UNIT ONE

CHAPTER TWO INDIAN FINANCIAL SYSTEM

Various criterions of classifying Financial Markets. Recent changes in ‘Financial System’. and the basic sources of long-term finance that are available to a fund to fund its investments You might have heard the term financial system what do you think it is? What is a financial system? Savings mobilisation and promotion of investment arc functions of the stock and capital markets. which depends on the income and distribution of income in terms of real goods and services in the economy. In order to gain an understanding of how firms carry out the finance function. Functions of Financial Markets. The production of output. The objective of all economic activity is to promote the well being and standard of living of the people. it is very important for you to understand the financial system of which the firm is a part. which is vital to the growth process in the . This requires a study of the financial institutions and markets that comprise the financial system. Various constituents of financial market.Lesson no 3 Chapter 2 Indian financial System Unit 1 Core concepts in financial management After reading this lesson you will be able to understand the following: Concept of ‘Financial System’. which are a part of the organised financial system in India. their characteristics and the instruments used.

. These institutions are all a part of the financial system. viz. while real goods and services are part of the real system. human inputs (in the form of labor and enterprise) and financial inputs (in the form of capital. These inputs are material inputs (in the form of physical materials. cash and credit). is a function of the many inputs used in the productive process. While cash creation is the function of the RBI. plant. Trading in money and monetary assets constitute the activity in the financial markets and are referred to as the financial system. For financial system it is necessary that there is a financial activity. banks do credit creation and financial institutions including the RBI. raw materials. provision of liquidity and trading in liquidity are the major functions of the financial system. The financial inputs emanate from the financial system. banks and term-leading institutions. government and business sectors are the major borrowers whose . The efficient functioning of the financial system facilitates these flows of funds. Sector-wise.). deal in claims on money or monetary assets. Besides. the financial system is also geared to the mobilisation of savings and channelisation of these savings into productive activity. machinery. The interaction between the real system (goods and services) and the financial system (money and capital) is necessary for the productive process. The easy availability of financial inputs promotes the growth process through proper coordination between human and material inputs. money and nearness to cash.economy. can you comment on what it is? What is financial system? The term "liquidity" is used to refer to cash. Money and monetary assets are traded in the financial system. etc. Through appropriate differentials in the rate of return and other incentives. Thus. funds flow from less productive to more productive activities.

A financial market consists of investors or buyers. The investors are reached by direct mailing. trading in securities is screen-based. 'sellers. The Bombay Stock Exchange (BOLT) now introduces on-line trading. dealers and brokers and does not refer to a physical location. Investors seek the highest return for a given level of risk (by paying the lowest price) and users of funds attempt to borrow at .investment is always greater than savings. and other exchanges are in the process of introducing the same that is screen-based. The value of financial assets change with the investors' expectations on earning or interest rates. On the other hand. Now let us move on to functions of financial markets What are Functions of financial markets? The primary function of the financial markets is to facilitate the transfer of funds from surplus sectors (lenders) to deficit sectors (borrowers). Financial markets trade in money and their price is the rate of return the buyer expects the financial asset to yield. exceed their savings. households have excess of funds or savings. The financial system provides the intermediation between investors and helps the process of specialisation and sophistication in the financial infrastructure. the secondary market or stock exchange where existing securities are traded. On the other hand. The primary market in which public issue of securities is made through a prospectus is a retail market and there is no physical location. is an auction market and may have a physical location such as the rotunda of the Bombay Stock Exchange or\the trading floor of Delhi. with savings exceeding investment. Ahmedabad and other exchanges where the exchange members meet to trade securities face-to-face. In the Over-The-Counter (OTCEI) market and National Stock Exchange. in India the household and foreign sectors are the net savers. which they lend to borrowers in the corporate and public sectors whose requirement of funds. Formal trading rules and communication networks for originating and trading financial securities link the participants in the market. Normally. leading to greater financial development that is pre-requisite for faster economic development.

Financial markets facilitate price discovery. the motivation of investors to hold financial assets will be considerably diminished. it is possible for companies (and other entities) to raise long-term funds from investors with short-term and medium-term horizons.the lowest rate possible. 3. Did you ever tried to classify financial markets. While one investor is substituted by another when a security is transacted. Investors receive the highest return and the users obtain funds at the lowest cost. of investors and users of funds in a properly functioning capital market ensures the flow of capital to the best user. Information costs refer to costs incurred in evaluating the investment merits of financial assets. the company is assured of long-term availability of funds. The three important functions of financial markets are: 1. Financial markets considerably reduce the cost of transacting. The continual interaction among numerous buyers and sellers who throng financial markets help in establishing the prices of financial assets. Investors can readily sell their financial assets through the mechanism of financial markets. Search costs comprise explicit costs such as the expenses incurred on advertising when one wants to buy or sell an asset and implicit costs such as the effort and time one has to put in to locate a customer. Well-organised financial markets seem to be remarkably efficient in price discovery. The aggressive interaction. In the absence of financial markets. That is why financial economists say: "If you want to know what is the value of a financial asset simply look at its price in the financial market" 2. Thanks to negotiability and transferability of securities through the financial markets. Financial markets provide liquidity to financial assets. please do so right now. The two major costs associated with transacting are search costs and information costs. How to Classify Financial Markets? . which provide such liquidity.

. An over-the counter market is a decentralised market with customised procedures. The debt market is the financial market for fixed claims (debt instruments) and the equity market is the financial market for residual claims (equity instruments). A cash or spot market is one where the delivery occurs immediately and a forward or futures market is one where the' delivery occurs at a pre-determined time in future A fifth way to classify financial markets is by the nature of its organisational structure.1ims is called the capital market Traditionally the cut-off between short-term and long-term financial claims has been one year-though this dividing line is arbitrary. One way is to classify financial markets by the type of financial claim. The market for short-term financial claims is referred to as the money market and the market for long-term financial cli. An exchange-traded market is characterised by a centralised organisation with standardised procedures. Since short-term financial claims are almost invariably debt claims. The market where issuers sell new claims is referred to as the primary market and the market where investors trade outstanding securities is called the secondary market A fourth way to classify financial markets is by the timing of delivery. A second way is to classify financial markets by the maturity of claims. the money market is the market for short-term debt instruments. it is widely accepted.There are different ways of classifying financial markets. The capital market is the market for long-term debt instruments and equity instruments. A third way to classify financial markets is based on whether the claims represent new issues or outstanding issues.

These include transactions in . financial institutions and corporate sector.Nature of Claim Debt Market Equity Market Maturity of Claim Money Market Capital Market Seasoning of Claim Primary Market Secondary Market Timing of Delivery Cash Market Spot Market We will concentrate on classification as per maturity of claim. which refers to all transactions in near money such as short-term claims on banks. SBI and foreign banks are the major players in this market. This provides a link between the cash and near-money assets and to long-term wing of the capital market. It is also a place to secure the short-term requirements of banks and FIs. The duration should normally be less than one year. It is a market for short-term monetary assets or claims on money. The inter-bank market matches the deficits and surplus of banks. This market provides an important era or venue for central bank intervention in the economy. Money Market Characteristics The money market establishes the link between the RBI and banks and the policy of RBI is felt in this market first before it percolates to other markets. An important segment of the financial system is the money market.

They do not carry an explicit (or coupon rate). Government. Instruments in Money Market Debt instruments. They represent the obligations of the Government of India. commercial paper. and corporates dominate the money market. may run for three to six months. which have a maturity of less than one year at the time of issue. The banks. Hence the implicit yield of T Bill is a function of .inter-bank call money (Call money market) and treasury bills issued by the government and commercial bills issued by the private corporate sector (Bills market). both of the government and the private corporate sector. financial institutions. banks. The money market is the short-term wing of the financial system dealing in claims on money of a short-term nature. The inter-corporate funds market is also a part of this market. which conducts the borrowing and lending operations among the corporate units in the private sector. A brief description of money market instruments is given below: Treasury Bills Treasury bills are the most important money market instruments. Instead. say. which have a primary tenor like 91 days and 364 days. These instruments are highly liquid have negligible risk. Individual investors participate in the money market directly. Certificates of deposit. But all these instruments would generally be of a few days to one year and fall into the category of short-term monetary instruments. The bills. the most liquid assets are the short-term claims or call money of duration of up to 15 days. of a few days to a few months. Next to the currency. and repos. are called money market instruments. financial institutions and companies operate in these markets and effect purchase and sale transactions in these near-money assets. The major money market instruments are Treasury bills. The Reserve Bank of India sells them on an auction basis every week in certain minimum denominations. they are sold at a discount and redeemed at par.

though the most popular duration is 90 days. (iii) CDs generally offer Irate of interest than Treasury bills or term deposits. It is generally companies with very good rating which are active in the CP market. CDs are issued in either bearer or registered form. . Banks and financial institutions are the major issuers of CDs. While most of the issuing entities have established working capital limits with banks. Though the yield on Treasury bills is somewhat low. (ii) CDs are generally risk-free. The principal investors in CDs are banks. The credit ratings for CP are issued by leading rating agencies. CDs are a popular form of short-term investment for companies for the following reasons(i) Banks are normally willing to tailor the denominations and maturities to suit the needs of the investors. the tenure and the general level of rates besides the credit rating of the proposed issue. which are transferable from. though RBI permits a minimum credit rating of Crisil-P2. They generally have a maturity of 3 months to 1 year. These instruments are offered at a discount to the face value and the rate of interest depends on the quantum raised. yet they have following reasons: (a) these can be transacted readily and there is a secondary market for them. Certificate of Deposits Certificates of deposits (CDs) represent short-term deposits. financial institutions. they still prefer to use the CP route for flexibility in interest rates. (b) Treasury bills have nil credit risk and negligible price risk (thanks to their short tenor). Commercial paper A Commercial Paper is a short term unsecured promissory note issued by the raiser of debt to the investor. and mutual funds. The tenure of CPs can be anything between 15 days to one year. Corporates.the size of the discount and maturity. to one party to another. For a corporate to be eligible it must have a tangible net worth of Rs 4 crore or more and have a sanctioned working capital limit sanctioned by a bank/FI. CDs are issued at a discount and redeemed at par.

It also provides liquidity to the initial buyers in the primary market to reoffer the securities to any interested buyer at any price. A Repo involves a simultaneous "sale and repurchase" agreement. (ISEIL) where existing instruments including negotiable debts are traded. 6. The market value of listed stock on the stock exchanges in India was Rs. An active secondary market actually promotes the growth of the primary market and capital formation because investors in the primary market are assured of a continuous market and should the occasion arise. preference shares and debentures. Party A sells securities to Party B at a certain price and simultaneously agrees to repurchase the same after a specified time at a slightly higher price. . A Repo works as follows. various public sector industrial units (PSU). they can liquidate their investments in the stock exchange.Repos The term Repo is used as an abbreviation for Repurchase Agreement or Ready Forward.83. Repos are a very convenient instrument for short-term investment. The difference between the sale price and the repurchase price represents the interest cost to Party A and conversely the interest income for Party B. including the National Stock Exchange.986 crores in July 2000. The secondary market consists of 23 stock exchanges. if mutually accepted. Party A needs short-term funds and Party B wants to make a short-term investment. The public sector consisting of Central and State governments. The primary market deals with the issue of new instruments by the corporate sector such as equity shares. statutory and other authorities such as state electricity boards and port trusts also issue bonds and shares especially as a part of disinvestments of government holdings. They are safe and earn a predetermined return Capital Market The capital market consists of primary and secondary markets. Capital formation occurs in the primary market while the secondary market provides a continuous market for the securities already issued to be bought and sold in volume with little variation in the current market price. the Over-the-Counter Exchange of India (OTCEI) and Interconnected Stock Exchange of India Ltd.

The claims on the corporate sector can also take the form of preference shares. Another very important component of the stock exchange deals with trading in corporate shares. local bodies. which deal in money debt claims. modernisation. In this market. the individual investors: and in the secondary market. Foreign institutional investors (FIIs) and the anchor of the market.short. With a view to protect investors' interest and orderly development of the capital market. . and financial institutions. Besides. the mutual funds. which are also of ownership category. there are various types of term-lending institutions. foreign institutional investors (FIIs). they constitute the new issues market. financial institutions. mutual funds. allIndia and state financial corporations and finance companies and development corporations. In the stock and capital markets. Securities and Exchange Board of India (SEBI) regulates the capital market and intermediaries. The major players in the primary market are the merchant bankers. equities. When the companies as shares float equities to the public for the first time. The trading in debt claims of a medium and long-term nature can be classified into those of the government sector and of the private sector. etc. The new issues and further issues are the claims of the public on the corporate sector. The securities of government are traded in the stock market as a separate component. called gilt-edged market. medium and long-dated government securities. there are again three types of securities . and individual investors.There is a symbiotic relationship between the primary and secondary markets. and Deferred and preference shares. the stockbrokers who are members of the stock exchanges. there are also further issues that are floated by the existing companies for additional capital for expansion. These securities may have a maturity running up to 25 to 30 years. depending upon the maturity period. The securities of the government sector include those of the Central and State Governments. which is a component of the Capital market. semi -Government bodies and those guaranteed by the Government.

be cumulative or non-cumulative depending on the provision for accumulation of dividends or not. reflected in market capitalisation as a proportion of GDP and the usual ratios. The reforms in general and increasing role of technology and competitive forces in particular have improved the quality of service. Financial inter-relations ratio - . privatization and globalisation of markets and freer flow of funds into and outside country. which can be converted into equity shares at a later stage. depending on the availability of option for conversion into equity. Efficiency of Financial System. etc. Similarly. preference shares. The strengthening of the institutions evidences the Width of Services Structure and increasing the instruments of mobilising funds. introduction of technological innovations in the Stock and Capital markets and in the banking system. lowering of costs raising funds from the capital market through the route of book building and private placement. quality of service and its width. (2) Its contribution to economic growth and its impact on real economic variables. More recently. such as Finance ratio . The real test of development of financial system is its efficiency in operations and functional roles. lowering of costs of credit and greater flow of bank credit into these markets. convertible preference shares are also permitted. Debentures may be convertible or non-convertible. Any financial system can be assessed for its functional efficiency through following criteria in general (1) Quantity of funds raised through saving for investment and pattern of allocation from less to more productive purposes.There are also securities of a debt nature such as bonds/debentures. deregulation. The operational efficiency is reflected in the costs of intermediation. The improved operational efficiency during the nineties is seen from significant reforms in the capital market and stock markets.ratio of total issues to national income.

LlBERALlSATlON OF THE FINANCIAL SYSTEM A radical restructuring of the economic system consisting of industrial deregulation. liberalisation of policies relating to foreign direct investment.whether the company valuarion_are reflected in scrip prices. In the capital market the focus of reforms has been on strengthening the disclosure standards. raising of debt at close-to-market rates and improving the liquidity of government securities by developing an active secondary market. and financial intermediation ratio ratio of secondary issues raised by banks and financial institutions to primary issues in the market (3) Information absorption . namely from banks and financial institution or one hand and directly from the capital market on the other. trade liberalisation and financial sector reforms have been initiated in 1992-93. The focus of reforms in the financial markets has been on removing the structural weaknesses and developing the markets on sound lines. The money and foreign exchange market reforms have attempted to broaden and deepen them.whether all information an market and economy are fully reflected in the scrip prices. The non-governmental and non-financial economic units and corporate Sector have two major sources of funds. There has been an improvement in both these respects in more recent years due to reforms introduced. public enterprise reforms. Reforms in the government securities market sought to smoothen the maturity structure of debt. Financial sector reforms in the area of commercial banking. developing the market infrastructure and strengthening the risk management systems at stock exchanges to protect the integrity . reforms of taxation system. since 1985. formation. capital markets and non-banking finance companies have also been undertaken. (4) Fundamental valuation efficiency .ratio of total issues to net domestic capital.

the enlargement of the number of participants and introduction of new instruments. dematerialising shares by setting up depositor and trading in derivative securities (stock index futures). accentuated the inherent weaknesses of public sector dominated banking systems. a regulatory and supervisory agency over commercial banks under the Banking Companies Regulation Act 1949. The removal of external constraints in norms of pre-emption of funds benefits and prudential regulation and recapitalisation and writing down of capital base are reflected in the relatively clean and healthy balance sheets of banks. allotment of shares. the Reserve Bank of India has . The improvement of financial health of banks is sought to be achieved by capital adequacy norms in relation to the risks to which banks are exposed.and safety of the market. There is a need to further improve financial soundness and to measure up to the increasing competition that a fast liberalising and globalising economy would bring to the Indian banking system. uniform settlement introduction of screenbased online trading. the Securities and Exchange Board of India (SEBI) was set up in 1992 to protect the interests of investors in securities and to promote development and regulation of the securities market. In the area of capital market. stipulating access to capital market to improve the quality of public issues. The reform process has. private placement. however. takeover of companies and venture capital In the area of secondary markets. SEBI has issued guidelines for primary markets. Elements of the structural reforms in various market segments are introduction of free pricing of financial assets such as interest rate on government securities. measures to control volatility and transparency in dealings by modifying the backend system. There is a sea change in the institutional and regulatory environment in the capital market area. pricing of capital issues and exchange rate. book building. laying down insider regulations to protect integrity of markets. prudential norms for income recognition and provision of bad debts. In regard to Non-Bank Finance Companies (NBFCs). Improving financial soundness and credibility of banks is a part of banking reforms undertaken by the RBI.

functions (deployment funds) and level of managerial competence of the NBFCs affect their effective regulation. The regulations stipulate upper limit for public deposits. which NBFCs can accept. such as the Economic Times and the Business Standard.issued several measures aimed at encouraging disciplined NBFCs. reduction of transaction costs and allocation of capital the most productive users. which include current price data along with statistics on recent price behavior. The most up-to-date '"quotes" can be obtained electronically. or in international markets. which they may not be able to service. Price information is available from stockbrokers and is widely published in news media-both financial and non financial. via a personal computer. An upper limit is also placed on the rate of interest on deposits order to restrain NBFCs from offering incentives and mobilising excessive deposits. particularly over those. Since the liberalisation of the economy in 1992-93 and the initiation of reform measure the financial system is getting market-oriented. The heterogeneous nature. Further. or the business sections of daily general newspapers published in most major cities. Popular sources of daily security price quotations are financial newspapers. size. The measures seek to protect the interests of depositors and provide more effective. INTERPRETING BOND AND STOCK PRICE QUOTATIONS The financial manager needs to stay abreast of the marker values of the firm's outstanding bonds and stocks. which run on sound business principles. stocks. number. prevision. These prices are important because they represent the current value of their investment. over the counter. Similarly. Market efficiency would be reflected in the wide dissemination of information. existing and prospective bondholders and stockholders need to monitor the prices of the securities they own. which accept public deposits. . freeing the financial system from government interference has been an important element of economic reforms. whether they are traded on an organized exchange. Security price quotations are readily available for actively traded bonds and stocks. Information on bonds. and other securities is contained in quotations. This limit is linked to credit rating an approved rating agency.

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4.IMPORTANT To update yourself on regular basis read financial newspapers on regular basis. What are the various criterions of classifying Financial Markets? Discuss in detail. Explain the concept of ‘Financial System’? 2. What are the various instruments under capital market & money market? . What are the functions of Financial Markets? 3. Questions 1.

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