forwards, futures and options.
34

Forward Contract
A forward contract is an agreement to
exchange an asset for cash, at a
predetermined future date specified today.
At the end of the contract, one can enter
into an offsetting transaction by paying in
the difference in the price.
It is settled by the delivery of the asset on
the expiration date.
35

Futures Contract
Future contracts are standardised contact to buy
or sell the underlying assets at a specified price
and specified date.
They are agreements between two counterparties
to fix forward the term of an exchange/lock-in the
price today, of an exchange that will take place
between them at some fixed future date, ranging
between 3 to 21 months.
Depending on the underlying asset, future
contracts could be stock futures or index futures.
36

Options Contract
Option is a right but nit obligation to buy or sell
the underlying asset.
Options give the holder the right (but not the
obligation) to buy (call option) or sell (put option)
securities
at
a
predetermined
price
(strike/exercise price) within/at the end of a
specified period.
In order to acquire the right of option, the buyer
pays to the seller, an option premium as the
price for the right. He can lose no more than the
option premium paid but his possible gain is
unlimited.
The sellers possible loss is unlimited but his 37

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