Financial System

 Finance (Noun, Verb)

 The American Heritage® Dictionary of the
English Language, Fourth Edition defines the
term as under-
 1:"The science of the management of money
and other assets.";
2: "The management of money, banking,
investments, and credit. ";
3: "finances Monetary resources; funds,
especially those of a government or corporate
body"
4: "The supplying of funds or capital."
 Financial System
 Finance as a function (i.e. verb) is defined
by the same dictionary as under-
 1:"To provide or raise the funds or capital
for": financed a new car
2: "To supply funds to": financing a
daughter through law school.
3: "To furnish credit to".
 :"the commercial activity of providing
funds and capital"
4: "the branch of economics that studies
the management of money and other
assets"
5: "the management of money and credit
and banking and investments"
 Financial System
 System: Set of complex and closely connected or
interlinked institutions, agents, practices, markets,
transactions, claims, and liabilities in the economy
 FinancialSystem: Money, Credit, Finance
 Heart to human body: Important for Economy
 A financial system functions as an intermediary and
facilitates the flow of funds from the areas of surplus
to the areas of the deficit.
 Money
Generally accepted as payment for goods
and services and repayment of debts
Functions of money:
Medium of Exchange
Unit of Account
Store of value
Standard of deferred payment
Money forms: Commodity Money and Fiat
Money
 Measures of Money
M1:Currency (coins and bills) and
checking account deposits
M2: Currency, checking account
deposits and savings account
deposits
M3: M2 plus time deposits
M0: Currency plus deposits of banks
and other institutions at the central
bank
 Credit
Money Loaned
A method of paying for goods or
services at a later time, usually
paying interest as well as the original
money
 Finance
Activityby which claims to resources
are either assembled from those
released by domestic savings,
obtained from abroad, or specifically
created usually as bank deposits or
notes and then placed in the hands of
investors.
 Investments
Activityby which resources are
actually committed to production
Volume of capital formation: Intensity
of savings, finance and investment.
Conversion of savings to investment:
Transfer Process
 Transfer Process
 Genesis of Financial System: Divorce between
savings and investment
 Relationship between savings and investment
vary considerably among economic units
 Goldsmith’ designated categories of economic
units: Savings-surplus units (Savings in excess
of investments), Economic Units (Investments
exceed their savings) and Neutral units
(Savings equal to investments)
Financial System
Function of efficient allocation
of funds
Financial innovation
Growth of technology
Rudimentary Finance
Direct Finance
Indirect Finance
 Rudimentary Finance
Financial System of underdeveloped
or traditional economy
Per capita output low and declining
Absence of an array of financial
assets/ instruments that would
stimulate savings
Absence of an array of financial
markets that would allocate savings
competitively to investment
 Direct Finance
Improvement over rudimentary
finance by removing the obstacles to
efficient capital formation
Improved capital formation under
direct finance through: Financial
assets/ instruments, Brokers/
Investment Bankers, Secondary
Markets/ Stock Exchanges
 Financial Assets/ Instruments
(Securities)
Financial instrument/ asset is a claim
against another economic unit and is
held as a store of value and for the
return that is expected.
Examples: Shares, Debentures, etc.
Financial assets stimulate capital
formation and speedy economic
development
 Brokers/ Investment
Bankers
Find savers and bring them with
economic units needing funds
Brokerage function, Underwriting
function
 Secondary Markets/ Stock
Exchanges/ Markets
Provide savers with ability/ facility to
dispose of their investment portfolio
and realise cash to finance their
current consumption
Provide liquidity and marketability
 Indirect Finance
 Flow of savings from savers to entrepreneurs through
intermediary financial institutions like mutual funds,
insurance companies, etc.
 Services offered by financial intermediaries:
 Convenience (Divisibility, Flexibility, Maturity)
 Lower risk
 Expert Management
 Economies of Scale
 Channelisation of savings (Encouraging, Sponsoring,
Discriminating between various industries)
 Financial System
Functions
Saving Function
Liquidity Function
Payment Function
Risk Function
Policy Function
 Saving Function
Public saving find their way into the
hands of those in production through


the financial system. Financial claims

are issued in the money and capital
markets which promise future income
flows. The funds with the producers
result in production of goods and
services thereby increasing society
living standards.
 Liquidity Function
The financial markets provide the
investor with the opportunity to
liquidate investments like stocks,
bonds, debentures, etc. whenever
they need the fund.
 Payment Function
The financial system offers a very
convenient mode for payment of
goods and services. Cheque system,
credit card system etc are the easiest
methods of payments. The cost and
time of transactions are drastically
reduced.
 Risk Function
The financial markets provide protection
against life, health and income risks.
These are accomplished through the sale
of life and health insurance and property
insurance policies. The financial markets
provide immense opportunities for the
investor to hedge himself against or
reduce the possible risks involved in
various investments
 Policy Function
The government intervenes in the
financial system to influence
macroeconomic variables like interest
rates or inflation so if country needs more
money government would cut rate of
interest through various financial
instruments and if inflation is high and too
much money is there in the system then
government would increase rate of
interest.
Financial System:
Composition
 Financial System:
Intermediary
Intermediary
Market Role

Stock Exchange Capital Market Secondary Market to

securities

Investment Bankers Capital Market, Credit Corporate advisory

Market services, Issue of
securities
Underwriters Capital Market, Money Subscribe to
Market unsubscribed portion
of securities
Registrars, Depositories, Capital Market Issue securities to the
Custodians investors on behalf of
the company and
handle share transfer
activity

Primary Dealers Satellite Money Market Market making in

Dealers government securities

Forex Dealers Forex Market Ensure exchange ink

 Indian Financial System
Phases
Upto 1951
!951 to the mid-eighties
After early nineties
Defined as the market in which financial
assets are created or transferred.

These assets represent a claim to the

payment of a sum of money sometime in the
future and/or periodic payment in the form
of interest or dividend.
Classification

Money market
(Short term instrument)

Capital markets
(Long term instrument)

The most important distinction between

the two:
The difference in the period of maturity.
Main Function
To channelize savings into short term productive
investments like working capital .

Instruments in Money Market

Call money market
Treasury bills market
Markets for commercial paper
Certificate of deposits
Bills of Exchange
Money market mutual funds
Promissory Note
Part of the national money market
Day-to day surplus funds mainly of banks are
traded
Short term in nature
Maturity of these loans vary from 1 to 15 days
Lent for 1 day: Call money
Lent for more than 1 day but less than 15 days:
Notice money
Convenient interest rate
Highly liquid loan repayable on demand
Unsecured Promissory note.

Issued by well known companies with strong

and high credit rating.

Sold directly by the issuers to investors or

through agents like merchant banks and security
houses.

Flexible Maturity

Low interest rates with compared to banks.

Imparts a degree of financial stability to the

Referred as note payable in accounting

Itis a contract detailing the terms of a

promise by one party (the maker) to pay a
sum of money to the other (the payee).

The obligation may arise from the

repayment of a loan or from another form
of debt.

For example, in the sale of a business, the

purchase price might be a combination of
an immediate cash payment and one or
Defined as short term deposit by way of
usance promissory notes.

Greaterflexibility to investors in the

deployment of surplus funds.

Permitted by the RBI to banks

Maturity of not less than 3 months and upto

1 year.

Transferable in nature

Free negotiability and limited flexibility

Investprimarily in money market
instruments of very high quality.

RBI and public financial institution can set

it either directly or through its existing
subsidiaries.

MMMF
Open Ended
Close Ended
Provided resources needed by medium
and large scale industries.
Purpose for these resources
Expansion
Capacity Expansion
Investments
Mergers and Acquisitions

Deals in long term instruments and

sources of funds
Main Activity

Functioning as an institutional mechanism

to channelize funds from those who save to
those who needed for productive purpose.

Provides opportunities to various class of

individuals and entities.
 Primary Markets Secondary Markets
When companies need financial The place where such securities are
resources for its expansion, they borrow traded by these investors is known as the
money from investors through issue of secondary market.
securities.
Securities issued Securities like Preference Shares and
a)Preference Shares Debentures cannot be traded in the
b)Equity Shares secondary market.
c)Debentures
Equity shares is issued by the under Equity shares are tradable through a
writers and merchant bankers on behalf private broker or a brokerage house.
of the company.
People who apply for these securities Securities that are traded are traded by
are: the retail investors.
a)High networth individual
b)Retail investors
c)Employees
d)Financial Institutions
e)Mutual Fund Houses
f)Banks

One time activity by the company. Helps in mobilising the funds for the
investors in the short run.
 Components of Indian
Financial System
1. Financial institutions
2. Financial Markets
3. Financial
Instruments/Assets/Securities
4. Financial Services.
Indian Financial System
 International Financial
Market
Financial Markets
Foreign Exchange and Eurocurrency
market
Domestic and International Bond
Market
Domestic and International Stock
Markets
Derivatives Markets
 Important Characteristic of
Financial Markets
Liquidity: The ease of capturing an
asset’s value
Reflects a market’s operational
efficiency
Impacts a market’s informational and
allocational efficiency
 The inter bank foreign exchange
market for large transactions is the
world’s most liquid market
 Other Market
Characteristics
 Maturity:
 Short-term: Money market
 Long-term: Capital market
Regulatory Jurisdiction:
 Single-country internal markets
 Multi-country external markets
Middlemen
 Intermediated through a commercial bank
 Non-intermediated or direct to the public,
through a broker or investor bank
 Foreign Exchange Markets
conducted through commercial
banks

Spot Market
Cash market with delivery in two
business days
Forward Market
Trade at a prearranged date and price
 Intermediated Markets in
bank deposits and loans
Money Markets Capital Markets

Internal Short term accounts Long term accounts

Markets with domestic clients with domestic clients

External Eurocurrency deposits Long term accounts

markets and loans with foreign clients
 Non-intermediated (Direct)
markets
Money Markets Capital markets

Internal Short term Commercial Stocks and bonds issued in the

Markets Paper domestic market

External Eurocommercial paper Global equity, foreign bonds

markets and Euro bonds
 Eurocurrency Markets
Eurocurrencies: Bank deposits and loans
residing outside any single country
Floating rate pricing usually with
maturities less than five years
Few regulatory restrictions because they
are outside the jurisdiction of any single
government
Competitive pricing – outstanding in 2.5
trillion dollars
 Few regulations in
eurocurrency market
 Typically there are
No reserve requirement
No interest rate regulations or caps
No with holding taxes
No deposit insurance requirements
No credit allocation regulations
Less stringent disclosure
requirements
 Floating rate pricing in
eurocurrency market
Low interest rate risk: Interest rates
tied to a variable rate base such as
the LIBOR
Low default risk: Traded between
large commercial banks, investment
banks and multinational corporations
Relatively short maturities: Typically
less than five years
 Global Equity offerings
Cross listing of shares: Increase
demand and enhance share price,
Improves image of the firm, Gets
more customer and investor base
Cross listing benefits the firm in
improving transparency and
disclosure, reduces opportunity for
hostile takeover.
Dominant: 56 per cent
 International Bond Market
 DomesticBonds
Foreign Bonds
Euro Bonds: Samurai, Bull
dog, Yankee
USA dominant: 31 per cent
 Derivatives Market
Forwards
Swaps
Options
Futures