UNIT Financial System and

Its Components

1. MEANING OF FINANCIAL SYSTEM

The history of trade and commerce is as old as man himself and their future too is as
far as that of mankind. They are a lasting symbol of man's interdependence and his
quest for prospcrity and are a key determinant of sovercign relationships and politi-
cal alignments in today's times. This trade and commerce has forced human socie-
tics to create various types of systems to conduct, facilitate and regulate trade and
commerce. The financial system is one of the most important innovations of modern
society. A financial system functions as an intermediary and facilitates the flow of
funds from the areas of surplus to the areas of deficiency. It is composed of various
institutions, markets, regulations and laws, practices, moncy managers, analysts,
transaction, claims and liabilities.
Financial System =Finance+System
Finance" signifies investment in the assets of an organisation, either capital or finan-
cial asset. Infact, linance is requirement of funds or money by businesses, individuals
and the government to meet their financial requirements and needs.
System" is a complete set of integrated components or entities that work to acheive a
particular task or function. System can be said to be a set of things working together
as parts of a mechanism or an
interconnecting network; a complex whole. A system
is a set of people and machines with pre-defined commands and methods to acheive
specific task(s).
"Financial System allocates savings efficiently in an economy to ultimate users, either
for
investment in real assets or for consumption" - Van Horne.
"Financial system consists of variety of institutions, markets and instruments related in a
systematic manner and provides the principal means by which savings are
into instruments" - Prasanna Chandra
transformed
Financial System can be defined as the set of procedures that tracks the financial ac-
tivity of the economy. It covers both Cash and Credit transactions. A
financial sys-
I.1
 I.2
Indian Financial System for Students
Em may be defined as a set of institutions, instruments and markets that fosters sav.

ngs and channels them to their most efficient use. Thus a financial system is a set of

uIOnal arrangements through which financial surpluses are mobilized from the
sgenerating surplusincomeand transferring them to the others in need of them.
The following figure depicts a financial system:
Seckers of funds Flow of
services, incomes, claimS Suppliers of funds

Companies Retail, Wholesale And

And
Institutional

Other
Investors
Flow of funds
Institutions
The whole structure of
financial system consists of three
cial market, financial components namely, finan
institutions and financial products.
Questions:
1. What
is Financial System?
2. Writea
[2011, 2012, 2013]|
brief note on the 'financial system' of a country
3. What is financial market? [2014]
1.1 SIGNIFICANCE
[2012
OF FINANCIAL SYSTEM
Financial System plays an important role in the economy of
any
significance of financial system in the economic development ofa country. Some of the
country is -

(a) Savings Mobilization: Financial System helps in

borrower thercby facilitating in mobilization of
connecting the lenders with the
surplus funds.
(b) Investment: Financial System helps the investor
by providing investment oppor
tunities through various medium
(c) Capital Formation: Financial System helps in capital formation in the economy
which helps to determine the growth in the
economy.The rate of
largely dependent upon the
tion is financial system of the
capital forma-
economy.
(d) Confidence of Public: A transparent financial
system helps in gaining confidence
of the people which helps to attract
investment.
Financial System and Its Components 1.3
(e) FinancialAssistance: Financial System helps in providing a platform to mobilize
resources through different investors. In many cases it is not practically possible
for the entrepreneurs to accumulate the resources required to establish a busi-
ness, in such situations financial system helps in connecting the lenders such as
IFCI, IDB1, etc, with the entrepreneur

Questions
1. Bricly identify the contribution ofthe filidncial system toa country's economic
development [2005]|
2. Discuss thesignificance of financial system in a modern economy? [2008
1.2 FUNCTIONS OF FINANCIAL SYSTEM

Following are the functions of a good financial system -

1. Regulation of Currency
2. Banking Functions
3. Performance of agency services and custody of reserves
4. Credit Control
5. Administrating national, fiscal and monetary policy to ensure stability
6. Maintaining liquidity in the economy
The long term growth of financial system is ensured through
-

1. Education of investors
2. Giving autonomy to Fll's to become efficient under competition

3. Consolidation through mergers

4. Facilitating entry of new institution to add depth to the market
5. Minimizing regulatory measures and market segmentation

Question
1. Explain in brief the functions of Indian Financial System [2011]
1.3 CONSTITrUENTS/COMPONENTS OF FINANCIAL SYsTEM

There are five major components of Financial System-

efficient
1. Financial Market: Financial Markets provides a platform for the
trans-

fer of resources from those having idle resources to others who have a pressing
market in which the financial as-
need for them. Financial market constitutes the
assets not only represent a claim to the
sets are created or transferred. These
 I.4
Indian Financial System for Studente
payment of a sum of money sometime in the future but also confer a right of peri.
odic payment in the form of interest or dividend sometimes. Financial market in
1act
forms the basis of the whole financial
system .It not only creates channel for
allocation of savings to investment but also
provide a variety of assets to savers.
F'inancial markets can be classified into
money markct and capital market.The dis-
tinction bctween them is based on
the differences in the period of maturity of
financial assets issued in these the
markets. On one hand the moncy market deals
all transactions in with
short term instruments li.e.
one
generally with amaturity period of
ycar or
less].
On the other hand
capital market deals with transactions related
to
long-term transactions. Both the money market and the
capital market plays an
important role in the over all working of financial
n
system. Infact the financial
ket helps in the flow of
funds from the household sector to the
mar
and ensures corporate world
proper functioning of financial system.
2.
Financial Institutions: These are the institutions that provide financial
to its clients
members. One of the
or services
cial intermediary. Financial significant role provided is to act as a finan-
Institutions are of two types
nancial intermediation and (a) those providing fi
-

(b) those providing direct

3.
Financial Intermediary: Financial institutions and financing.
a whole intermediaries comprises of
group of organizations providing
institutional finance to
include a set oflarge organizations which helps to meet the industry. They
E
ments of corporate sector and
they broadly include:
long-term require-
(a) Devclopment finance institutions including IDBI,
cater to the needs of IFCI, SIDBI, IIBI etc which
growing industrial sector as well as foster the
capital market growth of
(b) Commercial banks including various
public sector, private sector and foreign
banks, which provide medium and
long term, support to business firms.
(c) NBFCs which provides various financial services, and
(d) Insurance organizations like LIC, GIC, etc
P
These institutions again are an
important part of overall
financial system. They
not only mobilize savings of household but also
provide long-term finance to in-
dustry. Infact their activity has a very significant
and hence are regulated impact on the financial system
accordingly. It is an organization that
cial markets linking lenders and operates in finan
borrowers or savers and
investors.
 I.5
Ran Systn and ts Components
& INLARtERRERES The thind constituent of tinancial system is financial In-
struittsN These înstruments act as a means through which the financial market

aN 2nermNdaries can provide medium and long-term funds to corporates.

Thse anstrumments not only provide credit to corporates but also ensures that an

NESTOT S a rSUnable ntum These instruments can be broadly be of two

p s ie. struments acknowledging cquity eg. Equity shares, preference

shars ete and instrumonts acknowledging debt ie. debentures, bonds, etc. They
are ustruments that are used to create claims on financial assets. These instru-
n s arv isui by wrporates banks. government. etc, for raising funds.

t A MarketNegudater As there are lange amount of public money which is

mvahod in the financal market the conãidence of the investor is very important
This can b posibie onily when there is fair dealing of securities, increased trans
in the financial
pareny in the operations ete in order to ensure that the dealings
market ane air various market rngulators are established by the government
Some of these are - Nnistry of Finance, Resernve Bank of lIndia, SEBI, IRDA, etc.

Cacstias
1 What is by
meant Financial System? Discuss the main components ofthe lIndian
imancial systom [2005
Gve a bruad idea of the mior components of a financial system [2005, 2007 New]
3 Analyse e Indian financial system by ciassifying its components [2009
What are the diferent components of Indian financial system? [2011
Describe the major components of Financial System [2012]
&What s inancial system' State the components ofa financial system. (2017
7. Dscuss he role offinancial intermediaries [2018
1.4 FUNCTIONS OE FINANCIAL MARKET

Failowng are the func s of Financial Market

1 a c i s he taser of furis from surplus sector (lender) to the deficit'sec-

2 Price disvvery process that results from the interaction of buyers and sellers in
h market wben they trade the assets
 I.6
Indian Financial System for Studa.
3. Provision of liquidity by providing a mechanism tor an investor to
to sell
udents
financial
financ
assets and
4Low cost of transactions and information
Question
1. Write the
on
important functions of financial market
1.5 FINANCIAL MARKET PaRTICIPANTS
[2014
Financial market participants can be categorised into two broad categorics -
A.
nvestors and Speculators: Investor means those people/ institutions who
regularly purchase securities for financial gain in exchange tor funding an ex-
panding company.
Speculation, in the narrow sense of financial
speculation, involves the
buying,
holding, selling, and short-selling of stocks, bonds, commodities, currencies, col.
lectibles, real estate, derivatives or
any valuable financial instrument to
from fluctuations in its profit
price as opposed to buying it for use or for income via
methods such as dividends or interest.
B.
Institutional and Retail Investors: An institutional investor is an investor, such
as a bank, insurance company, retirement fund,
is
hedge fund, or mutual fund, that
financially sophisticated and makes large investments, often held in
very large
portfolios of investments. Because of their
sophistication, institutional investors
may often participate in private
placements of securities, in which certain as-
pects of the securities laws may be
A retail investor is an individual
inapplicable.
investor possessing shares of a
Retail investors can be further divided into
given security.
two categories of share
ownership.
(a) A Beneficial Shareholder is a retail investor who holds shares of their securi-
tics in the account of
a bank or
broker, also known as "in Street Name." The
broker is in possession of the securities on behalf
of the underlying share-
holder.
(b)A Registered Shareholder is a retail investor who holds shares of their
ties directly through the issuer or its transfer
securi
agent. Many registered share-
holders have physical copies of their stock certificates.
 I.7
Financial System and Its Components
-

Question:
1. Who are the participants of financial market? 12012]
2. KINDS OF FINANCE
The most important function of the Financial System is capital formation. The major
economic development id capital formation. The function of capitall
component of
formation is carried out by financial markets and financial intermediaries. The capi-
tal formation results in two types of finance: Direct and Indirect Finance.
Direct finance is a method of financing where borrowers borrow funds directly
a financial in-
from the financial market without using a third party service, such as
securities and/or
termediary. Direct financing is usually done by borrowers that sell
intermedi-
sharcs to raise money and circumvent the high interest rate of financial
markets as indi-
ary(banks). Direct financing is a direct connection to the financial
directly
securities on the market. Common methods
cated by borrower
the issuing
is bid
for direct financing include a financial auction (where price of the security
sold for a set initial price).
upon) or an initial public offering (where the security is
markets in which
These direct financial arrangements take place through financial
dealers and
lenders (investors) lend their savings directly to borrowers. Brokers,
investment bankers play important roles in direct financing. We may regard
trans-

actions as direct finance, even when a financial intermediary is included, in case no

asset transformation has taken place. An example is a household which buys a newly
issued government bond through the services of a broker, when the bond is sold by
business
the broker in its original statc. Another good example for direct finance is a

which directly buys newly issued commercial papers from another business entity

Indirect finance is where borrowers borrow funds from the

financial market

through indirect means, such as through a financial intermediary. In indirect financ-

takes the money from the lender with an interest rate
ing a financial intermediary
and lends it to a borrower with a higher interest rate. Financial intermediaries pur
transform
chase direct claims with one set of characteristics from borrowers and
them into direct claims with a different set of characteristics, which they sell to the
lenders. The indirect finance are arranged by financial intermediaries like mutual

funds, insurance companies,etc.

Questio
1. What is financc? Distinguish between direct and indirect finance. [2018
 I.8
Indian Financial System for Stud
3.
STRUCTURE OF FoRMAL FINAN CIAL SYSTEM
lents
A tormal Financial System has the following
(a) Regulators
components
(Ministry of Finance, SEBI, RBI, IRDA, etc.)
(b) Financial Institutions
(c) Financial Instruments
(Intermediaries)
E (d) Financial Services
(Depositories, Credit Rating,
F'actoring, Forfeiting, Merchant
cC Banking, Leasing, lire Purchases, Guaranteeing, Portfolio Management,
de Under.
writing, etc.)
p
St Regulators Financial System in India is highly
C regulated. Various regu-|
latory bodies monitors the activities of financial
m
system.
re ForInstance,
SEBI monitors the
activity of Primary and Secondary
IS Market
RBI monitors the
activity of money market
IRDA monitors the
activity of Insurance Business
Financial
A
tions
Institu-Securities market intermediaries
provide a vital link be-
tween the Investors, Issuers ahd Regulator. The
F of these objective
intermediaries is to smoothen the process of in-
vestment and to establish a link between the investors and
P
the user of the fund
Financial Instru- Financial Instruments are those
ments
instruments which is used
in the financial market for
lending or borrowing
of funds
Financial Services| Depositories, Credit
Rating, Factoring, Forfeiting, Merchant
Banking, Leasing, Hire Purchases, Guaranteeing,
Portfolio
Management, Underwriting, etc. offers various services in the
financial market.

P Qucstions:
1. Give overvicw of the structure of Indian financial
an
system [2015]
2. Discuss the structure of Indian Financial System
 I.9
FinancialSystem and Its Components
3.1 STRUCTURE OF FINAN CIAL INSTITUTIONs
Financial Institutions
(Intermediary)

Banking Mutual Funds Jnsurance and

Non-Banking Housing Finance
Institutions
lustitutions
Companies

Public Privale
Scheduled Sclheduled Non-Banking Develupnent Sector
Cooperative Finance Finance Sector
Commercial
Bank Bank Companies Institutions

Public Private Foreign Regional All India Satet-Level Other

Sector Sector Banks in Aural Institutions
Financial Institutions
Banks India Sanks
Danks Institutiuns (SFC, SIDC) (ECGC, DICGC)
(IFCI, IDI,
SIDBI, IDFC,
NABARD, etc)

3.2 STRUCTURE OF FINANCIAL MARKET

Financial Market

Money Market
Capital Market

Secondary Segment
Equity Market Debt Market Primary Segment

Derivatíve
Markut
Primary Market Secondary Market

Exchange Truded Over the Counter

3.2.1 MONEY MARKET

borrowers and lenders ex-

market refers to the market where the
Meaning: Money
financial needs. Such trading is generally
changeshort term funds to solve their
done over the counter.
I.12 Indian Financial System for Student
ts
4.2 SECONDARY MARKET

Secondary market refers to a market where securities are traded after being offered
to the public in the primary market or listed on the Stock Exchange. Following are
some of the functions of secondary market -

I t provides regular information about the value ofthe security,

I t helps to assess the price ofthe securities and the returns,
I t offers liquidity in the market,
The cost of transaction is low.
The secondary market is operated through two mediums, namely, the Over-the-
Counter (OTC) market and the Exchange-Traded market. However the two major
components of secondary markets are - Spot Market ie. where the securities are

traded for immediate delivery & payment and Futures Market i.e. where the securi-
ties are traded for future delivery and payment. Option Market is also anothervari
ant of secondary market.

4.3 DIFFERENCE BETWEEN PRIMARY MARKET AND SEcONDARY MARKEr

Following are some of the differences between the primary market and secondary
market

Point of
Primary Market Secondary Market
Distinction
Nature if It deals with the issue of new Secondary market trades with
Issues securities brought by corporate the securities already issued in
to raise funds for projects. the primary market.
Role of Issuer In Primary Market transac-| There is no direct involvement
tions issuer is directly in- of issuer in secondary market
volved. transaction.
Number of Total Outstanding shares of | Total outstanding shares remains
Outstanding issuer are increased by pri-unchanged in secondary market
Shares
mary market transactions. transactions.
Fund Raising| Funds are raised by issuer in a | No fund raising takes place by the
primary market transaction. issuer in market
secondary
transaction
 Financial System and Its Components I.13

Forms The primary market does not Secondary market deals with
include other long term fi- | variety of assets and includes
nance such as loans and bor-|loans and borrowings also.
rowing from financial institu-
tions and banks.

5. RELATION BETWEEN SECURITTES MARKET AND EcONOMIC GROWTH

A securities market which is functioning well is conducive to sustained economic

growth. There exist a robust two way relationship between securities market and
cconomic growth. Securities market contributes to the economic growth in the fol-
lowing m a n n e r -

(a) augments the quantity of real savings and capital formation from any given level of
national income
(b) increases the net inflow from abroad
(c) increases the productivity of investments by proper allocation of funds
(d) reduces the cost of capital
For any economy to grow, the most important pre-requisite is the mobilization of funds
and capital accumulation. Securities market provides a platform where capital accumu-
lation can talke place. If economic units rely on self finance, growth is restricted. Securi
ties market provides a platform to help investors and borrowers to meet their fund re-
quirements.
Following are some of the additional contributions of securities towards the eco-
nomic growth -

1. It facilitates the internationalization of an economy by linking it with the rest of

the world. This linkage assists through the inflow of capital in the form of portfo
lio investment.
2. It helps in improved investment allocations.
3. The securities market and its institutions help the user in many ways to reduce
the cost of capital. They provide a convenient market place to which investors
and issuers of securities go and thereby avoid the need to search a suitable coun-
terpart.
4. The securities market provides a fast-rate breeding ground for the skills and
judgment needed for entrepreneurship, risk bearing, portfolio selection and

management.