ELEMENTS OF A FINANCIAL SYSTEM

What Is a Financial System?

Financial systems are made up of different financial institutions working together or within the
same economy. Any type of business that’s involved in financial transactions is a financial
institution. Stock exchanges are one type of financial institution and play a major role in most
financial systems. Banks, mortgage lenders and insurance companies are also common financial
institutions.
A financial system also includes the markets through which financial institutions move money. A
third component of a financial system is the regulations, either set by the government or by the
financial organizations, that control how money can move from one institution to the next. The
financial system is responsible for handling all of the financial service needs of people and
businesses that exist and operate within an economy.

What Are the Elements of a Financial System?

The six elements of a financial system are lenders and borrowers, financial intermediaries,
financial instruments, financial markets, money creation and price discovery. These financial-
system components keep money flowing between people and businesses in an organized manner.
Here’s what each is and how it functions.

1. Lenders and Borrowers

Lenders loan money to borrowers. Although people can be lenders on a private basis, lenders in a
financial system are typically financial institutions. Mortgage lenders, banks and credit unions are
some of the most common types of lenders. Credit cards are also forms of loans, making credit
card companies a type of lender.
A borrower is any person or entity that takes out a loan. A homebuyer often finances the purchase
of their home through a mortgage loan, making them a borrower. Businesses also take out loans
from financial institutions. The processes of lending and borrowing help keep money flowing
through a financial system because they allow people and entities to make purchases that they
could not afford otherwise.
One characteristic of a good financial system is regulation surrounding lending. Loans have
interest rates and other additional fees that require a borrower to pay back more than the original
amount, called the principal, that they borrowed. If borrowers get loans without understanding the
full cost, they may not be able to pay the money back. Financial institutions could run out of money
if a large number of borrowers were unable to pay back their loans. That’s why there are
regulations surrounding criteria for getting loans and the amount of interest and other fees a lender
can charge a borrower. These regulations protect both the borrower and lender, and they keep
money moving throughout the financial system.

2. Financial Intermediaries
Financial intermediaries act in between two financial institutions to make the entire financial
system more stable. Think of a financial intermediary as a “middle man.” Financial intermediaries
rarely own the money they hold. Rather, these businesses and organizations move funds from one
part of the financial system to the next.
Financial intermediaries balance out financial systems because they move money from areas that
have too much to areas that don’t have enough. Banks are one example of a financial intermediary.
Suppose a business needs a $1 million loan. The bank can offer that loan by combining the funds
of 10,000 people who have $100 deposited in their bank accounts. Those 10,000 people won’t be
missing their $100 because the bank has more money, from other depositors, available.

3. Financial Instruments
A financial instrument is a contract for trading a financial asset. Financial instruments are an
important part of a financial system because they allow wealth to keep moving throughout the
system. Checks, bonds, certificates of deposit, stock trades and stock options contracts are all
examples of financial instruments.

4. Financial Markets
A financial market is any marketplace, physical or virtual, where financial instruments can be
traded between people and financial institutions. The stock market is a financial market. Other
examples of financial markets include the real estate market, the bonds market, the commodities
market and the foreign exchanges market.

5. Money Creation
Financial systems rely on money circulating throughout them. A government may introduce new
money to the market by printing it. In the United States, the Federal Reserve makes decisions
regarding the creation of money. Sometimes, money is given to banks virtually rather than being
physically printed.
Different financial systems may have different forms of money creation, but there must be an
adequate amount of money circulating to keep the system going. In regards to cryptocurrency,
money creation happens when a new type of currency is created. In terms of the stock market,
money creation happens when a company makes more shares available for the public to purchase.

6. Price Discovery
Price discovery is the process of setting a price for goods, services or even financial instruments.
Price discovery is based on a variety of factors, such as supply and demand. If more people want
something, its price rises. If there’s a limited supply of a certain good, its price rises. Items that are
unwanted or plentiful often have cheaper prices.
Although it may not always seem this way to consumers, price discovery is a collaborative effort
between buyers and sellers. Sellers must price their goods in order to make a profit, and buyers
must be willing to pay that price.
 CAPITAL MARKET SEGMENTS

What are Capital Markets?

Capital markets are venues where savings and investments are channeled between the suppliers
who have capital and those who are in need of capital. The entities that have capital include retail
and institutional investors while those who seek capital are businesses, governments, and people.
Capital markets seek to improve transactional efficiencies. These markets bring those who hold
capital and those seeking capital together and provide a place where entities can exchange
securities.

Capital Markets – Types

Capital markets are mainly divided into 2 different types.

1. Primary Markets:
The primary market is the part of the capital market that deals with the issuance and sale of
securities to investors directly by the issuer. An investor buys securities that were never traded
before. Primary markets create long-term instruments through which corporate entities raise funds
from the capital market.

2. Secondary Markets:
The secondary market, also called the aftermarket and follow on public offering is the financial
market in which previously issued financial instruments such as stock and bonds are bought and
sold

Capital Market – Examples

1. Stock Market:
A stock market, equity market or share market is the aggregation of buyers and sellers of stocks,
which represent ownership claims on businesses

2. Bond Market:
The bond market is a financial market where participants can issue new debt, known as the primary
market, or buy and sell debt securities

3. Currency and Foreign Exchange Markets:

The foreign exchange market is a global decentralized or over-the-counter market for the trading
of currencies. This market determines foreign exchange rates for every currency.

PARTICIPANTS IN CAPITAL MARKET

The participants of capital market are mainly those who have a surplus of funds and those who
have a deficit of funds. The persons having surplus money want to invest in capital market in hope
of getting high returns on their investment. On the other hand, people with fund deficit try to get
financing from the capital market by selling stocks and bonds. These two kinds of activities keep
the capital market going.

The term capital market refers to facilities and institutional arrangements through which long-term
funds, both debt, and equity are raised and invested. It consists of a series of channels through
which savings of the community are made available for industrial and commercial enterprises and
for the public in general.

Participants of the capital market may be discussed in groups because of their similar activities.
Groups or clusters of the participants are discussed below:

1. Loan Providers:
These types of organizations provide loans to my capital market. Others can take the loan from the
loan providers such as savings organizations, insurance organizations etc.

2. Loan takers:
A huge number of organizations want to take a loan from the capital market. Among them, the
following are prominent as Govt. organizations, Corporate bodies, Non-profit organizations, Small
business, and Local authorities.

3. Financial intermediaries:
Financial intermediaries are media between loan providers and takers. The financial intermediaries
are Insurance organizations, Pension funds, Commercial banks, financing companies, Savings
organizations, Dealers, Brokers, Jobbers, Non-profit organizations etc.

4. Service organizations:
Service organizations help to run capital market perfectly. These firms, on one hand, help issuers
or underwriters to sell their instruments with high value and in other hand help sellers and buyers
to transact easily. These are mainly service organization – invests banks, Brokers, Dealers,
Jobbers, Security Exchange Commission, Rating service, Underwriters etc.

5. Regulatory organizations:
Regulatory organizations are mainly govt. the authority that monitors and controls this market. It
secures both the investors and corporations. It strongly protects forgery in stock market Regulatory
organization controls the margin also. The Central bank, on behalf of govt. generally controls the
financial activities in a country.

FUNCTIONS OF CAPITAL MARKET

1. Economic Growth:
Capital Markets help to accelerate the process of economic growth. It reflects the general
condition of the economy. The capital Market helps in the proper allocation of resources from
the people who have surplus capital to the people who are in need of capital. So, we can say
that it helps in the expansion of industry and trade of both public and private sectors leading to
balanced economic growth in the country.

2. Promotes Saving Habits:

After the development of Capital Markets, the taxation system, and the banking institutions
provide facilities and provisions to the investors to save more. In the absence of Capital
 Markets, they might have invested in unproductive assets like land or gold or might have
indulged in unnecessary spending.

3. Stable and Systematic Security prices:

Apart from the mobilization of funds, Capital Markets help to stabilize the prices of stocks.
Reduction in speculative activities and providing capital to borrowers at a lower interest rate
help in the stabilization of the security prices.

4. Availability of Funds:
Investments are made in Capital Markets on a continuous basis. Both the buyers and sellers
interact and trade their capital and assets through an online platform. Stock Exchanges like
NSE and BSE provide the platform for this and thus the transactions in the capital market
become easy.

THE REGULATORY FRAMEWORK OF CAPITAL MARKET IN

INDIA

The regulation of capital markets has been very important for development and growth as
they provide a stable, steady, and secure platform for both the suppliers and the buyers. If not
then there can be massive loss or gain in finance which would be unfair for the general
public. Various organizations regulate the market to keep the economy stable. The regulatory
structure has been framed under the four pillars that are the Ministry of Finance, Reserve
Bank of India, Security and Exchange Board of India, and the National Stock Exchange.

1. Ministry of Finance (MOF)

The ministry depicts that the Government of India plays a very important role and their
economic policies and manifestos help in market regulation and framework. They formulate
rules and analyze them for the efficient and effective growth of the market. The Department
of Economic Affair which manages the market works under certain sets of laws that are the
Depositories Act, 1996, Securities Contract (Regulation) Act, 1956, and Securities and
Exchange Board of India Act, 1992. There are many other laws such as the Companies Act,
2013, etc.

2. Reserve Bank of India

The body that was established in 1934 frames the policies, formulates the bodies and
regulates the rules as per the current situation. RBI has active participation in the stock
market and also sets the various parameters that are used in the transactions of debt, equity,
and other types of securities. They are the bank regulators also as they have access to many
bank accounts as they have large funds to control the capital market since banks have the
most generated capital on hold. They also set various parameters for regulation such as repo
rate, reverse repo rate, etc. They are the intermediary body between the market and the
government. They have other various functions in capital markets such as the implementation
of various monetary policies, managing the foreign exchange system, settlement, and
payments systems.

3. Security Exchange Board of India (SEBI)

This body can also be considered as the apex body of capital market regulators. SEBI is a
principal regulatory body that is also a statutory body established under the SEBI Act 1992.
SEBI was earlier established as the non-statutory body in 1988. They not only protect the
interest of investors in securities but also promote the market. It supervises, controls, and
manages several institutional brokers, investors, companies, and all other associated persons
related to the market. The body’s primary function is to prohibit malpractice or unfair trade
practices such as insider trading or manipulating funds. The stock exchanges work under the
direct control of this body as they adopt the flexible and adaptable approach for regulating
the market. They perform many other such regulatory functions such as training of
intermediaries, auditing of stock exchanges, regulating and registering the mutual funds.

Recently, the review and merger of SEBI(Issue and Listing of Debt Securities) Regulations,
2008 and SEBI(non-convertible Redeemable preference shares) Regulations 2013 into a
single regulation- SEBI(Issue and Listing of Non-Convertible Securities) Regulations, 2021.

AN OVERVIEW OF VARIOUS CAPITAL MARKET INSTRUMENTS

AVAILABLE IN INDIA

 Shares
Shares are a unit of ownership in an organisation or corporation. It is a part of the company’s
capital. Those individuals who are getting shares from any company, are called Shareholders.
When a company wants to borrow and increase their capital, they issue their shares in the
stock market (exchange) for their investors.

However, companies also require to refund the amount from their Net Profit. Therefore,
shares play a significant role in the lives of companies and investors / shareholders.
Companies can issue two types of shares, which they offer to investors/shareholders. The two
types of shares are:
(a) Equity shares
(b) Preference shares

 Bonds
Bonds are issued by the banks, organisations and financial institutions. They issue bonds for
getting an amount of money from public (as a loan) and commit them a refund with an
actual interest and within a maturity period. They issue their bonds for financing their capital
expenses and their various projects or activities.

This is one of the most frequently used methods for increasing their capital and profits. When
companies offer their bonds to public, they define a specified interest rate and maturity
period in an applicant form.
Bonds have various types( i.e risk free bonds, high interest bonds, etc.) and different
companies issued various types of bond to public

 Debentures
Debenture is an instrument which is used by the Corporations and Government for getting a
loan from public and it is given under the company’s Stamp Act. Corporations and
Government can secure their debenture on company assets which it issues as long term
loans. In Debentures, companies are required to announce a fixed return at the time of
issuing.

Therefore, holders know that, how much amount they will get in future by issuer. Debentures
have various advantages for holders and issuers. It implies that holders know that how much
amount they will get in future, therefore they do not worry about their payment and, in
general, debentures are freely transferable by their holder to others. Therefore, holders have a
right to transfer their shares to anyone before their redemption.

 Fixed Deposit
Fixed Deposit is that kind of bank account, where the amount of deposit is fixed for a
specified period of time. All Commercial banks are given these opportunities to their
customers for opening a fixed account in their bank. In a Fixed account, the amount of
deposit is fixed, which means we cannot withdraw an unlimited amount from this account,
therefore it is also called a Fixed Deposit.

If an account holder wants to withdraw a small amount of money from their account, then he
will require closing of the Fixed deposit account. The main purpose of account holders to
open this account, is to earn interest money from their actual money, which is given by the
banks during a specified period of time.

 Foreign exchange market (Forex market)

Forex is one of the most biggest investment markets in the world and it is a huge platform for
investors for their investment. There are various forms of currencies included for trading on
international level. The investors invest their money on the value of currencies fluctuation
because of variation in the economic position of countries and entire world economy.

In the Forex market, we are dealing with different currencies of countries. We are not dealing
with only one currency at one time, we have to deal with a couple of currencies at one time,
for example USD/INR. In the example, the left side currency is called a Base currency and
the right side currency is called a Quote/Counter currency.

A price of one currency expressed in terms of the currency of another country is called as the
exchange rate. For example, the ratio of both currencies is 53.9, which implies that one unit
of US Dollar can buy or equals 53.9 Rupees of India. In that case, the US Dollar is a base
currency and the Indian Rupee is quote currency.

 Gold ETF
Gold ETF is one of the most popular funds as it does not get influenced due to stock
fluctuations or inflation. Gold ETF fund is a fiscal instrument which works as a mutual fund
and whose prices are depending upon the market price of gold. When the market price of
gold increases, gold ETF prices also increase.

The services of Gold ETF fund transfers is available in few stock exchanges, such as
Mumbai, Paris, Zurich and New York. Gold ETF fund provides a variety of advantages to
their holders, such as Low cost, Tax advantage, Gold purity, there is no need to worry about
safety, Issue of selling gold bars and also beneficial in short term investments.